An overview of amendments to Ind AS 116, impacting sale and leaseback accounting

An overview of amendments to Ind AS 116, impacting sale and leaseback accounting

On 9 September 2024, the Ministry of Corporate Affairs (MCA) notified amendment to Indian Accounting Standard (Ind AS) 116 Leases (the amendment). This amendment deals with subsequent accounting for a seller-lessee in respect of the sale leaseback transaction accounted for as a sale under Ind AS 115, Revenue from Contracts with Customers. The amendment specifies how a seller-lessee should measure lease liability arising in a sale and leaseback transaction so that the seller-lessee does not recognize any amount of the gain or loss that relates to the right of use it retains.

The amendment does not change accounting for leases unrelated to sale and leaseback transactions. Further, it does not include any new requirements for initial measurement of the right-of-use asset and lease liabilities arising from a sale- and-leaseback transaction.

The amendment applies to annual reporting periods beginning on or after 1 April 2024.

Background

A sale and leaseback transaction involves the transfer of an asset by an entity (the seller-lessee) to another entity (the buyer-lessor) and the leaseback of the same asset by the seller-lessee. In such transaction, the seller-lessee assesses whether the transfer of the asset satisfies the requirements in Ind AS 115 to be accounted for as a sale. If it is accounted for as a sale, Ind AS 116 requires the seller-lessee to measure the right-of-use asset arising from the leaseback at the proportion of the previous carrying amount of the asset that relates to the right of use retained by the seller-lessee. Accordingly, the seller-lessee recognizes only the amount of any gain or loss that relates to the rights transferred to the buyer-lessor.

However, Ind AS 116 did not specify the measurement of the liability that arises in a sale and leaseback transaction. Hence, pre-amendment, a seller-lessee could have recognized a gain excluded from initial measurement of the right of use asset through remeasurement/ subsequent measurement of lease liabilities. This could have been particularly the case for leaseback transactions, which include variable lease payments that do not depend on an index or rate.

This has been addressed in the amendment.

Amendment to Ind AS 116

The amendment does not prescribe any new requirement for initial measurement of the right-of-use asset and lease liabilities arising from a sale-and-leaseback transaction. On initial recognition, the seller-lessee measures the right-of-use asset as a proportion of the carrying amount of the underlying asset and includes variable lease payments when it measures a liability arising from a sale-and-leaseback transaction.

The amendment prescribes that after the commencement date in a sale and leaseback transaction, the seller-lessee applies paragraphs 29 to 35 of Ind AS 116 to the right-of-use asset arising from the leaseback and paragraphs 36 to 46 of Ind AS 116 to the lease liability arising from the leaseback. In applying paragraphs 36 to 46, the seller-lessee determines ‘lease payments’ or ‘revised lease payments’ in such a way that the seller-lessee would not recognize any amount of the gain or loss that relates to the right of use retained by the seller-lessee. Applying these requirements does not prevent the seller-lessee from recognizing, in profit or loss, any gain or loss relating to the partial or full termination of a lease, as required by paragraph 46(a) of Ind AS 116.

The amendment does not prescribe specific measurement requirements for lease liabilities arising from a leaseback. However, it is clear that the initial measurement of the lease liability arising from a leaseback may result in a seller-lessee determining ‘lease payments’ that are different from the general definition of lease payments in Ind AS 116.

As part of the amendments, an Appendix D has been added to Ind AS 116 which contains two illustrative examples to illustrate the Sale and leaseback transaction with fixed payments and above-market term and the subsequent measurement of a right-of-use asset and lease liability in a sale and leaseback transaction with variable lease payments that do not depend on an index or rate. The second illustrative example clarifies two approaches a seller-lessee may adopt to determine subsequent lease payments. This will require the seller-lessee to develop and apply an accounting policy that results in information that is relevant and reliable in accordance with Ind AS 8 Accounting Policies, Changes in Accounting Estimates and Errors.

The following new examples are included in Ind AS 116.

Example – Sale and leaseback transaction with fixed payments and above-market terms

An entity (Seller-lessee) sells a building to another entity (Buyer-lessor) for cash of INR2,000,000. Immediately before the transaction, the building is carried at a cost of INR1,000,000. At the same time, Seller-lessee enters into a contract with Buyer-lessor for the right to use the building for 18 years, with annual payments of INR120,000 payable at the end of each year. The terms and conditions of the transaction are such that the transfer of the building by Seller-lessee satisfies the requirements of Ind AS 115, Revenue from Contracts with Customers to be accounted for as a sale of the building. Accordingly, Seller-lessee and Buyer-lessor account for the transaction as a sale and leaseback.

The fair value of the building at the date of sale is INR1,800,000. Because the consideration for the sale of the building is not at fair value, Seller-lessee and Buyer-lessor make adjustments to measure the sale proceeds at fair value. Applying paragraph 101(b) of Ind AS 116, the amount of the excess sale price of INR200,000 (INR2,000,000 – INR1,800,000) is recognized as additional financing provided by Buyer-lessor to Seller-lessee.

The interest rate implicit in the lease is 4.5% per annum, which is readily determinable by Seller-lessee. The present value of the annual payments (18 payments of INR120,000, discounted at 4.5% per annum) is INR1,459,200, of which INR200,000 relates to the additional financing and INR1,259,200 relates to the lease-corresponding to 18 annual payments of INR16,447 and INR103,553, respectively.

Buyer-lessor classifies the lease of the building as an operating lease.

Seller-lessee

Applying paragraph 100(a) of Ind AS 116, at the commencement date, Seller-lessee measures the right-of- use asset arising from the leaseback of the building at the proportion of the previous carrying amount of the building that relates to the right-of-use retained by Seller-lessee, which is INR699,555. Seller-lessee calculates this amount as: INR1,000,000 (the carrying amount of the building) × INR1,259,200 (the discounted lease payments for the 18- year right-of-use asset) ÷ INR1,800,000 (the fair value of the building).

Seller-lessee recognizes only the amount of the gain that relates to the rights transferred to Buyer-lessor of INR240,355 calculated as follows. The gain on sale of the building amounts to INR800,000 (INR1,800,000 - INR1,000,000), of which:

a) INR559,645 (INR800,000 × INR1,259,200 ÷ INR1,800,000) relates to the right to use the building retained by Seller-lessee, and

b) INR240,355 (INR800,000 × (INR1,800,000 – INR1,259,200) ÷ INR1,800,000) relates to the rights transferred to Buyer-lessor.

At the commencement date, Seller-lessee accounts for the transaction as follows:

Buyer-lessor

At the commencement date, Buyer-lessor accounts for the transaction, as follows:

After the commencement date, the buyer-lessor accounts for the lease by treating INR103,553 of the annual payments of INR120,000 as lease payments. The remaining INR16,447 of annual payments received from seller-lessee are accounted for as (a) payments received to settle the financial asset of INR200,000 and (b) interest revenue.

Second example illustrates a sale and leaseback transaction with variable lease payments that do not depend on an index or rate.

Example: subsequent measurement of a right-of- use asset and lease liability in a sale and leaseback transaction with variable lease payments that do not depend on an index or rate

An entity (Seller-lessee) sells a building to another entity (Buyer-lessor) for cash of INR1,800,000 (the fair value of the building at the date of sale). Immediately before the transaction, the building is carried at a cost of INR1,000,000. At the same time, Seller-lessee enters into a contract with Buyer-lessor for the right to use the building for five years. Lease payments — payable annually — comprise fixed payments and variable payments that do not depend on an index or rate.

The terms and conditions of the transaction are such that the transfer of the building by Seller-lessee satisfies the requirements of Ind AS 115 Revenue from Contracts with Customers to be accounted for as a sale of the building. Accordingly, Seller-lessee accounts for the transaction as a sale and leaseback.

The interest rate implicit in the lease cannot be readily determined. Seller-lessee’s incremental borrowing rate is 3% per annum.

Under paragraph 100(a) of Ind AS 116, the seller-lessee determines 25% of the building transferred to the buyer-lessor pertains to the right of use it retains1.

Consequently, at the commencement date Seller-lessee accounts for the transaction as follows.

Seller-lessee expects to consume the right-of-use asset’s future economic benefits evenly over the lease term and, thus, depreciates the right-of-use asset on a straight-line basis.

In measuring the lease liability applying paragraphs 36-46 of Ind AS 116, Seller-lessee develops an accounting policy for determining ‘lease payments’ in a way that it would not recognize any amount of the gain that relates to the right of use it retains. Depending on the circumstances (including the method Seller-lessee used - applying paragraph 100(a) of Ind AS 116 - for determining the measurement of the right-of- use asset and the gain recognized on the transaction at the commencement date), either Approach 1 or Approach 2 could meet the requirements in paragraph 102A.

1. Applying paragraph 100(a) of Ind AS 116, Seller-lessee determines the proportion of the building transferred to Buyer-lessor that relates to the right of use retained by comparing, at the commencement date, the right of use it retains via the leaseback to the rights comprising the entire building. Paragraph 100(a) does not prescribe a particular method for determining that proportion.

Approach 1: expected lease payments at the commencement date

Applying paragraph 102A of Ind AS 116, Seller-lessee determines ‘lease payments’ to reflect the expected lease payments at the commencement date that, when discounted using its incremental borrowing rate, result in the carrying amount of the lease liability at that date of INR450,000. The lease liability and the right-of-use asset arising from the leaseback are:

In applying paragraph 102A and paragraph 38(b) of Ind AS 116, seller-lessee recognizes in profit or loss the difference between the payments made for the lease and the lease payments that reduce the carrying amount of the lease liability. For example, if seller-lessee pays INR99,321 for the use of the building in Year 2, it recognizes INR1,197 (INR99,321 – INR98,124) in profit or loss.

Approach 2: equal lease payments over the lease term

Applying paragraph 102A of Ind AS 116, Seller-lessee determines ‘lease payments’ to reflect equal periodic payments over the lease term that, when discounted using its incremental borrowing rate, result in the carrying amount of the lease liability at the commencement date of INR450,000.

The lease liability and the right-of-use asset arising from the leaseback are:

In applying paragraph 102A and paragraph 38(b) of Ind AS 116, seller-lessee recognizes in profit or loss the difference between the payments made for the lease and the lease payments that reduce the carrying amount of the lease liability. For example, if seller-lessee pays INR99,321 for the use of the building in Year 2, it recognizes INR1,061 (INR99,321 – INR98,260) in profit or loss.

2. Applying paragraph 102A and paragraph 36(b) of Ind AS 116, Seller-lessee reduces the carrying amount of the lease liability with ‘lease payments’ that reflect the expected lease payments estimated at the commencement date and, when discounted, result in the carrying amount of the lease liability at that date of INR450,000.

3. Applying paragraph 102A and paragraph 36(a) of Ind AS 116, Seller-lessee increases the carrying amount of the lease liability to reflect interest on the lease liability using its incremental borrowing rate.

4. Applying paragraph 102A and paragraph 36(b) of Ind AS 116, Seller-lessee reduces the carrying amount of the lease liability with ‘lease payments’ that reflect equal periodic payments over the lease term that, when discounted, result in the carrying amount of the lease liability at the commencement date of INR450,000.

Effective date and transition

The amendment is effective for the annual reporting periods beginning on or after 1 April 2024.

A seller-lessee applies the amendment retrospectively in accordance with Ind AS 8 to sale and leaseback transactions entered into after the date of initial application of Ind AS 116. (i.e., the amendment does not apply to sale and leaseback transactions entered into prior to the date of initial application). The date of initial application is the beginning of the annual reporting period in which an entity first applied Ind AS 116 .

How we see it

The amendment may represent a significant change in accounting policy for entities that enter into sale and leaseback transactions with variable payments that do not depend on an index or rate. Entities will need to determine an accounting policy in accordance with Ind AS 8 for the ‘lease payments’ in these types of transaction.