Ind AS 116 Lease Accounting

Since its mandatory adoption for accounting periods beginning on or after 1 April 2019, Ind AS 116 has transformed lease accounting for Indian companies. The standard, which converges with IFRS 16 issued by the International Accounting Standards Board (IASB), eliminated the operating-versus-finance lease distinction for lessees and introduced a single on-balance-sheet model. For professionals engaged in business valuation, understanding these accounting changes is not optional — it is essential for producing credible, defensible valuation reports.

This article provides a comprehensive analysis of how Ind AS 116 affects valuation, EBITDA computation, financial ratio analysis, debt covenant compliance, and discounted cash flow (DCF) modelling. We also examine practical expedients, transition approaches, and audit considerations relevant to Indian entities.

1. Overview of Ind AS 116: Key Principles

Under the erstwhile Ind AS 17, lessees classified leases as either operating or finance leases. Operating leases remained off-balance-sheet, with rental payments recognised as an expense on a straight-line basis. Ind AS 116 fundamentally changes this by requiring lessees to:

• Recognise a right-of-use (ROU) asset — representing the lessee’s right to use the underlying asset over the lease term.
• Recognise a lease liability — measured at the present value of future lease payments, discounted using the interest rate implicit in the lease or, if that rate cannot be readily determined, the lessee’s incremental borrowing rate (IBR).
• Depreciate the ROU asset — typically on a straight-line basis over the shorter of the lease term and the useful life of the underlying asset.
• Recognise interest expense — on the lease liability using the effective interest method.

For lessors, the accounting model remains largely unchanged — lessors continue to classify leases as operating or finance leases under Ind AS 116.

2. Right-of-Use Asset Recognition & Measurement

The ROU asset is initially measured at cost, which comprises:

• The initial measurement of the lease liability;
• Any lease payments made at or before the commencement date, less any lease incentives received;
• Initial direct costs incurred by the lessee; and
• An estimate of costs to dismantle and remove the underlying asset or restore the site (decommissioning obligations).

Subsequently, the ROU asset is measured at cost less accumulated depreciation and impairment losses, unless the lessee applies the revaluation model under Ind AS 16 (Property, Plant and Equipment) or the fair value model under Ind AS 40 (Investment Property).

2.1 Impact on the Balance Sheet

The recognition of ROU assets and lease liabilities grosses up the balance sheet. For asset-light businesses — such as retail chains, airlines, and IT services companies that rely heavily on leased office space — the impact can be dramatic. A company that previously showed minimal fixed assets may now report substantial non-current assets, alongside a corresponding increase in financial liabilities.

This balance sheet expansion has direct consequences for valuation. Metrics such as return on assets (ROA), return on capital employed (ROCE), and the debt-to-equity ratio are all affected. Valuers must be aware of these shifts when performing ratio analysis as part of a valuation engagement.

3. Lease Liability Measurement & Discount Rate Determination

The lease liability is measured at the present value of lease payments not yet paid at the commencement date. These payments include:

• Fixed payments (including in-substance fixed payments), less any lease incentives receivable;
• Variable lease payments dependent on an index or rate;
• Amounts expected to be payable under residual value guarantees;
• The exercise price of a purchase option, if the lessee is reasonably certain to exercise it; and
• Penalties for terminating the lease, if the lease term reflects the lessee’s exercise of a termination option.

3.1 Incremental Borrowing Rate (IBR)

The discount rate used to calculate the lease liability is a critical input. Ind AS 116 prescribes the use of the interest rate implicit in the lease. However, since this rate is rarely available to lessees, most Indian entities use the incremental borrowing rate (IBR) — the rate the lessee would pay to borrow funds of a similar amount, for a similar term, with similar security, in a similar economic environment.

Determining the IBR involves judgement. Factors to consider include:

• The lessee’s credit profile and credit rating;
• The tenure of the lease;
• The nature and quality of the underlying asset (as security);
• The economic environment and prevailing interest rates (including the Reserve Bank of India’s repo rate); and
• The currency in which lease payments are denominated.

For valuation purposes, the IBR directly affects the magnitude of the lease liability recognised. A lower IBR inflates the lease liability (and the corresponding ROU asset), while a higher IBR reduces it. Since the lease liability is treated as debt-like in many valuation frameworks, the IBR selection can materially influence enterprise value calculations.

4. EBITDA vs EBITDAR: Adjustments in Valuation

One of the most significant consequences of Ind AS 116 for valuation practitioners is its impact on EBITDA (Earnings Before Interest, Tax, Depreciation & Amortisation). Under Ind AS 17, operating lease rentals were deducted as an operating expense before EBITDA. Under Ind AS 116, these payments are replaced by:

• Depreciation of the ROU asset — which is excluded from EBITDA; and
• Interest on the lease liability — which is also excluded from EBITDA.

The net effect is that EBITDA under Ind AS 116 is higher than it would have been under Ind AS 17 for the same underlying economics. This inflation is not indicative of improved operational performance — it is purely an accounting reclassification.

4.1 Implications for EV/EBITDA Multiples

The EV/EBITDA multiple is one of the most widely used valuation metrics in India, particularly for mid-market transactions and private equity deals. If EBITDA is inflated under Ind AS 116, using unadjusted EV/EBITDA multiples will understate the effective valuation multiple and potentially lead to overvaluation.

To maintain comparability, valuation professionals have two primary approaches:

1. Use EBITDAR (Earnings Before Interest, Tax, Depreciation, Amortisation & Rent) — Add back the operating lease rental to arrive at a pre-lease earnings metric that is consistent across both accounting regimes. This is particularly useful when comparing companies that adopted Ind AS 116 at different times or when benchmarking against companies reporting under other GAAPs.
2. Adjust enterprise value — If using EBITDA as the earnings metric, ensure that enterprise value (EV) includes the capitalised lease liabilities as a debt-like item. This ensures that the numerator and denominator of the EV/EBITDA ratio are consistent.

Both approaches should yield similar valuation conclusions if applied consistently. The key is to avoid mixing pre-Ind AS 116 multiples with post-Ind AS 116 EBITDA figures without appropriate adjustment.

4.2 Sector-Specific Considerations

The magnitude of the EBITDA impact varies significantly by sector. Industries with substantial lease commitments — such as retail (store leases), aviation (aircraft leases), hospitality (hotel property leases), telecommunications (tower leases), and IT/ITES (office space leases) — experience the most pronounced effects. For example, an airline company’s EBITDA may increase by 30–50% under Ind AS 116, fundamentally altering the perception of its operational profitability.

5. Impact on Debt Covenants & Credit Analysis

The recognition of lease liabilities as financial liabilities on the balance sheet can trigger breaches of debt covenants. Common covenants affected include:

• Debt-to-equity ratio — Lease liabilities increase total debt, potentially pushing the ratio beyond permitted limits.
• Interest coverage ratio (ICR) — While EBITDA increases, the interest expense also increases (due to the interest component of lease payments), and the net effect on ICR depends on the relative magnitudes.
• Net debt/EBITDA — Both the numerator (net debt, including lease liabilities) and denominator (EBITDA) increase, but the numerator typically increases by more, worsening this ratio.
• Fixed charge coverage ratio — This ratio may improve if the fixed charges now exclude the full lease rental (which is replaced by depreciation and interest).

Valuers conducting distressed asset valuations or assessing going concern should pay close attention to whether Ind AS 116 adoption has triggered covenant breaches. Such breaches can accelerate debt repayment obligations and affect the entity’s viability, which in turn affects valuation under both going concern and liquidation scenarios.

6. Sale-and-Leaseback Transactions

Ind AS 116 introduces specific guidance on sale-and-leaseback transactions. If the transfer of the asset satisfies the requirements of Ind AS 115 (Revenue from Contracts with Customers) to be accounted for as a sale, the seller-lessee recognises only the amount of any gain or loss that relates to the rights transferred to the buyer-lessor.

6.1 Valuation & Tax Implications

Sale-and-leaseback transactions are frequently used for balance sheet optimisation, particularly in real estate. From a valuation perspective, the critical question is whether the transaction reflects an arm’s length fair value for the underlying asset.

Under the Income Tax Act, 1961, the interaction of sale-and-leaseback transactions with provisions such as Section 115BAC (for individuals opting for the new tax regime) and Section 43CA (for transfer of land or building below stamp duty value) requires careful analysis. While Section 115BAC is primarily applicable to individual taxpayers, corporate entities engaged in sale-and-leaseback transactions must consider the capital gains implications, GST treatment, and stamp duty considerations specific to the state in which the property is located.

For the buyer-lessor, the acquisition represents a capital investment, and the lease income must be assessed under the appropriate head of income. Transfer pricing implications may also arise if the sale-and-leaseback is between related parties.

7. Practical Expedients: Short-Term & Low-Value Leases

Ind AS 116 provides two important practical expedients that allow lessees to avoid the full recognition requirements:

7.1 Short-Term Leases

A short-term lease is one with a lease term of 12 months or less at the commencement date, without a purchase option. For such leases, the lessee may elect (on a class-by-class basis) to recognise lease payments as an expense on a straight-line basis over the lease term, without recognising an ROU asset or lease liability.

7.2 Low-Value Leases

Leases for which the underlying asset has a low value when new (the IASB indicated a threshold of approximately USD 5,000) may also be exempted. This exemption is applied on a lease-by-lease basis. Common examples include laptops, tablets, small office furniture, and mobile phones.

From a valuation standpoint, these exemptions mean that not all leases will appear on the balance sheet. Valuers should request a schedule of off-balance-sheet lease commitments (short-term and low-value leases) to assess whether material lease obligations remain unrecognised.

8. Transition Approaches: Modified Retrospective Method

When Ind AS 116 was first adopted, entities could choose between two transition approaches:

1. Full retrospective approach — Restate comparative periods as if Ind AS 116 had always been applied. This approach, while theoretically purer, was rarely used due to the significant data requirements and cost.
2. Modified retrospective approach — Apply Ind AS 116 at the date of initial application (1 April 2019 for most Indian entities) without restating comparatives. The cumulative effect of initial application is recognised as an adjustment to the opening balance of retained earnings.

The modified retrospective approach further offered two measurement options for the ROU asset:

• Measure at an amount as if Ind AS 116 had been applied since commencement, discounted using the IBR at the date of initial application; or
• Measure at an amount equal to the lease liability, adjusted for any prepaid or accrued lease payments.

For valuers, the transition approach adopted affects the comparability of financial statements across periods. If the entity used the modified retrospective approach, the opening balance sheet will show a step-change in assets and liabilities that does not reflect any change in the underlying business economics. Historical trend analysis — critical for DCF modelling and relative valuation — must account for this discontinuity.

9. Impact on DCF Models & Enterprise Valuation

Discounted cash flow (DCF) modelling requires careful treatment of lease-related cash flows under Ind AS 116. There are two primary approaches:

9.1 Approach 1: Treat Leases as Operating Expenses (Pre-Ind AS 116 Basis)

Under this approach, the valuer reverses the Ind AS 116 adjustments and treats lease payments as operating expenses in the free cash flow (FCF) calculation. This means:

• Adding back ROU asset depreciation;
• Adding back interest on lease liabilities;
• Deducting the actual lease rental payment as an operating expense;
• Excluding lease liabilities from the bridge between enterprise value and equity value.

This approach is simpler and avoids double-counting, but it requires access to the actual lease payment schedule.

9.2 Approach 2: Treat Leases as Financing (Post-Ind AS 116 Basis)

Under this approach, the Ind AS 116 accounting is retained in the DCF model. The valuer:

• Computes EBITDA inclusive of the Ind AS 116 benefit (i.e., without deducting lease rentals);
• Deducts depreciation of ROU assets and interest on lease liabilities in the appropriate line items;
• Treats the principal repayment portion of lease payments as a financing cash flow;
• Includes lease liabilities as a debt-like item in the enterprise value-to-equity value bridge.

Both approaches should yield the same equity value if applied correctly. However, Approach 2 requires the valuer to ensure that the weighted average cost of capital (WACC) computation is consistent — specifically, that the cost of debt reflects the inclusion of lease liabilities in the capital structure.

9.3 Terminal Value Considerations

In the terminal value calculation, the treatment of leases must be consistent with the explicit forecast period. If leases are treated as financing, the terminal value EBITDA should include the Ind AS 116 uplift, and the terminal value enterprise value must be adjusted for the present value of lease liabilities extending beyond the forecast period. Failure to maintain consistency here is a common source of valuation error.

10. Impact on EV/EBITDA Multiples: A Worked Example

Consider a hypothetical Indian IT services company with the following financials:

If the company’s equity value is INR 3,000 Cr and non-lease debt is INR 200 Cr:

• Pre-Ind AS 116 EV: 3,000 + 200 = 3,200 Cr; EV/EBITDA = 3,200 / 300 = 10.7x
• Post-Ind AS 116 EV (including lease liability): 3,000 + 200 + 450 = 3,650 Cr; EV/EBITDA = 3,650 / 400 = 9.1x

The multiple appears to decrease post-Ind AS 116 because the EBITDA inflation (33%) exceeds the EV inflation (14%). This demonstrates why comparing multiples across accounting regimes without adjustment can be misleading.

11. Audit Considerations for Lease Accounting

Auditors reviewing Ind AS 116 implementation should focus on several key areas that also have direct relevance for valuation:

• Completeness of the lease register — Have all leases been identified, including embedded leases in service contracts?
• Lease term determination — Has the entity appropriately assessed extension and termination options? The lease term directly affects the magnitude of the ROU asset and lease liability.
• IBR determination — Is the incremental borrowing rate reasonable and supportable? Has it been updated for lease modifications?
• Lease modifications — Have modifications (changes in scope, consideration, or term) been correctly accounted for as either a separate lease or a remeasurement?
• Disclosure adequacy — Has the entity provided the maturity analysis of lease liabilities, variable lease payment information, and qualitative disclosures required by the standard?

For valuers relying on audited financial statements, the quality of the Ind AS 116 audit directly affects the reliability of the lease-related inputs to the valuation model. Engaging with the statutory auditor to understand key judgements made in lease accounting is a recommended best practice.

12. Interaction with Other Standards & Regulations

12.1 Ind AS 36 (Impairment of Assets)

ROU assets are subject to impairment testing under Ind AS 36. If the recoverable amount of a cash-generating unit (CGU) that includes ROU assets falls below its carrying amount, an impairment loss must be recognised. This is particularly relevant for leased assets in underperforming business segments.

12.2 Ind AS 8 (Accounting Policies, Changes in Estimates & Errors)

Changes in estimates — such as revised assessments of lease terms or updated IBRs — are accounted for prospectively under Ind AS 8. Valuers should be alert to significant changes in estimates that may indicate management judgement or potential earnings management.

12.3 Companies Act, 2013

The recognition of ROU assets and lease liabilities affects various computations under the Companies Act, 2013, including net worth calculations (relevant for Section 135 CSR thresholds), dividend distribution (available profits), and the preparation of financial statements in compliance with Schedule III.

13. Practical Guidance for Valuation Professionals

Based on our experience at Virtual Auditor, we recommend the following practical steps when valuing entities with material lease obligations under Ind AS 116:

1. Obtain the complete lease register — including details of all leases, their terms, payment schedules, extension/termination options, and the IBR applied.
2. Reconcile EBITDA to a pre-lease basis — to ensure comparability with historical periods and peer companies.
3. Assess whether lease liabilities should be treated as debt — In most valuation frameworks (DCF, comparable companies, precedent transactions), lease liabilities under Ind AS 116 are treated as debt-equivalent items. However, the treatment may vary depending on the purpose of the valuation and the applicable regulations.
4. Adjust WACC for lease liabilities — If lease liabilities are included in the capital structure, the cost of debt component of WACC should reflect the blended cost of financial debt and lease liabilities.
5. Perform sensitivity analysis on the IBR — Given the judgement involved, test the valuation sensitivity to changes in the IBR.
6. Consider off-balance-sheet leases — Short-term and low-value leases excluded from Ind AS 116 recognition may still represent material commitments.

14. Impact on Specific Valuation Approaches

14.1 Income Approach (DCF)

As discussed in Section 9, the DCF model must consistently treat leases as either operating or financing items. The choice affects free cash flow computation, WACC, and the equity value bridge. Consistency between the explicit forecast period and terminal value is paramount.

14.2 Market Approach (Comparable Companies & Precedent Transactions)

When using EV/EBITDA multiples from comparable companies, the valuer must ensure that both the subject company and the comparables are on the same accounting basis. If comparable companies report under IFRS 16 (equivalent to Ind AS 116), the multiples should be directly comparable. However, if comparables report under US GAAP (which has a different leasing standard, ASC 842, with a dual-model approach for operating vs finance leases), adjustments are necessary.

14.3 Asset Approach (Net Asset Value)

Under the asset approach, ROU assets must be fair valued. This requires an assessment of whether the lease terms are at, above, or below market rates. A lease at below-market rates represents a favourable lease intangible, while an above-market lease represents an unfavourable lease liability — both relevant for purchase price allocation under Ind AS 103 (Business Combinations).

15. Future Developments & Emerging Issues

The Institute of Chartered Accountants of India (ICAI) continues to issue guidance on Ind AS 116 implementation. Emerging issues include the treatment of COVID-19-related rent concessions (which were addressed through amendments permitting practical expedients), the accounting for variable lease payments linked to revenue or usage, and the interaction of Ind AS 116 with the Insolvency and Bankruptcy Code, 2016 (IBC) — where the classification of lease liabilities as financial debt or operational debt has significant implications for resolution plans.

The Ministry of Corporate Affairs (MCA) also periodically updates the Indian Accounting Standards through notifications, and valuation professionals must stay current with these developments.

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About the Author

Virtual Auditor | CA V. Viswanathan | IBBI Registered Valuer (Reg. No. IBBI/RV/03/2019/12333) | No. 7/5, Madley Road, T. Nagar, Chennai 600017 | virtualauditor.in | +91-44-2434-0634