Accounting for Construction on Leased Land under Ind AS 116: A Complete Guide

Introduction

The implementation of Ind AS 116 has significantly changed lease accounting in India. One area that requires careful judgment is the accounting treatment of construction carried out on leased land.

When a business constructs a building, factory, or office on land taken on lease, an important question arises:

Should the construction cost be treated as part of the Right-of-Use (ROU) asset, or should it be recognized separately?

This article explains the correct accounting treatment in a clear and practical manner.

Overview of Ind AS 116

Ind AS 116 requires a lessee to recognize:

• A Right-of-Use (ROU) Asset
• A Lease Liability

The ROU asset represents the right to use the leased land over the lease term. However, it does not automatically include any building or structure constructed on that land.

Nature of Construction on Leased Land

Construction on leased land generally falls into two categories:

Leasehold Improvements

These are assets that:

• Are attached to the land
• Cannot be easily separated
• Must be handed over to the lessor at the end of the lease

Examples include temporary structures, interiors, and site development work.

Independent Building or Structure

These include:

• Factory buildings
• Warehouses
• Office premises

Such assets are typically controlled and used by the lessee to generate economic benefits.

Key Accounting Treatment

Treatment of Land

The leased land is recognized as a Right-of-Use (ROU) asset under Ind AS 116.

Treatment of Construction

The construction cost is generally not included in the ROU asset.

Instead, it is recognized separately as Property, Plant and Equipment (PPE) under Ind AS 16, provided the lessee controls the asset and derives economic benefits from it.

Capitalization of Costs

The following costs are capitalized:

• Material and labor costs
• Direct construction expenses
• Professional fees (architects, engineers)
• Site preparation costs

The following costs are not capitalized:

• Administrative expenses
• Abnormal losses or wastage

Depreciation of Constructed Asset

Depreciation depends on the terms of the lease:

• If ownership is not transferred to the lessee, depreciation is charged over the shorter of:
  • Useful life of the asset, or
  • Lease term
• If lease renewal is reasonably certain, the extended lease period should be considered.

Practical Example

A company takes land on lease for 10 years and constructs a factory building costing ₹2 crore.

Accounting treatment:

• Land is recognized as a Right-of-Use (ROU) asset
• Building is recognized as PPE under Ind AS 16
• Depreciation is charged over 10 years

Common Mistakes to Avoid

• Including construction cost in the ROU asset
• Ignoring lease terms while calculating depreciation
• Not analyzing lease agreements properly
• Ignoring renewal options

Conclusion

Accounting for construction on leased land requires a clear understanding of both Ind AS 116 and Ind AS 16.

In most cases:

• Land is treated as a Right-of-Use asset
• Construction is treated as a separate PPE asset
• Depreciation is based on lease terms

Proper evaluation of lease agreements and asset control is essential to ensure accurate financial reporting.

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