Accounting for Construction on Leased Land under Ind AS 116

1. Query

Gamma Limited (hereinafter referred to as ‘the Company’), is a public sector undertaking incorporated with the primary objective of executing railway infrastructure projects. The Company has been established as a joint initiative of the Ministry of Railways (MoR) and a State Government, with the Ministry of Railways being the majority stakeholder. The Company functions as a project implementation agency for railway infrastructure development.

As per the governing arrangements between the Company and the Ministry of Railways, the Company undertakes the execution of infrastructure projects on behalf of the Railways. In such cases, the assets created under these projects are owned by the Railways, and the Company merely acts as an executing agency. Accordingly, expenditure incurred on such projects is not recognised as assets in the books of the Company.

Separately, pursuant to specific policy guidelines issued by the Ministry of Railways, the Company constructed residential quarters on land owned by the Railways using its own funds. As per these guidelines, the Company is required to bear the entire cost of construction, while the ownership of both land and constructed structures continues to vest with the Railways.

In consideration of such construction, 50% of the residential units are licensed to the Company for a period of 30 years at a nominal lease rent, while the remaining units are retained by the Railways for their own use. The licensed units are primarily used by the Company for accommodating its employees. The Company also has limited rights regarding allocation and usage of such units, subject to overall regulatory control of the Railways.

The Company has capitalised the entire construction cost incurred on these residential units as property, plant and equipment under leasehold premises and is amortising the same over the lease period, on the basis that the expenditure enables it to derive economic benefits through usage rights over the licensed premises.

In view of the above, the issue for consideration is whether the accounting treatment adopted by the Company, i.e., capitalisation of construction cost as property, plant and equipment and its amortisation over the lease term, is in compliance with Ind AS, and if not, what would be the appropriate accounting treatment and presentation.

2. Relevant Provisions

Ind AS 116 – Leases

Para 9 of Ind AS 116

At inception of a contract, an entity shall assess whether the contract is, or contains, a lease. A contract is, or contains, a lease if the contract conveys the right to control the use of an identified asset for a period of time in exchange for consideration.

Para B9 of Ind AS 116

To assess whether a contract conveys the right to control the use of an identified asset for a period of time, an entity shall assess whether, throughout the period of use, the customer has both of the following:

(a) the right to obtain substantially all of the economic benefits from use of the identified asset; and

(b) the right to direct the use of the identified asset

Para B13 of Ind AS 116

An asset is typically identified by being explicitly specified in a contract. However, an asset can also be identified by being implicitly specified at the time that the asset is made available for use by the customer.

Para 22 of Ind AS 116

At the commencement date, a lessee shall recognise a right-of-use asset and a lease liability.

3. Analysis

In the present case, although the Company has incurred the construction expenditure, the ownership of both land and structure remains with the Ministry of Railways at all times. Further, the Company does not obtain legal title or unfettered control over the constructed quarters. The rights available to the Company are limited to usage for a specified period and are subject to policy restrictions imposed by the Railways. Accordingly, the essential condition of control over the asset is not satisfied. Therefore, the construction cost cannot be recognised as property, plant and equipment.

Further, the substance of the arrangement between the Company and the Railways needs to be evaluated. The Company incurs construction costs and, in return, obtains the right to use a specified portion of the constructed residential units for a defined period at a nominal lease rent. This indicates that the consideration paid by the Company is not merely for construction, but effectively for obtaining usage rights over the premises.

In terms of Ind AS 116, a contract contains a lease if it conveys the right to control the use of an identified asset. In the present case, specific residential units are identifiable, and the Company has the right to use such units for a period of 30 years.

Further, the Company has the right to obtain substantially all economic benefits arising from the use of such units within the defined scope, such as use for accommodation of employees and officials. Additionally, the Company has the ability to direct the use of such units, including decisions regarding allocation and utilisation, albeit within the framework of Railway policies. These restrictions are in the nature of protective rights and do not negate the Company’s control over the use of the asset.

Accordingly, the arrangement satisfies the conditions of a lease under Ind AS 116, and the Company should account for the same as a lessee.

With regard to the construction costs incurred, it is necessary to determine their nature. In substance, such costs represent consideration paid by the Company for obtaining the right to use the underlying asset. Ind AS 116 requires that payments made for acquiring the right to use an asset, irrespective of timing, be included in the measurement of the right-of-use asset.

At the commencement date, the Company should recognise a right-of-use asset and a corresponding lease liability. The cost of the right-of-use asset should include the construction cost incurred (or the fair value of consideration, as the case may be), along with other components specified under Ind AS 116.