IFRS 16 defines a lease as a contract, or part of a contract, that conveys the right to use an asset (the underlying asset) for a period of time in exchange for consideration. At first sight, the definition looks straightforward. But, in practice, it can be challenging to assess whether a contract conveys the right to use an asset or is, instead, a contract for a service that is provided using the asset.
For example, an entity might want to transport a specified quantity of goods, in accordance with a stated timetable, for a period of five years from A to B by rail. To achieve this, it could either rent a number of rail cars or it could contract to buy the transport service from a freight carrier. In both cases, the goods will arrive at B – but the accounting might be quite different!
In future, there is likely to be a greater focus on identifying whether a contract is or contains a lease, given that all leases (except short-term leases and leases of low-value assets) will be recognised on the balance sheet of the lessee.
Currently, many companies that have contracts which include both an operating lease and a service do not separate the operating lease component. This is because the accounting for an operating lease and a service/supply arrangement is the same (that is, there is no recognition on the balance sheet and straight-line expense is recognised in profit or loss over the contract period).
Under the new standard, the treatment of the two components will differ. A lessee may decide as a practical expedient by class of underlying asset not to separate non-lease components (services) from lease components. If the lessee decides to apply this exemption each lease component and any associated non-lease component is accounted for as a single lease component. So the service component will either be separated or the entire contract will be treated as a lease.
Leases are different from service contracts: a lease provides a customer with the right to control the use of an asset; whereas, in a service contract, the supplier retains control.
IFRS 16 states that a contract contains a lease if:
- there is an identified asset; and
- the contract conveys the right to control the use of the identified asset for a period of time in exchange for consideration.
What is an identified asset?
An asset can be identified either explicitly or implicitly. If explicit, the asset is specified in the contract (for example, by a serial number or a similar identification marking); if implicit, the asset is not mentioned in the contract (so the entity cannot identify the particular asset) but the supplier can fulfil the contract only by the use of a particular asset. In both cases there may be an identified asset.
In any case, there is no identified asset if the supplier has a substantive right to substitute the asset. Substitution rights are substantive where the supplier has the practical ability to substitute an alternative asset and would benefit economically from substituting the asset.
The term ‘benefit’ is interpreted broadly. For example, the fact that the supplier could deploy a pool of assets more efficiently, by substituting the leased asset from time to time, might create a sufficient benefit as long as there are no significant costs. It is important to note that ‘significant’ is assessed with reference to the related benefits (that is, costs must be lower than benefits, it is not sufficient if the costs are low or not material to the entity as a whole). Significant costs could occur, in particular, if the underlying asset is tailored for use by the customer. For example, a leased aircraft might have specific interior and exterior specifications defined by the customer. In such a scenario, substituting the aircraft throughout the lease term could create significant costs that would discourage the supplier from doing so.
The assessment whether a substitution right is substantive depends on the facts and circumstances at inception of the contract and does not take into account circumstances that are not considered likely to occur.
A right to substitute an asset if it is not operating properly, or if there is a technical update required, does not prevent the contract from being dependent on an identified asset. The same is true for a supplier’s right or obligation to substitute an underlying asset for any reason on or after a particular date or on the occurrence of a specified event because the supplier does not have the practical ability to substitute alternative assets throughout the period of use.
If the customer cannot readily determine whether the supplier has a substantive substitution right, it is presumed that the right is not substantive (that is, that the contract depends on an identified asset).
Portion of an asset
An identified asset can be a physically distinct portion of a larger asset, such as one floor of a multi-level building or physically distinct dark fibres within a cable.
A capacity portion (that is, a portion of a larger asset that is not physically distinct) is not an identified asset unless it represents substantially all of the capacity of the entire asset. So, for example, a capacity portion of a fibre-optic cable that does not represent substantially all of the capacity of the cable would not qualify as an identified asset.
When does the customer have the right to control the use of an identified asset?
A contract conveys the right to control the use of an identified asset if the customer has both the right to obtain substantially all of the economic benefits from use of the identified asset and the right to direct the use of the identified asset throughout the period of use.
Substantially all of the economic benefits from use of the asset throughout the period of use
Economic benefits can be obtained directly or indirectly (for example, by using, holding or subleasing the asset). Benefits include the primary output and any by-products (including potential cash flows derived from these items), as well as payments from third parties that relate to the use of the identified asset. Economic benefits relating to the ownership of the asset are ignored.
The example below illustrates under which circumstances payments from third parties should be taken into account:
A customer rents a solar farm from the supplier. The supplier receives tax credits relating to the ownership of the solar farm, whereas the customer receives renewable energy credits from the use of the farm.
In this scenario, only the renewable energy credits are taken into account in the analysis, because the tax credits relate not to the use of the solar farm but, instead, to ownership of the asset.
Right to direct the use of an asset throughout the period of use
When assessing whether the customer has the right to direct the use of the identified asset, the key question is which party (that is, the customer or the supplier) has the right to direct how and for what purpose the identified asset is used throughout the period of use.
The standard gives several examples of relevant decision-making rights:
- Right to change what type of output is produced.
- Right to change when the output is produced.
- Right to change where the output is produced.
- Right to change how much of the output is produced.
The relevance of each of the decision-making rights depends on the underlying asset being considered. If both parties have decision-making rights, an entity considers the rights that are most relevant to changing how and for what purpose the asset is used. Decision-making rights are relevant when they affect the economic benefits to be derived from the use of the asset.
To illustrate the concept, the table below provides some questions to consider when evaluating which party has the relevant decision-making rights:
Which party decides …
Lease of trucks/aircraft/rail cars etc.
Which goods are transported?
When the goods are transported and to where?
How often the asset is used/how full it needs to be to run?
Which route is taken?
When and whether to light the fibres?
What and how much data the cable will transport?
How to run the cable?
Through which routes the data will be delivered?
Which goods will be sold?
The prices at which the goods will be sold?
Where and how the goods are displayed?
How much power will be delivered and when?
When to turn the power plant on/off?
However, there are several rights that are not taken into account:
- Protective rights: In many cases, a supplier might limit the use of an asset by a customer in order to protect its personnel or to ensure compliance with relevant laws and regulations (for example, a customer who has hired a ship is prevented from sailing the ship into waters with a high risk of piracy or transporting hazardous materials). These protective rights do not affect the assessment of which party to the contract has the right to direct the use of the identified asset.
- Maintaining/operating the asset:Decisions about maintaining and operating an asset do not grant the right to direct the use of the asset. They are only taken into account if the decisions about how and for what purpose the asset is used are predetermined (see below).
- Decisions made before the period of use:Decisions madebefore the period of use are not taken into account unless they are made in the context of the design of the asset by a customer (see below).
In some scenarios, the decisions about how and for what purpose the underlying asset is used are already predetermined before the inception of the lease. If this is the case, the customer has the right to direct the use of an asset if it either:
- has the right to operate the identified asset throughout the period of use without the supplier having the right to change those operating instructions, or
- has designed the identified asset (or specific aspects of the asset) in a way that predetermines how and for what purpose the asset will be used throughout the period of use.
The new concept of “pre-determined” introduced by IFRS 16 can be very complex and judgmental where decisions are made before the inception of the lease. When analysing these decisions, there are several questions to be considered, such as:
- Do any decisions that are not predetermined have a significant effect on how and for what purpose the asset is used?
- To what extent are decisions about how and for what purpose the asset is used predetermined?
- Do the decisions predetermine how and for what purpose the identified asset is used or do they only establish protective rights?
- Which party to the contract has made the decisions?
Sometimes, an identified asset is incidental to a service but has no specific use to the customer by itself. In these cases, the customer often does not have the right to direct the use of the asset.
A customer enters into a contract with a telecommunications company for network services. To supply the services, it is necessary to install a server at the customer’s premises. The supplier can reconfigure or replace the server, when needed, to continuously provide the network services; the customer does not operate the server, nor does it make any significant decisions about its use. The telecommunication company determines the speed and the quality of data transportation in the network using the servers.
The telecommunication company has the right to control the use of the server because it makes all the relevant decisions about the use of the server throughout the period of use. It decides how the data is transported, whether to reconfigure the servers and whether to use the servers for another purpose. The customer only decides about the level of network services (that is the output of the servers) before the period of use.
This arrangement does not contain a lease.
The flowchart below summarises the analysis to be made to evaluate whether a contract contains a lease:
Determining whether a contract contains a lease
The definition of a lease is now much more driven by the question of which party to the contract controls the use of the underlying asset for the period of use. A customer no longer needs only to have the right to obtain substantially all of the benefits from the use of an asset (‘benefits’ element), but must also have the ability to direct the use of the asset (‘power’ element).
This conceptual change becomes obvious when looking at a contract to purchase substantially all of the output produced by an identified asset (for example, a power plant). If the price per unit of output is neither fixed nor equal to the current market price, the contract would be classified as a lease under IAS 17 and IFRIC 4, Determining whether an Arrangement contains a Lease.
IFRS 16, however, requires not only that the customer obtains substantially all of the economic benefits from the use of the asset but also an additional ‘power’ element, namely the right of the customer to direct the use of the identified asset (for example, the right to decide the amount and timing of power delivered).
A customer enters into a contract that conveys the right to use an explicitly specified retail unit for a period of five years. The property owner can require the customer to move into another retail unit; there are several retail units of similar quality and specification available.
As the property owner has to pay for any relocation costs it can benefit economically from relocating the customer only if there is a new tenant that wants to occupy a large amount of retail space at a rate that is sufficient to cover the relocation costs. Those circumstances may arise, but they are not considered likely to occur.
The contract requires the customer to sell his goods during the opening hours of the larger retail space. The customer decides on the mix of goods sold, the pricing of the goods sold and the quantities of inventory held. He further controls physical access to the retail unit throughout the five-year period of use.
The rent that the customer has to pay includes a fixed amount plus a percentage of the sales from the retail unit.
Is there an identified asset?
The retail unit is explicitly specified in the contract. The property owner has a right to substitute the asset. But, because it would benefit from the exercise of the right only under certain circumstances that are not considered likely to occur, the substitution right is not substantive.
Hence, the retail unit is an identified asset.
Has the customer the right to obtain substantially all of the economic benefits from the use of the retail unit?
The customer has the exclusive use of the retail unit throughout the period of use. The fact that a part of the cash flows received from the use are passed to the property owner as consideration does not prevent the customer from having the right to substantially all of the economic benefits from the use of the retail unit.
Has the customer the right to direct the use of the retail unit?
During the period of use, all decisions on how and for what purpose the retail unit is used are made by the customer. The restriction that goods can only be sold during the opening hours of the larger retail space defines the scope of the contract, but it does not limit the customer’s right to direct the use of the retail unit.
The contract contains a lease of retail space.