Operating Lease vs Finance Lease
Under Ind AS 116 (Leases), which became effective for Indian listed companies from April 2019, virtually all leases are recognised on the lessee's balance sheet as a right-of-use asset and a corresponding lease liability, replacing the earlier distinction where operating leases were kept entirely off-balance-sheet and only finance leases appeared on it.
Before Ind AS 116, leases were classified into two types. A finance lease transferred substantially all the risks and rewards of ownership to the lessee and was recognised on the balance sheet as an asset and a liability. An operating lease was treated like rent — the periodic payment was expensed in the profit and loss account and no balance sheet entries were made. This created significant off-balance-sheet financing, particularly for companies in sectors like aviation, retail, hospitality, and telecom that leased large amounts of property, aircraft, towers, and equipment.
Ind AS 116, aligned with IFRS 16, eliminated this distinction for lessees. With limited exceptions (short-term leases of twelve months or less and leases of low-value assets), all leases must now be capitalised. The lessee recognises a right-of-use (RoU) asset (the present value of future lease payments discounted at the incremental borrowing rate) and a corresponding lease liability. The lease payment is then split into a depreciation charge on the RoU asset (going through the P&L) and an interest charge on the lease liability (also going through the P&L), rather than a single rent expense.
The financial impact on Indian companies was material. IndiGo (InterGlobe Aviation) saw its balance sheet expand significantly when RoU assets for hundreds of leased aircraft were recognised. Retailers like Future Retail, Avenue Supermarts, and Shoppers Stop showed massive increases in reported debt when hundreds of store leases were capitalised. EBITDA improved (because rent expense migrated to depreciation and interest, which are both below EBITDA), while net profit was temporarily lower in early lease years due to front-loaded interest charges.
For analysts and credit rating agencies, Ind AS 116 improved comparability — particularly when comparing Indian companies with global peers who already operated under IFRS 16. Adjusted metrics like EBITDA and EV/EBITDA could now be computed on a more consistent basis. However, leverage ratios such as net debt to EBITDA became elevated for high-lessee companies, and debt covenant calculations in loan agreements had to be carefully reviewed — some specified whether lease liabilities counted as debt for covenant purposes.
For lessors, the classification as operating or finance lease still matters under Ind AS 116, as the recognition model for lessors remains broadly similar to the previous framework under Ind AS 17.