The Hidden Mistake in CWIP Accounting: What Everyone Gets Wrong About ROU Depreciation & Lease Interest

Among finance controllers and technical accounting teams, few topics generate as much silent inconsistency as the treatment of lease-related costs during the construction phase. Over the years, practitioners have adopted different approaches: some capitalise both ROU depreciation and lease-liability interest into CWIP, some capitalise only the interest, and a small minority correctly expense both items in the P&L.

Such diversity in practice is not the product of ambiguity in the standards — it arises from a misunderstanding of the economic substance of a land lease and an overextension of the capitalisation principles under Ind AS 16 and Ind AS 23.

This article examines the issue through a substance-over-form lens. When the standards are applied correctly, the conclusion is unambiguous: ROU depreciation and lease-liability interest relating to land do not qualify for capitalisation and must be recognised in the Statement of Profit and Loss.

1. Why This Topic Matters

Incorrect capitalisation does more than shift an expense between periods; it distorts the reported cost of capital projects, inflates CWIP, alters future depreciation, and artificially modifies metrics such as EBITDA and ROCE. It can also complicate future impairment assessments, carve-out exercises, and diligence reviews.

More importantly, the treatment reflects the finance function’s conceptual understanding of Ind AS. Capitalising land lease costs into a plant asset signals a departure from the principle-based framework on which the standards are built.

2. Why Different Companies Treat the Same Cost Differently

The divergence in practice generally springs from intuitive reasoning rather than from standard-based analysis. The arguments often presented are:

• “Land is necessary for construction; hence its lease cost must relate to the project.”
• “Interest is a finance cost; therefore it should be capitalised under Ind AS 23.”
• “CWIP is incomplete without the occupancy cost of land.”

Each of these statements contains a kernel of logic but none aligns with the requirements of Ind AS. Land is undeniably essential for construction — but necessity is not the test for capitalisation. The correct test is direct attribution, and that is where these arguments fail.

3. The Core Logic: Why Capitalising ROU Depreciation Is Conceptually Incorrect

When teams debate whether ROU depreciation or lease-liability interest should be added to CWIP, the conversation often begins with operational logic: “We are building a plant on leased land, therefore the land lease must be a construction cost.” It sounds persuasive — but it collapses the moment you examine the underlying economics.

Ind AS does not ask whether a cost is necessary for a project.
It asks whether the cost creates or enhances the asset under construction.
A land lease does neither.

If you understand this one distinction, the entire issue becomes clear.

3.1 The Economics of a Land Lease

A land lease conveys a legal right to occupy and use land for a defined period. Under Ind AS 116, this right is recognised at inception through a Right-of-Use (ROU) asset measured at the present value of future lease payments. In substance, therefore, the full economic burden of the land lease is captured on day one, and depreciation merely represents the systematic allocation of this pre-recognised cost over the lease term.

This point is critical: depreciation does not represent an additional or incremental cost arising from construction activities. It reflects the consumption of a right that exists independently of whether a plant is built or not.

Moreover, the behaviour of land-ROU depreciation reveals its true character. It is a time-driven cost, not an activity-driven cost:

• If construction accelerates, depreciation does not increase.
• If construction slows or halts, depreciation does not decrease.
• Even if construction is abandoned entirely, depreciation continues until the lease expires or is terminated.

In economic terms, this makes depreciation of a land ROU a sunk cost—a cost that remains unavoidable and unaltered by project decisions. A sunk cost, by definition, cannot satisfy the conditions for capitalisation because it is not incurred because of construction. It exists regardless of construction, which disqualifies it from the directly attributable category under Ind AS 16.

Thus, the economics of a land lease fundamentally prevent depreciation on the ROU from being treated as a component of the cost of constructing a plant.

3.2 A Pre-Condition Is Not a Construction Input

A common but flawed argument is that since land is necessary for constructing a plant, the cost of leasing the land must somehow form part of the cost of that plant. This line of reasoning mistakes pre-conditions for inputs.

Ind AS draws a clear distinction between the two:

• A pre-condition is something required before construction can begin (e.g., land, approvals, licences).
• A construction input is something that actively participates in creating or enhancing the asset (e.g., materials, labour, machinery used in construction).

Land belongs firmly in the first category.

Land and plant also possess distinct economic lives and independent existence:

• The land retains value irrespective of what is built on it.
• The plant can be dismantled, replaced, or upgraded without altering the legal or economic substance of the land beneath it.
• The land’s depreciation (through consumption of the ROU) occurs solely through the passage of time—not through construction activity.

The fact that land merely hosts the plant underscores the principle: occupancy is not construction.

Ind AS capitalisation rules are purposefully narrow. They require direct attribution, meaning the cost must:

1. Create the asset, or
2. Enhance the asset, or
3. Alter the asset to bring it to its intended operating condition.

The land lease does none of these.

It does not excavate foundations, align turbines, erect structures, lay transmission infrastructure, or perform any of the active steps required to bring a plant into working condition. It simply provides the physical location for these activities.

Therefore, depreciation of the ROU for land fails the direct attribution test embedded in Ind AS 16. Treating it as part of CWIP would artificially convert a passive prerequisite into an active construction cost, which is contrary to the standard.

3.3 The Double-Counting Issue

Capitalising ROU depreciation on land introduces a more fundamental conceptual flaw: it recognises the same economic cost twice. An asset shall be recognised only when future economic benefits arise as a result of past events.
Costs that do not generate new economic benefits shall not be capitalised. ROU depreciation does not generate new assets. Lease interest does not generate new assets. Therefore, capitalising them is double-counting, explicitly prohibited.

This occurs through a simple but often overlooked mechanism:

Step 1 — Initial Recognition

At lease commencement, the present value of lease payments is fully recognised as the ROU asset. This captures the entire economic cost of securing the right to use the land.

Step 2 — Depreciation Allocation

Depreciation then allocates that initial cost over the lease term. It does not represent fresh expenditure or additional investment. It is merely an accounting allocation of an existing cost.

Step 3 — Capitalisation Error

If depreciation is added to CWIP, it effectively embeds the cost of the land lease into the plant asset in addition to its original recognition in the ROU asset.

This inflates the asset value and distorts capital employed.

The consequences are material:

• Inflated CWIP: The plant appears more expensive than it actually is.
• Inflated future depreciation: Since the plant’s carrying value is overstated, subsequent depreciation is also overstated.
• Distorted ROCE: Capital employed increases without justification, reducing returns artificially.
• Impairment complexity: Overstated asset values increase the risk of impairment losses.
• Comparability issues: Projects built on owned land and leased land become inconsistent in their accounting outcomes.

The principle here is straightforward:

A cost recognised once cannot be recognised again under a different asset heading without creating misrepresentation.

Capitalising ROU depreciation therefore violates both accounting logic and the faithful representation objective of Ind AS.

4. What the Ind AS Framework Actually Requires

Once the economic logic is clear, the next step is grounding the analysis in the standards themselves. Ind AS 16, Ind AS 23, and Ind AS 116 work together in a way that leaves no room for doubt: land lease depreciation and lease-liability interest do not meet the criteria for capitalisation into CWIP. The standards are principle-based, meaning they require you to think about why a cost occurs, not simply where it originates. If a cost does not help create or enhance the plant, it cannot form part of its cost. The relevant Ind AS guidance consistently points to one answer — these costs belong in the P&L.

4.1 Ind AS 16 – Principle of Directly Attributable Cost

IInd AS 16 sets out the foundational rules governing capitalisation of costs associated with the construction of a tangible asset. The standard requires that only those costs be included in the carrying amount of an asset which directly contribute to bringing it to the location and condition necessary for it to operate as intended by management. This is not a broad or permissive criterion; it is intentionally narrow, designed to prevent the inflation of asset values through inclusion of costs that merely accompany, rather than contribute to, the construction process.

In other words, Directly attributable costs are those that are necessary to bring the asset to the location and condition necessary for it to operate, which mainly includes construction labor site preparation, professional fees, installation/testing, costs directly related to construction.

ROU depreciation and Lease interest does not “create” the plant, hence, it cost should not be capitalised.

A critical provision within Ind AS 16 reinforces this discipline:

“Depreciation of the right-of-use asset represents consumption of the right to use the underlying asset.
Depreciation of an asset shall be recognised in the statement of profit and loss unless it is included in the carrying amount of another asset.”

This sentence embodies a default rule and an exception. The default is that depreciation must be charged to the Statement of Profit and Loss. The exception—capitalisation of depreciation—is allowed only when another Ind AS specifically requires or permits such inclusion, such as depreciation of construction equipment used directly in building the asset.

Applying this principle to leases:

• No Ind AS authorises the capitalisation of depreciation on a land ROU asset into CWIP.
  This is because the land does not participate in construction; it only provides the physical site.
• Depreciation of a machinery ROU asset may qualify, but only when the machinery is actively deployed in construction and thereby satisfies the “directly attributable” criterion.

Ind AS 16 thus draws a clear boundary:
Only depreciation that contributes to construction may be capitalised. Depreciation that merely reflects passage of time—such as on a land ROU—must remain a period expense.

4.2 Ind AS 16.19 – Costs That Must Be Expensed

Ind AS 16.19 strengthens the capitalisation framework by stating that all costs that do not meet the directly attributable test must be expensed as incurred. This provision is central to preventing the misclassification of general or indirect costs into capital expenditure.

The depreciation of a land ROU asset falls squarely within this mandatory expensing rule for three reasons:

1. It does not create or enhance the plant—the plant would be in the same technical condition whether the land lease exists or not.
2. It is incurred due to the passage of time, not due to construction activity.
3. It arises from the consumption of the right of occupancy, not from exertion of construction effort.

Therefore, land-related ROU depreciation is not eligible for capitalisation under any interpretation of Ind AS 16.19. The standard silently but firmly prohibits it by insisting that non-contributory costs be recognised in the P&L.

By contrast, machinery used directly in construction satisfies the enhancement criterion, and its costs—including depreciation—may be capitalised.

Ind AS 16.19 is thus not merely a guidance section; it is a filter that ensures asset values reflect only construction-driven expenditure.

4.3 Ind AS 23 – The Borrowing Cost Test

Ind AS 23 governs the capitalisation of borrowing costs and introduces an equally stringent requirement: a borrowing cost may be capitalised only when it is directly attributable to the acquisition, construction, or production of a qualifying asset.

For interest arising on lease liabilities relating to land, this test fails on multiple counts:

1. Not a borrowing for construction

A lease liability represents the discounted value of future lease payments. It does not resemble a construction-specific borrowing. The liability arises because the entity occupies land—not because it is constructing an asset.

2. Represents unwinding of discount

Lease-liability interest is not consideration paid for funds deployed in construction. It is simply the unwinding of a discount embedded at initial recognition of the lease. This unwinding is independent of the construction activity.

3. Persists irrespective of construction status

Even if the project is postponed or discontinued, lease interest accrues at the same rate. A cost that continues in the absence of construction cannot logically or legally be considered a borrowing cost “directly attributable” to construction.

For these reasons, interest on land-related lease liabilities cannot be capitalised under Ind AS 23.

Exception: Machinery leases used for construction

By contrast, where a leased asset such as a crane, batching plant, or piling rig is employed directly in construction:

• the ROU asset is a construction tool,
• its cost is tied to construction activity, and
• the associated interest serves to finance the use of that construction tool.

In such cases, interest on the lease liability may meet the criteria for capitalisation under Ind AS 23 because the underlying asset directly contributes to the creation of the qualifying asset.

Thus, Ind AS 23 sharpens the distinction between land leases and machinery leases: one represents an occupancy arrangement; the other may constitute a construction financing arrangement.

5. Practical Example: Land Lease vs Machinery Lease

Consider a company constructing a manufacturing plant:

Land Lease

• ROU asset: ₹40 crore
• Annual depreciation: ₹2 crore
• Interest on lease liability: ₹1.2 crore

These costs relate solely to the right to occupy land. They do not influence construction progress. Whether construction accelerates, pauses, or stops, these costs remain unchanged. They therefore belong in the P&L.

Machinery Lease

• ROU asset for a crane: ₹3 crore
• Annual depreciation: ₹1 crore
• Lease-liability interest: ₹0.3 crore

The crane performs construction activities. Its use directly enhances the plant’s readiness for operation. Depreciation and interest arising from such a lease satisfy the conditions for capitalisation.

6. Brief Note on Tax Considerations

Misclassifying land-related lease costs as capital expenditure inflates the depreciable base and may invite tax scrutiny. While the accounting treatment must be guided by Ind AS, practitioners should be aware that improper capitalisation may carry tax implications.

Conclusion

Under Ind AS, the treatment of lease costs hinges on economic substance, not on intuitive association. The standards collectively establish that:

• ROU depreciation relating to land is a cost of occupancy and must be charged to the P&L.
• Lease-liability interest relating to land does not constitute borrowing cost for construction.
• Only when a leased asset (e.g., construction machinery) contributes directly to creating the plant can its related costs be capitalised.
• Capitalising land lease costs into CWIP results in double counting and misrepresenting project economics.

A disciplined application of Ind AS principles ensures accurate measurement of capital projects and reinforces the credibility of financial reporting — an essential responsibility of every controller and CFO.