Lease accounting audit under Ind AS 116: what changed

Auditing leases under Ind AS 116 means testing that a right-of-use asset and a corresponding lease liability have been recognised for substantially all leases — including most leases that were previously kept off balance sheet as operating leases — and that the two key judgements behind the numbers, the discount rate and the lease term, are reasonable and consistently applied. It also means confirming the short-term and low-value asset exemptions have been applied only where the lease genuinely qualifies, since misuse of these exemptions is the most common way a company keeps a lease off the balance sheet that should be on it.

What actually changed

Before Ind AS 116, a lease classified as an operating lease — most office and warehouse rentals, and many equipment rentals — stayed off the balance sheet entirely, with only the rental expense appearing in the P&L on a straight-line basis. Ind AS 116 removed that distinction for lessees: with narrow exceptions, every lease is now recognised as a right-of-use asset on one side of the balance sheet and a lease liability on the other, both measured at the present value of the lease payments. The P&L impact changes shape too — instead of a single straight-line rent expense, the company now recognises depreciation on the right-of-use asset and interest on the lease liability separately, which front-loads the total expense in the earlier years of a lease compared to the old straight-line pattern.

How the right-of-use asset and liability are built

Testing the discount rate

The discount rate used to measure the lease liability is the single assumption with the largest effect on both the balance sheet number and the split between depreciation and interest in the P&L, and it is the one most often set by convenience rather than by analysis on a mid-market client.

1. 01Identify which rate the standard calls forThe interest rate implicit in the lease, if that can be readily determined; otherwise the lessee's incremental borrowing rate — the rate the company would have to pay to borrow, over a similar term and with similar security, the funds necessary to obtain an asset of similar value in a similar economic environment.
2. 02Check how the incremental borrowing rate was actually derivedA rate plucked from an existing unrelated term loan, or a round number used across every lease regardless of term or asset type, is a common shortcut. Compare the rate used to the company's actual recent borrowing terms, adjusted for the lease's own tenure and the nature of the underlying asset.
3. 03Check for consistency across similar leasesLeases of similar term, currency and economic environment should generally use a consistent rate-setting approach. A noticeably different rate applied to one lease, with no stated reason, deserves a specific question.
4. 04Recompute the present value for a sampleUsing the payment schedule from the lease agreement and the rate as determined, independently recompute the initial lease liability and compare to what was booked.

Testing the lease term

The lease term is not simply the non-cancellable period stated in the agreement. It includes periods covered by an extension option the lessee is reasonably certain to exercise, and excludes periods covered by a termination option the lessee is reasonably certain to exercise. This judgement directly drives both the lease liability and the right-of-use asset, and it is where management's incentive to keep numbers smaller shows up most often.

• Read the actual lease agreement for renewal and termination clauses, rather than relying on a summary schedule prepared by the client — summaries routinely omit renewal options that were not expected to be exercised at inception but have since become likely.
• Check the company's own history with similar leases: a tenant that has renewed every office lease for the past decade has a pattern that bears on whether 'reasonably certain to renew' should include the next renewal option too.
• Look for economic indicators pointing toward renewal — significant leasehold improvements made to the premises, the business-critical nature of the location, or penalties for not renewing — all of which push toward including the option period.
• Confirm that a change in circumstances during the year — a decision to renew, or a decision not to — has triggered the required remeasurement of the liability and the asset, not just a note for next year's renewal decision.

The short-term and low-value exemptions

Two elections remain available and, used genuinely, are legitimate: a short-term lease (term of 12 months or less at commencement, with no purchase option) and a lease of a low-value underlying asset (assessed on an absolute basis, not relative to the lessee's size) can be expensed on a straight-line basis instead of capitalised. Both are tested for abuse because both are easy to stretch.

1. 01Check the 12-month test at the right dateThe short-term assessment is made at the commencement date of the lease, including any renewal periods the lessee is reasonably certain to exercise. A lease repeatedly renewed year after year, each renewal treated as a fresh short-term lease, defeats the purpose of the exemption and should be challenged.
2. 02Check the low-value assessment is on an absolute basisThe exemption is meant for assets that are low in value when new — typical examples are small items like laptops, tablets or office furniture — assessed in absolute terms, not scaled to how large the lessee's balance sheet is. A fleet of mid-sized vehicles claimed as low-value because the lease payments look small relative to the company's total assets is a misapplication.
3. 03Check for a pattern of leases just under a capitalisation thresholdSeveral leases individually small enough to look immaterial, taken together, can represent a meaningful off-balance-sheet position. Aggregate the exempted leases and assess materiality on the total.

Other errors that recur

• A renewable lease treated at only its non-cancellable term, understating both the asset and the liability when renewal is, in substance, a foregone conclusion.
• Variable lease payments linked to an index or rate included in the initial measurement at the wrong rate — these should be included at the rate or index prevailing at commencement, with subsequent changes affecting the liability only when the cash flows actually change.
• Lease modifications — a rent revision, an extension negotiated mid-term, a change in the leased area — not remeasured at all, left running on the original schedule.
• Right-of-use assets not reviewed for impairment indicators under the normal fixed asset procedures, on the mistaken assumption that lease accounting is a separate, self-contained exercise.
• Sub-lease arrangements, where the company is both lessee and lessor on the same underlying asset, accounted for inconsistently between the two legs.