A retailer leases 300 stores. It owns none of them. Until 2019, none of them appeared on its balance sheet either — the rent was simply an expense in the profit and loss account. Today those stores sit on the balance sheet as a single line item called a right-of-use asset, and the change reshaped how leased businesses look to anyone reading their accounts.
What is a Right-of-Use Asset?
A right-of-use (ROU) asset represents a lessee’s right to use an underlying leased asset over the lease term.
The conceptual shift matters. You are not recognising the building, the aircraft or the machinery — you do not own those. You are recognising the right to use them for an agreed period, which Ind AS 116 treats as an asset in its own right because it delivers economic benefits you control.
Every ROU asset has a matching lease liability — the obligation to make the lease payments. The two are recognised together at the commencement date.
What Changed
| Before (Ind AS 17) | Now (Ind AS 116) | |
|---|---|---|
| Lessee lease types | Operating and finance leases treated differently | Single model for almost all leases |
| Operating leases on balance sheet? | No — disclosed in notes only | Yes — ROU asset and lease liability |
| P&L charge | Single straight-line rent expense | Depreciation on ROU asset plus interest on liability |
| Balance sheet effect | Leases largely invisible | Assets and liabilities both increase |
The old distinction let companies structure leases to stay off balance sheet. Two retailers with identical economics could look very different depending on how their lease contracts were drafted. Ind AS 116 removed that choice for lessees.
Note that lessor accounting is largely unchanged — lessors still classify leases as finance or operating.
What Counts as a Lease
Ind AS 116 defines a lease as a contract, or part of a contract, that conveys the right to control the use of an identified asset for a period of time in exchange for consideration.
Two tests sit inside that definition:
- Is there an identified asset? The asset must be specified, either explicitly or implicitly. If the supplier has a substantive right to substitute a different asset, there is no identified asset and therefore no lease.
- Does the customer control its use? The customer must obtain substantially all the economic benefits and direct how and for what purpose the asset is used.
This assessment is made at the inception date — the earlier of the agreement date and the date the parties commit to the principal terms.
The practical consequence: some contracts that were never called leases turn out to contain them. Long-term outsourcing arrangements, dedicated warehousing and certain supply contracts can all embed a lease if a specific asset is dedicated to the customer.
Initial Measurement of the ROU Asset
The ROU asset is measured at cost, comprising four components:
| Component | Detail |
|---|---|
| Initial lease liability | Present value of remaining lease payments |
| Payments made at or before commencement | Less any lease incentives received |
| Initial direct costs | Incremental costs of obtaining the lease |
| Restoration costs | Estimated cost of dismantling, removing or restoring the asset |
In most straightforward leases the ROU asset and the lease liability start at similar amounts, because the first three components are small. They then diverge — which is the point covered next.
Why the Asset and Liability Diverge
After commencement, the two are measured on completely different bases:
- The ROU asset is depreciated on a straight-line basis over the lease term
- The lease liability unwinds using the effective interest method — interest accrues, payments reduce the balance
Straight-line depreciation is even. Interest unwinding is not — it is highest early, when the liability balance is largest, and falls as the liability is paid down.
The result is a front-loaded total expense. Combined depreciation plus interest exceeds the old straight-line rent in early years and falls below it later, even though total cost over the full term is identical.
| Year | Old: rent expense | New: depreciation + interest |
|---|---|---|
| Early years | Level | Higher |
| Middle years | Level | Roughly equal |
| Later years | Level | Lower |
| Total over lease | The same | |
For a company with a stable, continuously renewed lease portfolio, the front-loading across many leases at different stages largely evens out. For one that has recently expanded rapidly, the effect on reported profit can be pronounced.
Where It Appears in the Financial Statements
| Statement | Presentation |
|---|---|
| Balance sheet | ROU assets presented separately or within the same line as the corresponding owned assets, with disclosure; lease liabilities shown separately |
| Profit and loss | Depreciation within operating expenses; interest within finance costs |
| Cash flow — principal | Financing activities |
| Cash flow — interest | Operating or financing, per the entity’s policy under Ind AS 7 |
The cash flow reclassification is significant and often overlooked. Rent used to sit entirely in operating cash flow. Now the principal portion moves to financing, which increases reported operating cash flow without any change in the actual cash the business generates.
The Two Exemptions
Ind AS 116 permits lessees to skip recognition for two categories:
- Short-term leases — term of 12 months or less at commencement, with no purchase option. Elected by class of underlying asset.
- Low-value assets — assessed on the value of the underlying asset when new. Elected lease by lease.
Where an exemption applies, payments are simply recognised as an expense over the lease term. See Ind AS 116 lease exemptions for the detail, including why no monetary threshold exists for low-value assets.
Why Investors Should Care
If you compare a company’s FY2019 and FY2020 balance sheets and see debt jump sharply with no corresponding borrowing, lease capitalisation is very likely the reason.
The effects on commonly used metrics:
| Metric | Effect |
|---|---|
| Total assets | Increase |
| Total liabilities | Increase |
| Debt-to-equity | Rises — often materially for lease-heavy sectors |
| EBITDA | Rises — rent leaves operating expenses |
| Operating cash flow | Rises |
| Current ratio | Falls — current portion of lease liability added |
None of this reflected any change in the underlying businesses. Retail chains, airlines, hotels and telecom companies were affected most. Comparing pre-2019 and post-2019 figures without adjusting for this is a genuine analytical trap — covered in how Ind AS 116 changed financial ratios.
Key Takeaways
- An ROU asset represents the right to use a leased asset, not ownership of it
- Ind AS 116 (effective 1 April 2019) put almost all lessee leases on the balance sheet
- Every ROU asset has a matching lease liability
- ROU asset is depreciated straight-line; liability unwinds at effective interest
- This makes the total expense front-loaded, though total cost is unchanged
- Principal repayment moved to financing cash flow, lifting reported operating cash flow
- Two exemptions: short-term (≤12 months) and low-value assets
- Lessor accounting is largely unchanged
Frequently Asked Questions (FAQ)
Q: What is a right-of-use asset in simple terms?
A right-of-use asset is the value of your right to use something you have leased — an office, a vehicle, machinery — over the lease term. You do not own the underlying asset, but Ind AS 116 treats the right to use it as an asset because it delivers economic benefits you control.
Q: How is a right-of-use asset calculated?
At cost, comprising the initial lease liability (present value of lease payments), any payments made at or before commencement less incentives received, initial direct costs, and estimated restoration costs. It is then depreciated over the lease term.
Q: Is a right-of-use asset a fixed asset?
It is a non-current asset presented either separately or within the same line as the corresponding owned assets, with disclosure of the amounts. It is not property, plant and equipment in the ownership sense, since the entity holds a right to use rather than title.
Q: Why do the ROU asset and lease liability differ after year one?
Because they are measured differently. The ROU asset depreciates evenly over the lease term, while the lease liability unwinds using the effective interest method — reducing slowly at first and faster later. They start at similar amounts and diverge over the term.
Q: Does Ind AS 116 apply to lessors as well?
Lessor accounting is largely unchanged. Lessors continue to classify leases as finance or operating and account for them broadly as before. The substantial change applies to lessees.
Q: When did Ind AS 116 become applicable in India?
It became applicable from 1 April 2019, replacing Ind AS 17, following the Ministry of Corporate Affairs notification. It is the Indian equivalent of IFRS 16, which the IASB issued in January 2016.
Q: Which companies does Ind AS 116 apply to?
Any company required to follow the Ind AS framework, which includes listed companies and unlisted companies meeting prescribed thresholds. Certain scope exclusions apply, such as leases for exploration of natural resources and service concession arrangements.
Q: Why did some companies’ debt jump in FY2020?
Because lease liabilities that were previously off balance sheet were recognised for the first time. No new borrowing occurred — the obligations already existed and were disclosed in notes. Retail, aviation, hotels and telecom were affected most.
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