Financial Reporting · Ind AS 116 Leases

Ind AS 116 Lessee Accounting: Lease Term, Exemptions, Right-of-Use Asset and Lease Liability

Updated 5 October 2026 · Fact-checked

Under Ind AS 116, a lessee recognises a right-of-use asset and a lease liability at commencement, unless the lease is short-term or low-value. Fix the lease term, discount unpaid lease payments at the implicit rate or incremental borrowing rate, add direct costs to get the asset, then depreciate the asset and unwind interest on the liability.

Understand Lease Term, Recognition Exemptions and Lessee Accounting

Ind AS 116 has one lessee model. You get the right to use an asset, and you owe payments for it. So you show both on the balance sheet: a right-of-use (ROU) asset and a lease liability. There is no lessee split into finance and operating leases.

Everything starts with the lease term. It is the non-cancellable period, plus periods covered by an extension option if you are reasonably certain to exercise it, plus periods covered by a termination option if you are reasonably certain not to exercise it. Look for economic incentives: significant leasehold improvements, below-market renewal rent, high termination costs, and how critical the asset is to your business.

To fix the non-cancellable period, test enforceability first. A lease is no longer enforceable once both the lessee and the lessor each have the right to terminate it without permission from the other, with no more than an insignificant penalty. This is a test for the enforceable period. It is not the definition of the lease term, which also includes the option periods above.

Reassess the term when there is a significant event or significant change in circumstances that is within your control and affects whether you are reasonably certain to exercise an option. Also revise the term when you exercise an option that was not included in the term, or do not exercise an option that was included.

You may skip the model for two cases and expense the payments, usually straight-line over the lease term. A short-term lease has a lease term of 12 months or less at commencement and has no purchase option. You choose this exemption by class of underlying asset. A low-value asset lease is one where the asset is of low value when new, whatever its age or your own size. You choose this lease by lease. A lease that has a purchase option is never short-term. If the lease term of a short-term lease changes or the lease is modified, treat it as a new lease.

At commencement, the lease liability is the present value of lease payments not yet paid. Discount at the rate implicit in the lease if you can readily determine it. Otherwise use your incremental borrowing rate (IBR): the rate to borrow, over a similar term and with similar security, the funds to obtain a similar asset. The ROU asset is the liability plus payments made at or before commencement, plus initial direct costs, plus estimated restoration costs, less lease incentives received. Restoration costs are included only to the extent you incur the obligation at commencement or as a consequence of using the asset during the lease period. They are not included if the costs are incurred to produce inventories.

After that, under the cost model, you depreciate the ROU asset (Ind AS 16 principles) and test it for impairment (Ind AS 36). The liability goes up by interest at the discount rate and down by payments. So each year the P&L shows depreciation plus interest, not rent. The charge is front-loaded because interest is highest when the balance is highest.

Key rules to remember

Lease term: Non-cancellable period + extension periods (if reasonably certain to exercise) + periods after a termination option (if reasonably certain not to exercise); Assess at commencement. Reassess on a significant event or significant change in circumstances within the lessee's control that affects reasonable certainty. Also revise the term when an option is exercised, or not exercised, contrary to the earlier assessment.
Short-term lease test: Lease term ≤ 12 months at commencement AND no purchase option; Elected by class of underlying asset. Any change in term or a modification means the lease is treated as a new lease.
Low-value test: Value of the underlying asset when new is low; Judged on the asset itself, not on the lessee's size. Elected lease by lease. Not available if the asset depends on or is highly interrelated with other assets.
Lease payments included in the liability: Fixed payments (including in-substance fixed) – lease incentives receivable + index/rate-linked variable payments (at commencement index) + expected residual value guarantee payments + purchase option price (if reasonably certain) + termination penalties (if the term reflects termination); Other variable payments, such as sales-based rent, are left out and expensed when incurred.
Initial lease liability: Σ [Lease payment ÷ (1 + r)ⁿ] for unpaid payments; r is the implicit rate if readily determinable, otherwise the IBR. For payments in advance, the first payment at commencement has n = 0.
Initial ROU asset: Lease liability + payments at or before commencement – incentives received + initial direct costs + estimated restoration costs; Restoration costs are included to the extent the lessee incurs the obligation at commencement or as a consequence of using the asset during the period, and not where incurred to produce inventories. They are recognised as a provision under Ind AS 37.
Subsequent liability: Closing liability = Opening liability + Interest (opening × r) – Payments; Interest goes to the P&L as a finance cost, unless capitalised under Ind AS 23.
Depreciation of ROU asset: (Cost – residual value) ÷ shorter of lease term and useful life; if ownership transfers or a purchase option is reasonably certain, use the useful life; Depreciation starts at commencement date.

How to solve Lease Term, Recognition Exemptions and Lessee Accounting questions

Use this order for any lessee question. It keeps the working in the sequence an examiner marks it.

1Confirm there is a lease and note the commencement date, the lessee's role and the asset.
2Determine the lease term. Start with the non-cancellable period, then test each extension and termination option for economic incentive and reasonable certainty.
3Check the exemptions. Is the term 12 months or less with no purchase option? Is the asset low value when new? If you elect, expense the payments straight-line and stop.
4List the lease payments to include: fixed, index-linked at the current index, expected residual value guarantee, certain purchase option, certain penalties. Exclude other variable payments.
5Choose the discount rate (implicit rate if readily determinable, else IBR) and compute the present value to get the lease liability.
6Build the ROU asset: liability plus advance payments plus initial direct costs plus restoration costs less incentives. Pass the commencement journal.
7Prepare the schedule: for each year, opening liability, interest, payment, closing liability. Compute depreciation over the shorter of lease term and useful life, unless ownership transfers.
8State the year's P&L charge (depreciation plus interest) and the balance sheet figures, split current and non-current for the liability.

Quickest way: Table-first method for lease liability questions

When to use it: Use it when the question gives equal payments, a rate and a term, and asks for journals or year-end balances.

Write the lease term in years first. Mark any option you treat as reasonably certain, with a one-line reason.
Discount each payment separately in a small column: payment, factor, PV. Add to get the liability. Check that the last year's closing balance comes to zero.
Write the commencement entry in one line: Dr ROU asset, Cr Lease liability, Cr Cash (direct costs or advance payment).
Build the three-column schedule: interest = opening × rate, closing = opening + interest – payment.
Compute depreciation once and repeat it. Total P&L charge = depreciation + interest.

Common mistakes in Lease Term, Recognition Exemptions and Lessee Accounting

Using the non-cancellable period as the lease term even when a renewal option is reasonably certain to be exercised.
Students read the contract term and ignore the options and the facts around them, such as big fit-outs or below-market renewal rent.
Fix: Always list the economic incentives in the case. If the facts make renewal reasonably certain, include the renewal period in the lease term and in the payments.
Treating a 9-month lease with a purchase option as a short-term lease.
Students stop at the 12-month test.
Fix: Short-term means 12 months or less and no purchase option. Check both conditions.
Applying the low-value exemption based on the age or current condition of the asset, or the size of the company.
The word 'value' is read as current market value.
Fix: Judge the value of the asset when new. A used asset which was costly when new does not qualify.
Discounting at the lessee's general borrowing cost or WACC, or at the implicit rate when it is not readily determinable.
Students do not read the order of preference for the rate.
Fix: Use the implicit rate if readily determinable; otherwise the IBR for a similar term, security and asset.
Leaving out initial direct costs and advance payments from the ROU asset, or putting them into the lease liability.
Students treat the ROU asset as equal to the liability.
Fix: ROU asset = liability + advance payments + direct costs + restoration costs – incentives. Only the PV of unpaid payments goes into the liability.
Recording the rent paid as an expense after recognising the ROU asset and liability.
The old operating lease habit.
Fix: Payments reduce the liability. The P&L shows depreciation and interest only.

Worked examples

Example 1

Case: Kaveri Retail Ltd (an Ind AS company) takes three leases on 1 April 2026. (i) A showroom for 3 years non-cancellable, with an option to renew for 2 more years at rent well below the expected market rent. Kaveri has spent heavily on customised fit-outs that will last about 5 years and will be lost if it leaves. (ii) A machine for 9 months with an option to buy it at the end at a price below its expected fair value. (iii) Tablets for its staff, each of low value when new, taken for 4 years. Determine the lease term and the accounting approach for each.

Show the solution

Lease (i): the non-cancellable period is 3 years. The renewal rent is below market and the fit-outs have a 5-year life and would be lost on exit. These are strong economic incentives, so Kaveri is reasonably certain to renew.
So the lease term is 5 years. The lease is not short-term, and the ROU asset and lease liability are recognised, with the liability based on payments for 5 years.
Lease (ii): the period is 9 months, within the 12-month limit. But the lease contains a purchase option, so the short-term exemption is not available.
The lease term remains 9 months. A purchase option does not extend the lease term. So Kaveri recognises a ROU asset and a lease liability for the 9-month term.
The option price is included in the lease payments only if exercise of the purchase option is reasonably certain. Because the option is priced below expected fair value, Kaveri must assess this. If exercise is reasonably certain, the option price is included in the payments and the ROU asset is depreciated over the useful life of the machine. If not, the option price is left out and the ROU asset is depreciated over the 9-month term.
Lease (iii): each tablet is of low value when new, and tablets are not highly dependent on or interrelated with other assets. Kaveri can elect the low-value exemption lease by lease, despite the 4-year term.
If it elects, it expenses the payments straight-line over the lease term, or on another systematic basis, without recognising an asset or liability.

Answer: (i) Lease term 5 years; recognise ROU asset and liability. (ii) Not short-term because of the purchase option; lease term stays 9 months; recognise ROU asset and liability, and include the option price only if exercise is reasonably certain. (iii) Low-value exemption may be elected; expense the payments over the lease term.

Example 2

Case: On 1 April 2026, Meghna Textiles Ltd leases a printing machine for 3 years, non-cancellable, with no extension or purchase option. Annual payment is ₹1,33,100, payable at the end of each year. The rate implicit in the lease is not readily determinable. Meghna's incremental borrowing rate is 10% per annum. It pays ₹20,000 of initial direct costs on 1 April 2026. The machine has a useful life of 8 years and ownership does not pass to Meghna. Pass the commencement entry, prepare the liability schedule and find the total P&L charge for 2026-27.

Show the solution

Discount rate: the implicit rate is not readily determinable, so use the IBR of 10%.
PV of payments: Year 1 = 1,33,100 ÷ 1.10 = ₹1,21,000. Year 2 = 1,33,100 ÷ 1.21 = ₹1,10,000. Year 3 = 1,33,100 ÷ 1.331 = ₹1,00,000. Lease liability = ₹3,31,000.
ROU asset = 3,31,000 + 20,000 initial direct costs = ₹3,51,000.
Commencement entry: Dr Right-of-use asset ₹3,51,000; Cr Lease liability ₹3,31,000; Cr Cash ₹20,000.
Schedule, Year 1: opening 3,31,000; interest 33,100; payment 1,33,100; closing 2,31,000.
Year 2: opening 2,31,000; interest 23,100; payment 1,33,100; closing 1,21,000.
Year 3: opening 1,21,000; interest 12,100; payment 1,33,100; closing nil. The nil closing confirms the working.
Depreciation: ownership does not pass and there is no purchase option, so depreciate over the shorter of lease term (3 years) and useful life (8 years), i.e. 3 years. Annual depreciation = 3,51,000 ÷ 3 = ₹1,17,000.
P&L for 2026-27: depreciation ₹1,17,000 + interest ₹33,100 = ₹1,50,100.
Year-end entries for 2026-27: first the interest accrual, Dr Finance cost ₹33,100; Cr Lease liability ₹33,100. Then the payment, Dr Lease liability ₹1,33,100; Cr Cash ₹1,33,100. Liability: 3,31,000 + 33,100 – 1,33,100 = ₹2,31,000.
Depreciation entry: Dr Depreciation ₹1,17,000; Cr Right-of-use asset (accumulated depreciation) ₹1,17,000.

Answer: Lease liability ₹3,31,000; ROU asset ₹3,51,000; total P&L charge for 2026-27 is ₹1,50,100 (depreciation ₹1,17,000 + interest ₹33,100); lease liability at 31 March 2027 is ₹2,31,000.

Exam tips

Case scenario questions hide the lease term in the facts: fit-outs, below-market renewal rent, penalties, critical assets. Quote the fact and the conclusion in your answer, in the form provision, facts, conclusion.
Always check both conditions for the short-term exemption. A purchase option is the usual trap in MCQs.
In numerical questions show the schedule, even when only one year's figure is asked. It earns working marks and shows the closing balance reconciles to nil.
State the choice of discount rate in one line (implicit rate not readily determinable, so IBR). Examiners award a mark for it.
Remember the exemptions are elections. Say 'if the lessee elects' and name the expense pattern, straight-line or another systematic basis.

Practice questions from Ind AS 116 Leases

Lease Term, Recognition Exemptions and Lessee Accounting in other exams

The same ground in other exams, if you are preparing for more than one or want another angle on it.

Lease Term, Recognition Exemptions and Lessee Accounting: frequently asked questions

How do I decide whether a renewal option is included in the lease term?

Include it if you are reasonably certain to exercise it. Look at economic incentives such as below-market renewal rent, significant leasehold improvements, costs of relocating and how important the asset is to the business. Quote the facts from the case in your answer.

Which discount rate do I use for the lease liability?

Use the rate implicit in the lease if it can be readily determined. If not, use the lessee's incremental borrowing rate for a similar term, security and asset. The rate fixed at commencement is used for the schedule unless a remeasurement requires a revised rate.

Can I apply the low-value exemption to any small lease?

No. The test is the value of the underlying asset when new, not the size of the lessee or the rent. It is also not available if the asset depends on or is highly interrelated with other assets. It is elected lease by lease.

What is the effect on the P&L compared with the old operating lease rent?

The P&L shows depreciation of the ROU asset and interest on the liability instead of rent. Compared with straight-line rent, the total charge is front-loaded: higher in the early years and lower in the later years. Over the whole lease the total expense equals the total lease payments (including any made at or before commencement) plus initial direct costs and restoration costs, less any lease incentives received.