Lease Liabilities in Results: How Ind AS 116 Turns Rent Into Debt

Open the quarterly results of a retailer, an airline or a telecom company and you will find a line called lease liabilities sitting right next to borrowings. Many first-time readers assume the company has quietly taken on new debt. It usually hasn’t. Understanding lease liabilities in results is mostly about one accounting rule, Ind AS 116, which moved rent out of the expense line and onto the balance sheet. Once you see how that works, a lot of confusing numbers in results season start to make sense.

We will walk through what changed, how the numbers are built, a full worked example with a five-year shop lease, and the ratios that get distorted if you don’t adjust for it.

What Ind AS 116 changed about lease liabilities in results

Before April 2019, Indian companies following Ind AS used Ind AS 17. Leases were split into two buckets. Finance leases went on the balance sheet. Operating leases, which covered most store rents, office rents and a lot of aircraft, did not. The rent simply showed up as an expense, quarter after quarter.

According to the Institute of Chartered Accountants of India, Ind AS 116 became effective from April 1, 2019 for companies implementing Ind AS. It introduced a single lessee accounting model: the lessee recognises assets and liabilities for all leases with a term of more than 12 months, unless the underlying asset is of low value. The Indian standard mirrors the global one. The IFRS Foundation notes that IFRS 16 was issued in January 2016 and applies to annual periods beginning on or after 1 January 2019, replacing IAS 17.

So the old “dual model” is gone for the tenant. Every meaningful lease now creates two new balance sheet items:

• Right-of-use (ROU) asset: the company’s right to use the shop, office, aircraft or tower for the lease term. It sits with fixed assets and is depreciated.
• Lease liability: the present value of the lease payments the company is committed to make. It behaves like a loan. Interest is charged on it, and each payment reduces it.

There are two escape hatches. Short-term leases (12 months or less) and leases of low-value assets can still be expensed the old way. The EY India transition guide hosted by Invest India gives tablets, personal computers, small items of office furniture and telephones as examples of low-value assets.

How the lease liability is measured

The liability is the present value of the future lease payments. The discount rate is the interest rate implicit in the lease, and if that can’t be readily determined, the lessee’s incremental borrowing rate, which is roughly what it would pay to borrow a similar amount over a similar term. That is how the EY guide describes it.

The choice of rate matters more than people think. A higher discount rate gives a smaller liability on day one but more interest each year. Two companies with identical rent bills can therefore show different lease liabilities simply because one borrows more cheaply.

The rent bill didn’t change. The cash leaving the company didn’t change. Only the labels did, and those labels feed straight into EBITDA, debt and every ratio built on them.

A worked example: a five-year shop lease

The numbers below are an illustrative example, not any real company. Say a small retail chain signs a five-year lease for a new store. Rent is ₹12 lakh a year, paid at the end of each year, so ₹60 lakh over the full term. The company’s incremental borrowing rate is 9%.

Day one

Discount the five payments of ₹12 lakh at 9% and you get about ₹46.68 lakh. That is the lease liability. The ROU asset starts at the same ₹46.68 lakh (ignoring deposits and initial direct costs to keep it simple). The balance sheet just grew by ₹46.68 lakh on both sides, and the company hasn’t spent a rupee yet.

Year by year

Each year, interest at 9% is charged on the opening liability, and the ₹12 lakh payment first covers that interest, with the rest reducing the principal. The ROU asset is depreciated straight-line, ₹46.68 lakh over five years, so about ₹9.34 lakh a year.

Figures are rounded, so rows may not add exactly.

Look at the last column. Under the old method, the profit and loss account would have shown a flat ₹12 lakh of rent every year. Now the charge is ₹13.54 lakh in year one and falls to ₹10.33 lakh by year five. The total over five years is still about ₹60 lakh (roughly ₹46.68 lakh of depreciation plus ₹13.32 lakh of interest). The EY guide makes the same point: the different pace of depreciation and interest shifts profit between years, but there is no impact on profit over the total lease term.

The practical takeaway: a company that is opening lots of new stores, with many young leases, will show lower net profit in the early years than it would have under the old rules. A mature chain with mostly old leases sees the reverse.

Where it shows up in the income statement

This is the bit that trips up most readers of quarterly numbers. Under the old method, rent was an operating expense, so it reduced EBITDA. Under Ind AS 116, rent disappears from operating expenses. In its place come depreciation and finance cost, and both of those sit below EBITDA.

In our example, year-one EBITDA goes up by the full ₹12 lakh, because that rent is no longer an operating expense. EBIT (after depreciation) goes up by ₹12 lakh minus ₹9.34 lakh, or ₹2.66 lakh. Profit before tax goes down by ₹1.54 lakh (₹13.54 lakh charge versus ₹12 lakh rent). Three different answers to “did profits improve?” from the same store.

EY’s guide puts it plainly: the increase in EBITDA comes from the reduction in operating lease expenses, which now take the form of depreciation and interest. This is why it pays to work out an “EBITDA after rent” figure for retailers and other lease-heavy businesses. If you’re comparing margins with a company that owns its stores, that adjusted number is the honest one. Our guide to analysing quarterly results of a company covers where these lines sit in the standard results format.

What happens in the cash flow statement

The cash paid to the landlord is the same ₹12 lakh a year. What changes is the section it lands in. EY’s comparison table notes that under Ind AS 17, operating lease payments were included within operating activities. Under Ind AS 116, the principal portion of lease payments is classified within financing activities, and the EY table shows the interest portion within financing activities as well.

The effect is that operating cash flow looks better than before, by the full lease payment, while financing outflow looks heavier. Free cash flow calculated as “operating cash flow minus capex” therefore overstates the cash a lease-heavy business actually throws off. A quick fix: subtract the lease payments (usually disclosed as “payment of lease liabilities” in the financing section) before you call it free cash.

Ratios that move, and how to adjust them

EY lists the ratios Ind AS 116 affects, and the list is long: gearing, current ratio, asset turnover, interest coverage, EBITDA, operating profit, net income, EPS, ROCE, ROE and operating cash flows. Here is how we think about the main ones.

Debt and net debt to EBITDA

Another illustrative example. Suppose a company has ₹200 crore of bank debt, EBITDA of ₹100 crore before Ind AS 116, annual rent of ₹30 crore, and lease liabilities of ₹120 crore once the leases come on the books.

• Old view: debt ₹200 crore, EBITDA ₹100 crore, so debt to EBITDA is 2.0x.
• New view: debt plus lease liabilities ₹320 crore, EBITDA ₹130 crore (rent added back), so the ratio is about 2.46x.
• If someone mixes the two, bank debt of ₹200 crore over the new EBITDA of ₹130 crore, they get about 1.54x and the company looks far safer than it is.

That last mistake is common. Keep numerator and denominator on the same basis: either include lease liabilities and use post-Ind AS 116 EBITDA, or exclude both.

Interest coverage

Both EBIT and interest go up, since interest on lease liabilities is now a finance cost. Whether coverage looks better or worse depends on the lease book. When a company reports a sudden jump in finance costs with no new borrowing, check the notes; it is often lease interest.

ROCE and asset turnover

The ROU asset inflates capital employed and total assets, so asset turnover drops and ROCE can fall even though nothing changed on the ground. Comparing a pre-2019 ROCE with a current one for a retailer, without adjusting, gives you a meaningless trend.

When a lease-heavy company quotes EBITDA growth, the first question is simple: before or after rent?

Which sectors carry big lease liabilities

The EY guide singles out airlines, which finance much of their fleet through leases, retail and consumer businesses with store rentals, telecom with tower-sharing arrangements, and transport and logistics with “wet leases” that bundle a ship or vehicle with crew and maintenance.

For these businesses, the lease liability can rival or exceed bank debt. A “net cash” retailer may in fact have large fixed rent commitments that behave exactly like debt in a downturn, because the landlord still wants paying when footfalls drop.

A checklist for reading lease liabilities in results

1. Find the split. Look for current and non-current lease liabilities in the balance sheet, and for ROU assets within non-current assets.
2. Find the payments. In the cash flow statement, look for payment of lease liabilities in financing activities. That is the real rent bill.
3. Rebuild EBITDA after rent. Subtract those lease payments from reported EBITDA when comparing with peers who own their assets.
4. Check the finance cost note. See how much of interest expense is on lease liabilities versus borrowings.
5. Watch for new leases. A big jump in ROU assets usually means expansion, new stores, new aircraft or new offices, and early-year profits will be weighed down by front-loaded interest.
6. Be consistent. Use the same treatment across every company and every year you compare.

Lease accounting is one of several areas where reported profit and economic reality drift apart. Our explainer on goodwill impairment in results covers another, and listening to the earnings call is often where management explains how much of the margin story is just accounting.

None of this makes leasing bad. Renting a store instead of buying it can be a smart use of capital. The point is to see the commitment clearly, so that a jump in EBITDA after a change of accounting labels doesn’t get mistaken for a better business.

Disclaimer: This article is for educational purposes only and is not investment advice. The worked examples use illustrative numbers, not data for any real company. Please consult a SEBI-registered investment adviser before making investment decisions.