ABOUT ACCOUNTING CLUBS
Discover who we are and what we do
Expert Q&A’s
Read about various complex accounting concepts
PODCASTS
See the podcasts we offer to help in your respective areas
Chapter 2: Identifying a lease
A contract is, or 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.
Definition of a lease
A lease is defined 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”.
IFRS 16 supersedes IFRIC 4 and SIC-27. Although the detailed requirements regarding the identification of a lease are amended by IFRS 16, the key principles of IFRIC 4 and SIC-27 are carried forward, i.e., that:
- some arrangements that do not take the legal form of a lease may nevertheless meet the definition of a lease under the Standard; and
- not all transactions that involve the legal form of a lease will fall within the definition of a lease under the Standard.
Determination as to whether a contract is, or contains, a lease
Requirement to assess whether a contract is, or contains, a lease
At inception of a contract, an entity is required to 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.
Key aspects of this definition are that:
- the asset that is the subject of a lease must be specifically identified; and
- the contract must convey the right to control the use of that identified asset for a period of time.
For the purposes of IFRS 16, a ‘period of time’ may be described in terms of the amount of use of an identified asset (e.g., the number of production units that an item of equipment will be used to produce).
An entity is required to assess whether a contract contains a lease at inception of the contract, rather than at commencement of the lease term.
This is necessary because a lessor is required to classify a lease as either a finance lease or an operating lease at the inception date. In addition, a lessee is required to disclose information about leases not yet commenced to which the lessee is committed if that information is relevant to users of financial statements.
Examples 1 to 10 of the illustrative examples accompanying IFRS 16 illustrate how an entity determines whether a contract is or contains a lease. Although the Board believes that, in most cases, the assessment as to whether a contract is or contains a lease should be straightforward, it acknowledges that significant judgement will be required to make this assessment in some cases.
Identified asset
Identification of an asset – general
The asset that is the subject of a lease must be specifically identified. This will be the case if either of the following applies:
- the asset is explicitly specified in the contract (e.g., a specific serial number); or
- the asset is implicitly specified at the time that it is made available for use by the customer (e.g., when there is only one asset that is capable of being used to meet the contract terms).
If an asset is not explicitly specified in the contract, an entity should consider whether an asset is implicitly specified in the arrangement since under IFRS 16 an asset that is implicitly specified can qualify as an identified asset. When assessing at the inception date whether there is an identified asset, an entity does not need to be able to identify the particular asset (for example, a specific serial number) that will be used to fulfil the contract to conclude that there is an identified asset. If the asset is not specifically identified at the inception date, but the entity knows that an identified asset is needed to fulfil the contract at the commencement date, then the asset is implicitly specified.
Q&A: How is the term ‘consideration’ interpreted?
A contract is, or contains, a lease if it conveys the right to control the use of the identified asset for a period of time in exchange for consideration. The term ‘consideration’ should be interpreted broadly as including the possibility of receiving payments. Aside from those payments that meet the definition of lease payments and must be included in the measurement of the lease liability in accordance with IFRS 16, it also covers, for example, variable payments that do not depend on an index or a rate. So, even if all of the payments are variable payments that do not depend on an index or a rate, the contract still meets the definition of a lease, provided that the other conditions are met.
Q&A: How is the term ‘period of time’ interpreted?
The term ‘period of time’ should not be interpreted too literally. An amount of use of the underlying asset, such as the number of production units that an item of equipment will produce, can also describe a period of time as required by IFRS 16.
Q&A: Is a perpetual period a ‘period of time’?
In order to qualify as a lease, an arrangement must convey a right to use an identified asset for a ‘period of time’. However, some contracts such as certain land easements have no limitation on the time period (that is, they are for a perpetual time period). Since IFRS 16 does not define the term ‘period of time’, it is not clear whether perpetual use rights are covered by that term. One approach would be to argue that truly perpetual use rights are not over a (specified) ‘period of time’, and so they do not meet the definition of a lease in accordance with IFRS 16. However, an entity must consider the substance of the contract in determining whether it is truly perpetual.
For example, if the contract provides for ongoing payments, and the arrangement can be terminated by merely stopping the payments, the term would not be truly perpetual. Similarly, long-term leases of land (For example, 999-year leases) should not be considered to be perpetual. Truly perpetual use rights would need to be analyzed to determine whether an asset should be recognized under another standard, such as IAS 16 or IAS 38. An alternative approach would be to argue that, even though there is no limit on the time period, a ‘perpetual term’ is still a ‘period of time’.
Under this approach, a perpetual use right would meet the definition of a lease, provided that all other parts of the lease definition are met. In our view, in the absence of specific guidance in IFRS 16, both approaches would be acceptable, and so the entity has an accounting policy choice. The policy chosen should be consistently applied and disclosed. If this choice represents a critical accounting judgement, the entity should consider the IAS 1 disclosure requirements.
An entity assesses whether a contract is, or contains, a lease at the inception date. The inception date is the earlier of the date of a lease agreement and the date of commitment by the parties to the principal terms and conditions of the lease.
An entity does not re-assess whether a contract contains a lease unless the terms and conditions of the contract are changed.
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 but is implicitly specified when the supplier makes it available to the customer. Both cases could result in an identified asset.
Q&A: Evaluation of whether the fulfilment of an arrangement is dependent on the use of an identified asset
Entity A enters into an agreement to sell electricity to a steel works. In order to fulfil this agreement, entity A builds a power station next to the steel works. Entity A does not have access to any other electricity generating assets. Is the power station an identified asset? Yes. It is clear that fulfilment of the agreement is dependent on the use of the power station built next to the steel works.
There is no identified asset if the supplier has a substantive right to substitute the asset throughout the period of use. Substitution rights are substantive if the supplier has the practical ability to substitute an alternative asset and would benefit economically from substituting the asset.
Q&A: Assessing whether a lessor benefits 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. ‘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 cost of substitution is generally higher where an asset is located at the customer’s premises. The cost of substitution in these circumstances could outweigh its benefits.
The assessment of whether a substitution right is substantive depends on the facts and circumstances at inception of the contract. It 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.
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 does not prevent the contract from being dependent on an identified asset. The supplier does not have the practical ability to substitute alternative assets throughout the period of use.
A customer presumes that a substitution right is not substantive if it cannot readily determine whether the supplier has a substantive substitution right.
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 fibers 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. A capacity portion of a fiber-optic cable that does not represent substantially all of the capacity of the cable would not qualify as an identified asset, because it is not physically distinct.
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.
An entity can obtain economic benefits 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, within the defined scope of the entity’s right to use the asset. Economic benefits relating to the ownership of the asset are ignored.
The entity must determine 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 and, on the terms, and conditions of the contract. 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 where they affect the economic benefits to be derived from the use of the asset.
An entity does not take into account protective rights in its assessment. 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.
Decisions about maintaining and operating an asset do not grant the right to direct the use of the asset. An entity only takes them into account if the decisions about how and for what purpose the asset is used are predetermined.
The decisions about how and for what purpose the underlying asset is used could be predetermined before the inception of the lease. The customer in this case has the right to direct the use of an asset if either:
- it has the right to operate the identified asset throughout the period of use, without the supplier having the right to change the operating instructions; or
- it 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.
Q&A: Analyzing decisions that are made before the inception of the lease
The concept of ‘predetermined’ in IFRS 16, can be very complex and judgmental if decisions are made before the inception of the lease. When analyzing 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?
· 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?
Decisions made before the period of use are ignored, unless they are made in the context of the design of the asset by a customer that predetermines its use.
The analysis of whether a contract contains a lease can be complex. For various industries, examples are included below.
1. Applying the lease definition to a retail unit
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. Because the property owner has to pay for any relocation costs, it can benefit economically from relocating the customer only if there is a new lessee that wants to occupy a large amount of retail space at a rate that is sufficient to cover the relocation costs. Those circumstances might 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.
Analysis
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 the substitution right is not substantive because the property owner would benefit from the exercise of the right only under certain circumstances that are not considered likely to occur. 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 a retail unit.
2. Applying the lease definition to a rail car
Example 1
A customer enters into a contract that conveys the right to use an explicitly specified rail car for four years. The customer determines when, where and which goods are to be transported using the rail car. When the rail car is not in use, it is kept at the customer’s premises and it can be used for another purpose (For example, storage). The customer is, however, not allowed to transport particular types of goods, such as explosives. The supplier is required to substitute the rail car if it needs to be serviced or repaired. Aside from this, the supplier cannot retrieve the rail car during the period of use.
Analysis
Is there an identified asset?
The rail car is explicitly specified in the contract. The supplier cannot substitute the rail car during the period of use, except for service or repair. A supplier’s right or obligation to substitute an asset for repair or maintenance does not preclude the customer from having the right to use an identified asset. The rail car is an identified asset.
Has the customer the right to obtain substantially all of the economic benefits from the use of the rail car?
The customer has the exclusive use of the rail car throughout the period of use, including when it is not being used for transporting the customer’s goods. It therefore has the right to obtain substantially all of the economic benefits from the use of the rail car.
Has the customer the right to direct the use of the rail car?
During the period of use, all decisions regarding how and for what purpose the rail car is used are made by the customer. The restriction on the goods that can be transported defines the scope of the contract, but it does not limit the customer’s right to direct the use of the rail car. The contract contains a lease of a rail car.
Example 2
A customer enters into a contract that requires the supplier to transport a specified nature and quantity of goods by using a specific type of rail car in accordance with a stated timetable for a period of four years. The timetable and quantity of goods specified is equivalent to the capacity of one rail car for four years. The supplier has a large pool of rail cars that it can use to fulfil the requirements of the contract. When the rail cars are not in use, they are stored at the supplier’s premises.
Analysis
Is there an identified asset?
The rail car mentioned in the contract does not meet the definition of an identified asset, because the supplier has a substantive right to substitute the rail car.
First, the supplier has the practical ability to substitute the rail car (because alternative rail cars are available and the supplier does not need the customer’s approval when substituting the rail car).
Secondly, the supplier would benefit economically from substituting the car. Only minimal cost (if any) will occur, because the supplier has a large pool of rail cars stored at its premises. The supplier would benefit from a substitution, because it allows it to use its pool of rail cars more efficiently (For example, using the rail car to transport another customer’s goods based on its location, or using a rail car that would otherwise sit idle because it is not being used by the customer). The contract does not contain a lease.
3. Applying the lease definition to a fiber optic cable
Example 1
A contract conveys the right to the exclusive use of three specified, physically distinct dark fibers within a larger cable for two years. The customer makes all decisions about the use of these fibers by connecting each end to its electronic equipment (that is, the customer ‘lights’ the fibers). Furthermore, it decides which data and how much data the fibers transport. The supplier owns extra fibers, but it can only substitute the customer’s fibers for reasons of repairs, maintenance or malfunction.
Analysis
Is there an identified asset?
The fibers are explicitly specified in the contract and physically distinct from the other fibers within the cable. The supplier cannot substitute the fibers during the contractual period except for reasons of repairs, maintenance or malfunction. A supplier’s right or obligation to substitute an asset for repair or maintenance does not preclude the customer from having the right to use an identified asset. The fibers meet the definition of an identified asset.
Has the customer the right to obtain substantially all of the economic benefits from the use of the fibers?
The customer has the exclusive use of the fibers throughout the period of use, and it thereby obtains substantially all of the economic benefits from the use of the fibers.
Has the customer the right to direct the use of the fibers?
During the period of use, all decisions about how and for what purpose the fibers are used are made by the customer. The customer decides when or whether to light the fibers, and which data and how much data the fibers will transport. It therefore has the right to direct the use of the fibers. The contract contains a lease of the three fibers.
Example 2
A customer enters into a contract for the right to use a specified amount of capacity within a cable that contains 10 fibers for two years; the amount is equivalent to having the use of the full capacity of three fibers within the cable. The supplier makes the decisions about the transmission of data (that is, it ‘lights’ the fibers, decides which fibers to use to transport the customer’s traffic, and decides about the electronic equipment connected to the fibers).
Analysis
Is there an identified asset?
The capacity portion is not physically distinct from the remaining capacity of the cable, and it does not represent substantially all of the capacity of the cable. Hence, there is no identified asset. The contract does not contain a lease.
4. Applying the lease definition to a ship
Example 1
A customer enters into a contract with a ship owner for the transportation of cargo. The ship is explicitly mentioned in the contract, and the ship owner has no substitution rights. The cargo will occupy substantially all of the capacity of the ship. The contract specifies the cargo that will be transported, the date and place of pick-up, and the date and place of delivery. The ship owner operates the ship during the contractual period, and the customer is prohibited from hiring another operator or from operating the ship itself.
Analysis
Is there an identified asset?
The ship is explicitly specified in the contract and the ship owner has no substitution rights. The ship is an identified asset.
Has the customer the right to obtain substantially all of the economic benefits from the use of the ship?
Because the cargo will occupy substantially all of the capacity of the ship, the customer obtains substantially all of the economic benefits from the use of the ship.
Has the customer the right to direct the use of the ship? How and for what purpose the ship is used is already predetermined in the contract, without the customer having the right to change it. The contract explicitly specifies which goods will be transported, when they will be transported and to where they will be transported. Because the customer did not design the ship, or aspects of it, and does not have the right to operate the ship, it does not have the right to direct the use of the ship. The contract does not contain a lease.
Example 2
Same as above, but the customer decides which goods will be transported and whether, when and to which ports the ship will sail throughout the period of use. Analysis In this scenario, how and for what purpose the ship is used is no longer predetermined by the contract but will be decided by the customer. The customer therefore has the right to direct the use of the ship. The contract contains a lease of a ship.
5. Applying the lease definition to a solar farm/power plant
Example 1
An entity enters into a contract to buy all of the electricity (including any renewable energy credits) produced by a new solar farm for a period of 20 years. The solar farm is explicitly mentioned in the contract and the supplier has no substitution rights. The customer designed the solar farm before it was constructed; the supplier builds the solar farm based on the customer’s specifications, and afterwards operates and maintains it. There are no decisions to be made about whether, when and how much electricity the solar farm will produce.
Analysis
Is there an identified asset?
The solar farm is explicitly specified in the contract and the supplier does not have the right to substitute the solar farm. The solar farm is an identified asset.
Has the customer the right to obtain substantially all of the economic benefits from the use of the solar farm?
The customer has the exclusive use of the solar farm throughout the period of use, because it takes all of the electricity produced by the solar farm. It has the right to obtain substantially all of the economic benefits from the use of the solar farm.
Has the customer the right to direct the use of the solar farm? How and for what purpose the solar farm is used is predetermined by the design of the solar farm. Because the customer was responsible for the design of the solar farm, it has the right to direct the use of the solar farm. The contract contains a lease of a solar farm.
Example 2
An entity enters into a contract to buy all of the electricity produced by a power plant for 20 years. The power plant is explicitly mentioned in the contract and the supplier has no substitution rights. The supplier operates the power plant and designed it several years ago when it was constructed. The contract specifies the quantity and timing of power that the power plant produces; this specification cannot be changed throughout the period of use, in the absence of extraordinary circumstances.
Analysis
Is there an identified asset?
The power plant is explicitly specified in the contract and the supplier does not have the right to substitute the power plant. The power plant is an identified asset.
Has the customer the right to obtain substantially all of the economic benefits from the use of the power plant?
The customer has the exclusive use of the power plant throughout the period of use, because it takes all of the power produced by the power plant. It has the right to obtain substantially all of the economic benefits from the use of the power plant.
Has the customer the right to direct the use of the power plant? How and for what purpose the power plant is used (that is, whether, when and how much electricity is produced by the power plant) is predetermined in the contract. The customer neither operates the power plant nor was involved in the design of the power plant. The customer, therefore, does not have the right to direct the use of the power plant. The contract does not contain a lease.
Example 3
An entity enters into a contract to buy all of the electricity produced by a power plant for 20 years. The power plant is explicitly mentioned in the contract and the supplier has no substitution rights. The supplier operates the power plant and designed it several years ago when it was constructed. The customer instructs the supplier about the quantity and timing of the delivery of electricity; if the power plant is not producing electricity for the customer, it does not operate.
Analysis
Is there an identified asset?
The power plant is explicitly specified in the contract and the supplier does not have the right to substitute the power plant. The power plant is an identified asset.
Has the customer the right to obtain substantially all of the economic benefits from the use of the power plant?
The customer has the exclusive use of the power plant throughout the period of use, because it takes all of the electricity produced by the power plant. It has the right to obtain substantially all of the economic benefits from the use of the power plant.
Has the customer the right to direct the use of the power plant?
Decisions about how and for what purpose the power plant is used (that is, whether, when and how much power will be produced by the power plant) are made by the customer. The customer, therefore, has the right to direct the use of the power plant. The contract contains a lease of a power plant.
A joint arrangement, as defined by IFRS 11, ‘Joint arrangements’, or someone on behalf of the joint arrangement, could be the customer in a contract to receive goods or services. An assessment must be made as to whether the joint arrangement has the right to control the use of the identified asset.
Separating components of a contract
Contracts often combine different kinds of obligations of the supplier, which might be a combination of lease components or a combination of lease and non-lease components. For example, the lease of an industrial area might contain the lease of land, buildings and equipment, or a contract for a car lease might be combined with maintenance. In a multi-element arrangement, an entity has to identify each separate lease component (based on the guidance on the definition of a lease) and account for it separately.
An arrangement contains more than one lease component if both of the following criteria are met: the lessee can benefit from use of the asset, either on its own or together with other resources that are readily available to the lessee; and the underlying asset is neither highly dependent on, nor highly interrelated with, the other underlying assets in the contract.
When identifying non-lease components, an entity must consider whether a good or service is transferred to the lessee. For example, if a lessee pays for the right to use an asset and also for administrative tasks, which do not transfer a good or service to the lessee, the administrative tasks are not a separate non-lease component.
Q&A: Lessee accounting for costs such as insurance premiums, property taxes, and maintenance
Real estate arrangements often require the lessee to reimburse the lessor for certain costs related to the leased asset, such as insurance, property taxes or common area maintenance provided by the lessor.
How are these payments accounted for?
There are three steps. Firstly, it is necessary to identify all lease and non-lease components in the contract. In the example, there will be (at least) one lease component (the right to use the real estate) and one non-lease component (the common area maintenance). However, payments for insurance and property taxes typically do not involve a transfer of a separate service and generally do not represent a separate component.
Secondly, the overall consideration in the contract needs to be determined. This will include payments for the lease component(s) and might also include payments for non-lease components and/or payments that do not represent separate components. In some real estate arrangements, the payments for property taxes and insurance might be variable payments.
Finally, the overall consideration in the contract is allocated to the identified lease and non-lease components based on the relative stand-alone prices of the identified components. In the example, where insurance and property taxes do not represent a separate component, no payments are allocated to them; the payments are only allocated to the identified lease and non-lease components.
The consideration must be allocated between the components if the analysis concludes that there are separate components.
The lessee allocates the consideration on the basis of relative stand-alone prices. The lessee estimates prices if observable stand-alone prices are not readily available, and it should maximize the use of observable information.
The lessor allocates the consideration on the basis of relative stand-alone selling prices in accordance with IFRS 15.
As a practical expedient, lessees do not need to separate lease and non-lease components. A lessee can account for each lease component and any associated non-lease components as a single lease component.
For example, a lessee that leases several machines (each of which meets the definition of a separate lease component) and also receives maintenance services from the lessor has two alternatives: the lessee can account for each lease component and each service component separately; or it can decide to combine the lease of each machine and the maintenance service related to that lease, and account for it as a single lease component. The practical expedient is an accounting policy choice by class of underlying asset.
Combination of contracts
Several contracts with the same counterparty might be entered into, at or near the same time and in contemplation of each other. An entity combines contracts entered into at or near the same time with the same counterparty (or related parties of the counterparty) if one or more of the following conditions are met: the contracts are negotiated as a package with an overall commercial objective; the consideration in one contract depends on the price/performance of the other contract; or the assets involved are a single lease component. The combination affects both the assessment of whether there is a lease and the accounting for the potential lease.
Lease term
The lease term begins on the date on which the lessor makes the underlying asset available for use by a lessee (commencement date).
The lease term includes the non-cancellable period for which the lessee has the right to use an underlying asset. Periods covered by an option to extend the lease term are included in the lease term if the lessee is reasonably certain to exercise that option. The same rationale applies to termination options. Periods covered by a termination option are included in the lease term if the lessee is reasonably certain not to exercise the option. Otherwise, the lease term ends at the point in time when the lessee can exercise the termination option.
An entity should consider all facts and circumstances that create an economic incentive for the lessee to exercise an extension option (or not to exercise a termination option) in order to assess whether the exercise (or the non-exercise) is reasonably certain.
Examples of factors that an entity takes into account are:
- Contractual terms and conditions for optional periods compared with market rates: it is more likely that a lessee will not exercise an extension option if lease payments exceed market rates. Other examples of terms that an entity takes into account are termination penalties or residual value guarantees.
- Significant leasehold improvements undertaken (or expected to be undertaken): it is more likely that a lessee will exercise an extension option if a lessee makes significant investments to improve the leased asset or to tailor it for its special needs.
- Costs relating to the termination of the lease/signing of a replacement lease: it is more likely that a lessee will exercise an extension option if doing so avoids costs such as negotiation costs, relocation costs, costs of identifying another suitable asset, costs of integrating a new asset, and costs of returning the original asset in a contractually specified condition or to a contractually specified location.
- The importance of the underlying asset to the lessee’s operations: it is more likely that a lessee will exercise an extension option if the underlying asset is specialized or if suitable alternatives are not available.
- Conditionality associated with exercising the option, and the likelihood that those conditions will exist.
There could be contracts that combine options with other features so that the lessee guarantees the lessor a minimum or fixed return that is substantially the same, whether or not the lessee exercises the option. An example is a combination of an extension option and a residual value guarantee. An entity should, in this case, assume that the lessee is reasonably certain to exercise the option to extend the lease.
A lessee’s past practice regarding the period over which it has typically used particular types of assets, and its economic reasons for doing so, might also provide helpful information.
The assessment of the lease term is made at the commencement date.
A lessee re-assesses extension options and termination options only when a significant event or change in circumstances occurs that is within the control of the lessee and affects whether it is reasonably certain to exercise an option. A lessor does not re-assess whether or not an option is reasonably certain to be exercised.
A change in the non-cancellable lease period results in a change in the lease term for both lessee and lessor.
Examples of a change in the non-cancellable lease period include: the lessee exercises an option in a different way than the entity had previously determined was reasonably certain; or an event occurs that contractually obliges the lessee to exercise an option (/prohibits the lessee from exercising an option) not previously included in the determination of the lease term (/previously included in the determination of the lease term). For example, a lessee of a retail store might be contractually obliged to extend the lease term if revenues from that store exceed a certain amount for the first time.
Recognition and measurement exemptions
IFRS 16 contains two recognition and measurement exemptions: short-term leases; and leases for which the underlying asset is of low value. Both exemptions are optional, and they apply only to lessees.
A lessee that applies either or both of the exemptions recognizes the lease payments as expenses on a straight-line basis or another systematic basis that is more representative of the pattern of the lessee’s benefit.
Lease vs ‘in-substance’ sale or purchase
When assessing the nature of a contract, an entity should consider whether the contract transfers control of the underlying asset itself (as opposed to conveying the right to control the use of the underlying asset for a period of time). If so, the transaction is a sale or purchase within the scope of other Standards (e.g., IFRS 15 or IAS 16).
Leases vs service contracts
IFRS 16 aims to distinguish a lease from a service contract on the basis of whether a customer is able to control the use of the asset being leased. If the customer controls the use of an identified asset for a period of time, then the contract contains a lease. This will be the case if the customer can make the important decisions about the use of the asset in a similar way to that in which it makes decisions about owned assets that it uses. In contrast, in a service contract, the supplier controls the use of any assets used to deliver the service.
Substantive substitution rights
Right to use an identified asset is undermined by substantive substitution right
Even if an asset is specified as discussed, a customer is not considered to have the right to use an identified asset (and, therefore, the contract is not a lease) if the supplier has a substantive right to substitute the asset throughout the period of use.
The ‘period of use’ is “[t]he total period of time that an asset is used to fulfil a contract with a customer (including any non-consecutive periods of time)”.
If a supplier has a substantive right to substitute the asset throughout the period of use, there is no identified asset and the contract does not contain a lease. This is because the supplier, and not the customer, controls the use of the asset in such circumstances. In these arrangements, the supplier accounts for the contract applying IFRS 15.
If a substitution clause is not substantive because it does not change the substance of the contract, that substitution clause does not affect an entity’s assessment as to whether a contract contains a lease.
Substantive substitution right – definition
A supplier’s right to substitute an asset is substantive only if both of the following conditions are met:
- the supplier has the practical ability to substitute alternative assets throughout the period of use (e.g., the customer cannot prevent the supplier from substituting the asset and alternative assets are readily available to the supplier or could be sourced by the supplier within a reasonable period of time); and
- the supplier would benefit economically from exercising its right to substitute the asset (i.e., the economic benefits associated with substituting the asset are expected to exceed the costs associated with substituting the asset).
Substitution rights are not substantive if it is not likely, or practically or economically feasible, for the supplier to exercise those rights. The Board believes that, in many cases, it will be clear that the supplier would not benefit from the exercise of a substitution right because of the costs associated with substituting the asset.
Customer approval of supplier’s substitution of an asset
A supplier does not have a substantive substitution right if it is required to obtain the customer’s approval to substitute the asset, which may come in different forms. An entity should consider the substance and nature of any rights granted in the contract that may give the customer the right to prevent substitution as this would indicate that the supplier does not have the practical ability to substitute the asset.
Assessment of substantive substitution rights – explicit or implicit specified asset
The assessment of whether a supplier has a substantive substitution right is generally more relevant in contracts that explicitly specify the asset to be used to fulfil the contract than in arrangements for which fulfilment depends on the use of an implicitly specified asset. As discussed, an implicitly specified asset typically exists when the supplier has only one asset (or very few assets) that may be used to fulfil the supplier’s obligation under the contract. If a supplier only has one asset that can be used to fulfil its obligations under the contract, the supplier most likely does not have the practical ability to substitute the underlying asset.
Substitution on or after a specified future date or dependent on the occurrence of a specified event
If the supplier has a right or an obligation to substitute the asset only on or after either a particular date or the occurrence of a specified event, the supplier’s substitution right is not substantive because the supplier does not have the practical ability to substitute alternative assets throughout the period of use.
Supplier has substitution rights for part of the contract term – example
Entity A (the customer) enters into a contract for six years with Entity B (the supplier) that meets all of the conditions to constitute a lease under IFRS 16 except for the existence of a substitution right that requires further consideration.
Under the terms of the contract, Entity B has a right to substitute the identified asset at any time after the third anniversary of the contract (i.e., no substitution right for the first three years). Entity B has the practical ability to substitute the asset from that point onwards and would economically benefit from doing so.
The contract is a lease for its entire duration, i.e., six years, not only for the first three years (i.e., the period for which no substitution right exists).
As required by IFRS 16, the substance of substitution rights is evaluated based on the facts and circumstances at inception of the contract. This analysis is part of determining whether a contract constitutes a lease and is not part of determining the duration of the lease contract.
Under IFRS 16, “a customer does not have the right to use an identified asset if the supplier has the substantive right to substitute the asset throughout the period of use”.
In the circumstances described, because the substitution right is not for the entire duration of the lease (it comes into effect only after three years), at inception the contract is determined to be a lease.
IFRS 16 permits a reassessment of whether a contract is a lease only if the terms and conditions of the contract are changed and therefore, in the absence of changes to the terms or conditions of the contract, it will remain a lease for its entire duration.
The same conclusion would be reached (i.e., there is a lease for the entire six years) if Entity B had a right to substitute the identified asset at any time during the first three years of the contract, but no such a right after the third anniversary of the contract.
Evaluation to be based on circumstances at inception and to exclude consideration of future events not considered likely to occur
An entity’s evaluation of whether a supplier’s substitution right is substantive should be based on facts and circumstances at inception of the contract.
Future events that, at inception of the contract, are not considered likely to occur should be excluded from the evaluation. Examples of such future events include:
- an agreement by a future customer to pay an above market rate for use of the asset;
- the introduction of new technology that is not substantially developed at inception of the contract;
- a substantial difference between the customer’s use of the asset, or the performance of the asset, and the use or performance considered likely at inception of the contract; and
- a substantial difference between the market price of the asset during the period of use, and the market price considered likely at inception of the contract.
If a supplier would benefit from substitution only in circumstances that are not likely to occur, such as those listed in IFRS 16, those substitution rights are not substantive, regardless of whether the circumstances are specified in the contract.
Economic benefit from exercise of substitution rights
In addition to having the practical ability to substitute the asset, a supplier must benefit economically from the substitution for the right to be substantive. This is the case if the economic benefits associated with substituting the asset are expected to exceed the costs associated with substituting the asset. Accordingly, an entity may need to perform a quantitative analysis of the costs and benefits of substitution before concluding that the supplier would benefit economically from the exercise of its right to substitute the asset.
Costs associated with substituting an asset
When assessing if the supplier would benefit economically from the exercise of its right to substitute the asset, all costs that would be associated with substituting the asset should be considered, which may, for example, include:
- costs of removing the existing asset and transporting it to a new location or disposing of the asset;
- costs of gaining access to the customer’s premises when the underlying asset is located there;
- costs of transporting, installing, and testing the alternative assets; and
- additional costs of configuring and operating the alternative assets, as necessary.
Costs that would have been incurred regardless of the substitution should not be considered in the evaluation of whether the supplier would benefit economically from the substitution.
If the asset is located at the customer’s premises or elsewhere, the costs associated with substitution are generally higher than when located at the supplier’s premises and, therefore, are more likely to exceed the benefits associated with substituting the asset.
Substitution for repairs or technical upgrade
A supplier’s right or obligation to substitute the asset for repairs and maintenance, if the asset is not operating properly or if a technical upgrade becomes available, does not preclude the customer from having the right to use an identified asset.
Customer cannot readily determine whether the supplier has substantive substitution rights
If the customer cannot readily determine whether the supplier has a substantive substitution right, the customer should presume that any substitution right is not substantive.
It may be difficult for the customer to determine whether the supplier’s substitution right is substantive. For example, the customer may not have information about the costs of substitution that would be incurred by the supplier and therefore is unable to assess whether the substitution right gives the supplier an economic benefit. The Board believes that it should generally be relatively clear from the facts and circumstances whether substitution rights are substantive, and the Board intends that customer should assess whether substitution rights are substantive if they are reasonably able to do so. However, the requirement in IFRS 16 is intended to clarify that a customer is not expected to exert undue effort in order to provide evidence that a substitution right is not substantive. IFRS 16 is written with only the customer in mind. The supplier is expected to have enough information at its disposal to determine whether its substitution rights are substantive. Therefore, the guidance on substitution rights may result in asymmetry between the supplier’s and customer’s assessment.
Supplier’s exercise of a non-substantive substitution right
When a supplier’s substitution right is not substantive, the substitution right is not considered in determining whether the contract contains an identified asset. If the customer has a right to control the use of the identified asset, the contract contains a lease and is subject to IFRS 16. However, although a supplier’s substitution right may have been deemed non-substantive, instances may still arise in which the supplier may nevertheless substitute the asset for various reasons.
IFRS 16 does not provide guidance on how the parties to the contract should account for the actual substitution of the underlying asset by the supplier. Therefore, the determination of appropriate accounting should be based on facts and circumstances and include consideration of various factors, including whether the original asset and alternative asset are the same (or similar) and whether the parties modify other terms in the contract upon substitution.
In scenarios when the asset substituted is the same (or similar) to the previous asset and there are no other changes to the contract, it is appropriate not to assign any accounting impact to such a substitution (i.e., to continue the lease accounting applied immediately prior to the substitution) because there is no substance to the substitution. This is irrespective of whether the lease contract stipulated a contractual right of the supplier to substitute the asset.
However, when the original asset and alternative asset are not the same (or similar) and / or the parties modify other terms in the contract upon substitution, the parties should apply the requirements of IFRS 16 on lease modifications. For example, if the new asset is provided at a price commensurate with its stand-alone price (and any appropriate adjustments to that stand-alone price to reflect the current circumstances of the contract), it should be reflected as a new lease and result in the termination of the existing lease. However, if the new asset is not provided at a price commensurate with its stand-alone price, the lessee should apply the requirements in IFRS 16 and the lessor should apply the requirements in IFRS 16 if the lease being modified is a finance lease. If, from the perspective of the lessor, the lease is an operating lease, the modification results in a new lease applying the requirements in IFRS 16.
Portions of assets
A capacity portion of an asset is an identified asset if it is physically distinct (e.g., a floor of a building).
A capacity or other portion of an asset that is not physically distinct (e.g., a capacity portion of a fiber optic cable or a pipeline) is not an identified asset, unless it represents substantially all of the capacity of the asset and thereby provides the customer with the right to obtain substantially all of the economic benefits from use of the asset.
The Board concluded that a customer is unlikely to have the right to control the use of a capacity portion of a larger asset if that portion is not physically distinct because decisions about the use of the asset are typically made at the larger asset level.
The right to control the use of an identified asset
Elements of ‘control’
To assess whether a contract conveys the right to control the use of an identified asset for a period of time (as required under IFRS 16), an entity is required to assess whether, throughout the period of use, the customer has both of the following:
- 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).
The ‘period of use’ is “the total period of time that an asset is used to fulfil a contract with a customer (including any non-consecutive periods of time)”.
As discussed, the Board decided that to control the use of an asset, a customer is required to have not only the right to obtain substantially all of the economic benefits from use of an asset throughout the period of use (a ‘benefits’ element) but also the ability to direct the use of that asset (a ‘power’ element), i.e. a customer must have decision-making rights over the use of the asset in order to influence the economic benefits derived from use of the asset throughout the period of use. If the customer does not have such decision-making rights, it has no more control over the use of the asset than a customer who is purchasing supplies or services, in which case, the customer would not control the use of the asset. The shift in focus from ‘risks and rewards’ to ‘control’ is consistent with other recent Standards (e.g., IFRS 10 and IFRS 15) and with the concept of control in the Conceptual Framework issued in March 2018.
Right to economic benefits from use
Customer must have the right to obtain substantially all of the economic benefits from use of the asset
To control the use of an identified asset, a customer must have the right to obtain substantially all of the economic benefits from use of the asset throughout the period of use (e.g., by having exclusive use of the asset throughout that period).
Therefore, in circumstances when an asset might be considered to be implicitly identified (e.g., the supplier has only one machine capable of delivering the customer’s requirements), if the supplier can regularly use the machine for other purposes during the course of the contract (e.g., to supply other customers), the customer does not have the right to obtain substantially all of the economic benefits from the use of that asset and there is no lease.
Meaning of ‘substantially all’
Although IFRS 16 does not define ‘substantially all’, it uses the term frequently. In particular, the term is used in:
- IFRS 16 in regards to the determination of whether the customer has the right to obtain substantially all of the economic benefits from use of an identified asset; and
- IFRS 16 in regards to the determination of whether a capacity portion of an asset represents substantially all of its capacity and thereby provides the customer with the right to obtain substantially all of the economic benefits from use of the asset.
Consistent with the guidance, which discusses the meaning of ‘substantially all’ in the context of classifying a joint arrangement, it should generally be presumed that 90 per cent of the economic benefits represents ‘substantially all’ of the economic benefits for the purposes of assessing the right to control the use of an asset under IFRS 16.
Accordingly, if an entity has the right to obtain 90 per cent or more of the economic benefits from the use of the identified asset, it should generally be presumed that the entity controls the use of the identified asset.
Also consistent with the guidance, the assessment of whether a customer has the right to obtain substantially all of the capacity of an identified asset should be based on economic value and not physical capacity.
Nature of economic benefits from use of the asset
Economic benefits from use of an asset can be obtained by the customer in many ways (e.g., by using, holding or sub-leasing the asset); they include the primary output and by-products generated from use of the asset, and other economic benefits from using the asset that could be realized from a commercial transaction with a third party. All of these benefits should be considered in the assessment of whether the contract conveys the right to substantially all the economic benefits from the use of the asset.
The assessment as to whether a contract contains a lease should not consider economic benefits relating to ownership of an asset (e.g., tax benefits as a result of owning an asset). This is because a lease does not convey ownership of the underlying asset.
Intangible economic benefits
The concept of economic benefits in IFRS 16 is broad and not limited to the primary output and by-products of the asset. Benefits that result from the use of the asset and that can be realized through a commercial transaction with a third party should be considered economic benefits in the context of IFRS 16, regardless of whether they are tangible or intangible.
One example of an intangible economic benefit is renewable energy credits that accrue from use of the solar farm as illustrated in Example 9A of Illustrative Examples accompanying IFRS 16. These credits are intangible assets and, in some jurisdictions, they have clear economic value being exchanged in commercial transactions on the open market (e.g., as opposed to being claimed in an owner’s tax return).
Any intangible benefits or outputs from the customer’s use of the leased asset, which may be realized through a commercial transaction with a third party, will represent economic benefits from use that should be considered in the analysis of whether a customer has the rights to obtain substantially all of the economic benefits from use of the asset.
Examples of intangible economic benefits (or outputs) that might arise from the use of an asset may also include data generated by the asset or data captured regarding how the asset is used, and the identification and assessment of who receives the economic benefits in these scenarios may be more complex.
The following considerations are relevant when evaluating whether intangible benefits (or outputs) are economic benefits from use (i.e., in determining whether such benefits have substance).
- Are the benefits (or outputs) created by, or do they result from, the active use of the asset?
- If the customer does not actively use the asset, are the benefits still created? If so, such benefits would be more akin to benefits associated with ownership not usage of the asset.
- How may the benefit (or output) be realized? Can the benefits (or outputs) be realized in a commercial transaction with a third party? If the benefit can only be realized by the supplier in the form of cost savings, the benefit (or output) may not be an economic benefit from use.
If there are intangible economic benefits (or outputs) from use of the asset within the defined scope of the customer’s right to use the asset, an entity needs to:
- identify which parties obtain the benefits; and
- determine whether the benefit obtained by parties other than the customer is sufficient to conclude that the customer does not obtain substantially all of the economic benefits from the use of the asset.
Restrictions on economic benefits available to the customer
The economic benefits to be considered are those that are available within the defined scope of the customer’s right to use the asset. For example:
- if a contract limits the use of a motor vehicle to only one particular territory during the period of use, only the economic benefits from use of the motor vehicle within that territory should be considered; and
- if a contract specifies that a customer can drive a motor vehicle only up to a particular number of miles during the period of use, only the economic benefits from use of the motor vehicle for the permitted mileage should be considered.
Therefore, potential additional economic benefits outside the scope of the customer’s rights (e.g., in the second bullet point above, beyond the specified mileage for the motor vehicle) are not relevant to the determination as to whether the customer has the right to obtain substantially all of the economic benefits from use of the asset throughout the period of use.
Customer required to pay a portion of the cash flows derived from use of the asset as consideration
If a contract requires a customer to pay the supplier or another party a portion of the cash flows derived from use of an asset as consideration, those cash flows paid as consideration should be considered to be part of the economic benefits that the customer obtains from use of the asset.
For example, if the customer is required to pay the supplier a percentage of sales from use of retail space as consideration for that use, that requirement does not prevent the customer from having the right to obtain substantially all of the economic benefits from use of the retail space. This is because the total cash flows arising from those sales are considered to be economic benefits that the customer obtains from use of the retail space, a portion of which it then pays to the supplier as consideration for the right to use that space.
Contracts in which the customer’s rights to economic benefits change
It is common in off-take or other supply arrangements for the economic benefits obtained by the customer to change or fluctuate, contractually, throughout the period of use. For example, under the terms of a 10-year contract a customer may have the right to 100 per cent of the widget-production capacity at a manufacturing facility for the first five years followed by a right to 50 per cent of the widget-production capacity at that facility for the following five years. Alternatively, for an asset with a primary output and a by-product (both of which are identified as economic benefits from use) under a 10-year contract a customer may obtain 100 per cent of the primary output throughout the period of use but only 50 per cent of the by-product in the first five years followed by 100 per cent of the by-product for the following five years.
IFRS 16 states that “if the customer has the right to control the use of an identified asset for only a portion of the term of the contract, the contract contains a lease for that portion of the term”.
Accordingly, an entity will first need to determine whether there are contractually stipulated periods of time over which it has the right to obtain substantially all of the economic benefits from use of the asset and then whether over these periods it controls the use of the identified asset.
This assessment may result in dividing the period of use into the periods during which the customer has the right to obtain substantially all (generally defined as being at least 90 per cent) of the economic benefits from use of the identified asset, and those periods when it does not, resulting in a lease that includes non-consecutive periods.
The assessment is made over the contractually stipulated time periods for which the rights are specified rather than on expected usage. For example, in situations where a customer has the right to obtain 100 per cent of the economic benefits from use of an identified asset over five years, but expects to use less than that in certain years, the entity determines that it has a lease for the entire five-year period (if it also determines that it controls the use of the asset over that period). It would not be appropriate to break the contract into shorter periods not stipulated in the contract and identify a lease only for periods in which the entity expects to use substantially all of the benefits.
For example, Entity A has three supply arrangements. Each of these supply arrangements stipulate, on an annual basis, the percentage of output of an identified asset that Entity A is entitled to. These percentages change over time and result in Entity A being contractually entitled to the following percentage of economic benefits of the identified asset:
Y1 Y2 Y3 Y4 Y5 Y6 Y7 Y8 Y9 Y10 Total % Contract 1 40 40 100 100 100 100 100 100 100 100 88 Contract 2 100 100 100 100 100 100 100 100 40 40 88 Contract 3 100 100 70 100 100 70 100 100 70 70 88
Entity A obtains significantly all of the economic benefits from use of the identified asset during the following periods.
Contract 1: Years 3 to 10.
Contract 2: Years 1 to 8.
Contract 3: Years 1 to 2, 4 to 5, and 7 to 8.
Accordingly, for the periods identified above, the parties to the supply arrangements assess whether Entity A has the right to control the use of the asset during those periods. If this is the case, the supply arrangements would constitute leases for the following period(s).
Contract 1: eight-year lease with a commencement date at the beginning of Year 3 (i.e., over Years 3 to 10).
Contract 2: eight-year lease with a commencement date at the beginning of Year 1 (i.e., over Years 1 to 8).
Contract 3: six-year lease composed of three non-consecutive periods (Years 1 to 2, 4 to 5, and 7 to 8).
A portion of economic benefits from use of an asset is retained by the supplier
A portion of economic benefits from use of an asset is retained by the supplier – example
A manufacturing company (Customer) enters into a 20-year contract with a power-generating company (Supplier) to purchase all of the electricity produced by a specified power plant owned by the Supplier. The generation process uses natural gas to produce steam of a certain temperature and pressure that is used in steam turbines to generate electricity. Steam, once passed through the turbines, still possesses a level of heating energy that allows it to be deployed for another purpose and the Supplier sells it to a local council that has offices nearby to heat the property and provide hot water.
In accordance with the contract, the power plant is expected to operate at its full capacity since the Customer’s production process is stable and has a constant demand for electricity. The power plant is explicitly specified in the contract and the Supplier does not have the right to substitute it.
The parties assess that the steam available after the generation process represents a by-product of the power plant (the primary output is the electricity produced), i.e., it is an economic benefit that results from use of the power plant within the defined scope of the contract. Accordingly, the parties further assess whether the extent of this economic benefit that is retained by the Supplier is sufficient to conclude that the Customer does not obtain substantially all of the economic benefits from use of the power plant.
Whilst IFRS 16 does not provide explicit guidance on how to measure the economic benefits derived from use of the asset, it would be appropriate to perform this assessment based on the relative fair value or stand-alone prices of products arising from use. This assessment should not rely on the prices attributed to the products in the contract since these prices may not be reflective of fair values. The rate the Customer pays for the electricity may be adjusted to reflect the Supplier’s ability to generate further economic benefits from the steam by-product (e.g., the Customer pays a lower rate for the electricity supplied than they would if the steam by-product is not retained by the Supplier). However, this does not affect the relative economic benefits from the use of the power plant accruing to each party (i.e., the fair value of the steam by-product, the use of which is controlled by the Supplier, and the fair value of the electricity used by the Customer).
Right to direct the use
Circumstances when the customer has the right to direct the use of an identified asset
A customer has the right to direct the use of an identified asset throughout the period of use only if either:
(a) the customer has the right to direct how and for what purpose the asset is used throughout the period of use; or
(b) the relevant decisions about how and for what purpose the asset is used are predetermined and specified conditions are met.
If neither of the conditions in IFRS 16 is met, the supplier directs how and for what purpose the asset is used and, consequently, the contract does not contain a lease.
How and for what purpose the asset is used
Note that, as explained in IFRS 16, ‘how and for what purpose’ an asset is used is a single concept (i.e., ‘how’ an asset is used is not assessed separately from ‘for what purpose’ an asset is used).
A customer has the right to direct how and for what purpose the asset is used if it can change how and for what purpose the asset is used throughout the period of use. In making this assessment, the focus is on whether the customer has decision-making rights that affect the economic benefits to be derived from use of the asset.
Directing how and for what purpose an asset is used
The extent to which the customer directs how and for what purpose the asset is used will depend on whether the contract grants the customer decision-making rights over that asset. Therefore, a customer should:
(1) identify the decision-making rights that most affect how and for what purpose the asset is used during the period of use (i.e., which decision-making rights most affect the economic benefits from use of the asset);
(2) of those, identify the decision-making rights that are within the scope of the customer’s right to use the asset in the contract (i.e., as limited by the contract by, for example, protective rights or legal restrictions); and
(3) determine which party controls those rights.
Although some decisions about how and for what purpose the asset will be used during the period of use are predetermined, other significant decision-making rights related to how and for what purpose the asset will be used are still likely to be made during the period of use (e.g., when the asset is used to produce an output that the customer specified before the period of use). An entity should consider such decision-making rights when assessing which party determines how and for what purpose the asset is used throughout the period of use.
If all decisions about how and for what purpose the asset will be used throughout the period of use are predetermined such that no significant decision-making rights can be made during the period of use, the parties to the arrangement would consider whether the customer operates the asset throughout the period of use or designed the asset in a manner that predetermined how and for what purpose the asset will be used in accordance with IFRS 16.
The decision-making rights that are most relevant for this purpose are likely to be different for different contracts, depending on the nature of the asset and the terms and conditions of the contract. Depending on the circumstances, these could include rights to change:
- the type of output that is produced by the asset (e.g., to decide whether to use a shipping container to transport goods or for storage, or to decide upon the mix of products sold from retail space);
- when the output is produced (e.g., to decide when an item of machinery or a power plant will be used);
- where the output is produced (e.g., to decide upon the destination of a truck or a ship, or to decide where an item of equipment is used); and
- whether the output is produced, and the quantity of that output (e.g., to decide whether to produce energy from a power plant and how much energy to produce from that power plant).
Rights that are limited to operating or maintaining the asset are examples of rights that do not grant the right to change how and for what purpose the asset is used. Although such rights are often essential to the efficient use of an asset, they are not rights to direct how and for what purpose the asset is used and are often dependent on the decisions about how and for what purpose the asset is used.
Therefore, for example, if the contract covers the use of a fleet of trucks for an agreed period and the customer has the right to decide how and when the trucks are used, the fact that the supplier continues to operate and maintain the trucks does not undermine the customer’s ability to direct the use of the trucks.
In the Board’s view, the decisions about how and for what purpose an asset is used are more important in determining control of the use of an asset than other decisions to be made about use, including decisions about operating and maintaining the asset. This is because decisions about how and for what purpose an asset is used determine how, and what, economic benefits are derived from use.
Relevance of decision-making rights regarding operating or maintaining an asset
Decision-making rights regarding operating or maintaining an asset should not be ignored for the purposes of determining who has the right to direct the use of an identified asset. The discussion in IFRS 16 relates to the most common circumstances when the rights to operate or maintain an asset are not significant. However, this may not always be the case. IFRS 16 states that decision-making rights are relevant for the purposes of determining who has the right to direct the use of an identified asset when they affect the economic benefits to be derived from use. IFRS 16 clarifies that relevant rights include rights to change when output is produced and rights to change whether and how much output is produced. In some circumstances, decisions made regarding operating or maintaining an asset will have a direct and significant impact on the volume and timing of output and, consequently, will be relevant rights for this purpose.
Rights to operate an asset may grant the customer the right to direct the use of the asset if the relevant decisions about how and for what purpose the asset is used are predetermined as contemplated in IFRS 16.
Assessing which party has the right to direct the use of dedicated assets on the customer’s premises
Example A and B involves a contract for network services under which a telecommunication company (the supplier) installs and configures multiple servers at a customer site to support the customer’s network needs (primarily the storage and transportation of data). During the term of the arrangement, the supplier makes decisions about how to deploy the fleet of servers to satisfy customer requests. Although the arrangement involves dedicated equipment, some of which is maintained on the customer’s premises, the conclusion reached in the example is that the arrangement does not contain a lease since it is the supplier, and not the customer who has the right to direct how and for what purpose the individual servers are used.
This outcome may seem to be counterintuitive since the servers are dedicated solely to the customer for the term of the arrangement. However, the conclusion highlights that for a lease to exist, it is not sufficient for the customer to have the right to all of the asset’s productive output. The control of the use of an identified asset is determined in a two-part test that focuses on
(1) economic benefits and
(2) the right to direct the use of the identified asset(s).
In Example A, the second condition is not met; therefore, the arrangement does not contain a lease.
The key factors which are considered to lead to the conclusion that the customer does not have the right to direct the use of the servers in Example A are as follows:
- the analysis is performed at the level of each individual server, as opposed to the entire network;
- the consideration of how and for what purpose the asset is used also focuses on decisions related to each individual server – not the output produced by the overall network;
- the supplier retains the discretion to deploy each individual server in whatever manner the supplier decides will best fulfil the overall network service;
- since each server on its own can perform different functions (e.g., storing data, transporting data), the supplier has the right to make meaningful decisions about which server(s) should be used to satisfy a particular customer request; and
- the customer cannot decide how and for what purpose each individual server is used and cannot prevent the supplier from making those decisions. The customer’s decisions are limited to how the customer uses the network and do not extend to the individual servers.
In Example B, the arrangement involves a single server, and the customer makes the critical decisions about which data to store or transport by using this single server as well as about how, or whether, to integrate that single server into its broader operations. Accordingly, in that example, the customer is determined to have the right to direct the use of the server.
Relevant decisions are predetermined
When there are no relevant decisions to be made by either the supplier or the customer, the “how and for what purpose the asset is used” is predetermined.
The relevant decisions about how and for what purpose an asset is used can be predetermined in a number of ways. For example, the relevant decisions can be predetermined by the design of the asset or by contractual restrictions on the use of the asset.
When decisions about how and for what purpose an asset is used are predetermined, they cannot be changed by either the customer or the supplier during the period of use. The Board noted that it would expect these circumstances to arise in relatively few cases.
When the relevant decisions about how and for what purpose the asset is used are predetermined, a customer has the right to direct the use of an identified asset throughout the period of use only if either:
(i) the customer has the right to operate the asset (or to direct others to operate the asset in a manner that it determines) throughout the period of use, without the supplier having the right to change those operating instructions; or
(ii) the customer designed the 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 approach to determining whether a customer has the right to direct the use of an identified asset changes if the decisions about how and for what purpose an asset is used are predetermined. IFRS 16 clarifies that, in such circumstances, a customer can still direct the use of an asset if it has the right to operate the asset, or if it designed the asset in a way that predetermines how and for what purpose the asset will be used. In either of these cases, the customer controls rights of use that extend beyond the rights of a customer in a typical supply or service contract (i.e., the customer has rights that extend beyond solely ordering and receiving output from the asset). In these cases, the customer has the right to make (or, in the case of design, has already made) decisions that affect the economic benefits to be derived from use of the asset throughout the period of use.
Right to direct the use of an identified asset through right to operate when decisions about how and for what purpose the asset is used are predetermined – example
Entity D (the customer) and Entity E (the supplier) enter into a contract for the use of a specified fleet of trucks for an agreed period where the contract specifies that the trucks are to be used to carry rock from a specified quarry site to a specified crushing facility, which route should be used and that trucks should operate at their full loading capacity. These matters have been agreed between the parties prior to the commencement date and they cannot be changed. The trucks in question are of a type that is commonly used in the mining industry and Entity D was not involved in their design.
In accordance with IFRS 16, Entity D only has the right to direct the use of the fleet of trucks if it has the right to operate the trucks (or to direct others to operate the trucks in a manner that it determines) throughout the period of use, without Entity E having the right to change those operating instructions.
If Entity D has the right to operate the trucks throughout the period of use, it has the right to direct the use of the trucks, notwithstanding its inability to change how and for what purpose the trucks are used. In contrast, if Entity E is the operator, then Entity D does not have the right to direct the use of the trucks, and there is no lease.
If the “how and for what purpose the asset is used during the period of use” is predetermined and the supplier operates the asset, but the customer has the right to hire a new operator in replacement of the supplier (as operator), the customer has the right to direct others to operate the asset in accordance with IFRS 16. When such a kick-out right is substantive (i.e., when the customer can replace the operator without cause at any time), the customer is the decision maker with respect to the operation of the asset.
Assessing whether the customer has designed the asset
The assessment of whether the customer has designed the asset is expected to require entities to use significant judgement because of the different levels of influence a customer may have over the design decisions. A customer may often be involved in some, but not all, of the design decisions. When this is the case, the assessment should focus on whether the customer made the design decisions that most significantly affect the economic benefits to be derived from the use of the asset.
The design decisions that most significantly affect the economic benefits from use will differ depending on the nature of the asset and the technologies used. For example, for renewable energy generating assets, it can be expected that the most significant design decisions will often comprise a combination of the following:
- determining the technical functionality (e.g., the overall capacity);
- selecting the specific generating equipment (e.g., wind turbines or solar panels) and number to be installed; and/or
- selecting the site location and layout.
The assessment should also consider whether the customer’s involvement was limited to giving broad guidelines to be respected by the supplier or whether the customer was precise in establishing the design. For example, when designing a solar farm, did the customer:
- indicate a minimum capacity to be attained or specify the exact number of solar panels to be installed; and/or
- require the solar farm to be within a certain number of kilometers from the interconnection point or identify the exact plot of land and acreage?
When the customer gives broad guidelines, it is necessary to determine whether these are nonetheless specific enough such that decisions left to the discretion of the supplier will not significantly affect the economic benefits from use of the asset.
When the supplier is selected through a competitive request, the assessment of whether the customer designed the asset will generally include consideration of:
- the level of detail provided in the request for proposal issued by the customer – if the request for proposal is very specific, it may be that few decisions are left to be made by the suppliers except for the quoted price; and/or
- the level of the detail in the proposals submitted by the suppliers and the extent to which the plans proposed by the different suppliers differs – this may indicate that by choosing one particular supplier, the customer has, in effect, chosen the design of the asset.
Mix of decision-making rights between predetermined, customer and supplier
Mix of decision-making rights between predetermined, customer and supplier
As explained, a contract may specify that some relevant decisions about how and for what purpose an asset is used are predetermined and some are within the rights of the customer or supplier to make the decisions. When there is a mix of customer or supplier-controlled rights and predetermined relevant decisions, it is necessary to consider whether the decision-making rights available to the customer convey to the customer the right to direct the use of an identified asset in accordance with IFRS 16.
For example, Entity A enters into a contract to use a ship for five years that specifically identifies the ship which is operated and maintained by the supplier throughout the period. Entity A has the right to obtain substantially all the economic benefits from the use of the ship. Many, but not all, decisions about how and for what purpose the ship will be used are predetermined in the contract. Entity A has the right to make the remaining decisions about how and for what purpose the ship is used throughout the period of use. Entity A’s decision-making right is determined to be relevant because it affects the economic benefits to be derived from the use of the ship.
In assessing whether it has the right to direct the use of the identified asset throughout the period of use, Entity A considers the requirements of IFRS 16. IFRS 16 applies only when the relevant decisions about how and for what purpose the asset is used are predetermined. The Board noted that “it would expect decisions about how and for what purpose an asset is used to be predetermined in relatively few cases”.
As not all relevant decisions about how and for what purpose the ship is used are predetermined in this example, Entity A considers IFRS 16 in assessing whether it has the right to direct the use of the ship.
IFRS 16 specifies that a customer has the right to direct the use of an identified asset throughout the period of use if it has “the right to direct how and for what purpose the asset is used throughout the period of use”. To have the right to direct how and for what purpose the asset is used, within the scope of its right of use defined in the contract, Entity A must be able to change how and for what purpose the asset is used throughout the period of use. In assessing whether that is the case, Entity A must consider rights to make decisions during the period of use that are most relevant to changing how and for what purpose the asset is used throughout that period. Decision-making rights are relevant when they affect the economic benefits to be derived from use. Entity A should not consider decisions that are predetermined before the period of use unless the conditions in IFRS 16 exist.
IFRS 16 includes examples of decision-making rights that, depending on the circumstances, grant the right to change how and for what purpose the asset is used. Rights limited to operating or maintaining the asset do not grant the right to change how and for what purpose it is used.
In this example, Entity A has the right to direct how and for what purpose the ship is used throughout the period of use. Entity A has the right to make decisions about the use of the ship during the period of use that affect the economic benefits to be derived from that use. Therefore, within the scope of its right of use defined in the contract, Entity A can change how and for what purpose the ship is used. The predetermination in the contract of many decisions about how and for what purpose the ship is used defines the scope of Entity A’s right of use. Within that scope, Entity A has the right to make those decisions that are most relevant to changing how and for what purpose the ship is used. In addition, although the operation and maintenance of the ship are essential to its efficient use, the supplier’s decisions in this regard do not give it the right to direct how and for what purpose the ship is used. Entity A concludes that it has the right to direct the use of the ship throughout the period of use and, therefore, that the contract contains a lease.
This conclusion was confirmed by the IFRS Interpretations Committee in the January 2020 IFRIC Update.
Decisions determined during and before the period of use
In assessing whether a customer has the right to direct the use of an asset, an entity should consider only rights to make decisions about the use of the asset during the period of use, unless the customer designed the asset (or specific aspects of the asset) as described in IFRS 16. Consequently, unless the conditions in IFRS 16 exist, an entity should not consider decisions that are predetermined before the period of use.
For example, if a customer is able only to specify the output of an asset before the period of use, the customer does not have the right to direct the use of that asset. The ability to specify the output in a contract before the period of use, without any other decision-making rights relating to the use of the asset, gives a customer the same rights as any customer that purchases goods or services.
Decisions regarding the use of an asset made before the period of use
It is not unusual for a customer to specify its requirements prior to the commencement of a contract and to reach an agreement with the supplier as to how those requirements will be met. For example, a customer requires a supply of iron over an extended period. It agrees with the supplier prior to the commencement of supply that this requirement will be met by utilizing all of the capacity of a specifically identified smelting plant operating for an agreed number of hours over that period. Assuming that the customer was not involved in the design of the smelting plant, the fact that it is able only to specify the output of the smelting plant before the period of use does not mean that it has the right to direct the use of the plant. In this scenario:
- if the customer has the right to change how and for what purpose the smelting plant is used during the period of use, the customer has the right to direct the use of the smelting plant and, subject to other conditions, there may be a lease;
- if the supplier has the right to change how and for what purpose the smelting plant is used during the period of use, the supplier has the right to direct the use of the smelting plant and there is no lease; and
- if neither party has the right to change how and for what purpose the smelting plant is used, its activities are predetermined, and the right to direct its use will be determined by which entity is operating the smelting plant during the period of use.
Illustrative examples
The illustrative examples accompanying IFRS 16 include 10 examples of how an entity determines whether a contract is, or contains, a lease. These examples are summarized in a tabular format below, in each case highlighting the key determinants as to whether the contract is, or contains, a lease. Please refer to the full text of the illustrative examples accompanying IFRS 16 for complete details in each case.
Example Identified asset? Substantive substitution rights? Customer has a right to control the use of the identified asset? Lease? Contract between Customer and a freight carrier (Supplier) provides Customer with the use of 10 rail cars of a particular type for five years. Supplier also provides engines and drivers when requested by Customer. Yes. Specific rail cars identified in contract. No. Can only be substituted for repairs or maintenance. Yes. Customer has exclusive use of rail cars during the contract period so that it has the right to substantially all of the economic benefits from use of the rail cars. Customer has the right to change how and for what purpose the cars are used – it directs when and where the cars are used, and which goods are transported. Supplier’s rights (restrictions on specified types of cargo) are protective only. Supplier’s control of engines required to transport the rail cars does not give it the right to control the use of the cars. Yes – lease of rail cars (not engines). Contract between Customer and Supplier requires Supplier to transport a specified quantity of goods by using a specified type of rail car in accordance with a stated timetable for five years. No. Supplier has large pool of similar items and none are specified in the contract. Yes. Alternatives are readily available at minimal cost. Supplier benefits economically by using its pool of available rolling stock in the most efficient manner. No. Supplier selects which are used for each delivery and obtains substantially all of the economic benefits from use of the rail cars. No. Customer is purchasing freight capacity (service). Coffee company (Customer) enters into a contract with an airport operator (Supplier) to use an agreed amount of space in the airport (precise location not specified) to sell its goods for a three-year period. No. Many areas available for Customer to locate its kiosk and none specified in the contract. Yes. Alternatives are readily available at minimal cost. Supplier benefits economically by using its retail space in the most efficient manner. No. Supplier selects which space is allocated to Customer and obtains substantially all of the economic benefits from use of the concession space. No. Customer is purchasing space, which can be changed at the discretion of the supplier, and is a service. Customer enters into a 15-year contract with a utilities company (Supplier) for the right to use three specified, physically distinct dark fibers within a larger cable connecting Hong Kong to Tokyo. Yes. Fibers are specifically identified in the contract and are physically distinct from other fibers within the cable. No. Can only be substituted for repairs or maintenance. Yes. Customer has exclusive use of fibers during the contract period so that it has the right to substantially all of the economic benefits from use. Customer has the right to change how and for what purpose the fibers are used – it decides when and whether the fibers are connected and the type and volume of data transported. Yes – lease of specified fibers. Customer enters into a 15-year contract with Supplier for the right to use a specified amount of capacity within a cable connecting Hong Kong to Tokyo. No. Customer is purchasing capacity, equivalent to it having the use of three fibers, but specific fibers are not identified. Capacity purchased is not physically distinct and does not represent substantially all the capacity of the cable. Yes. Alternatives are readily available. Supplier benefits economically by using fibers in the most efficient manner. No. Supplier makes all of the relevant decisions and has the right to substantially all of the economic benefits from use of the fibers. No. Customer is purchasing transmission capacity (service). Customer enters into a contract with a property owner (Supplier) to use Retail Unit A for a five-year period. Retail Unit A is part of a larger retail space with many retail units. Yes. Specific retail unit identified in the contract. No. Although Supplier has the practical ability to substitute another retail unit, it would be required to pay relocation expenses and the circumstances in which it would benefit economically (major new tenant) are, at the inception date, not considered likely to arise. Yes. Customer has exclusive use and has the right to obtain all of the economic benefits from use of the retail unit during the contract period (notwithstanding the requirement to make variable payments based on retail sales to the Supplier). Customer makes all of the relevant decisions regarding what to sell and at what price. Supplier’s inputs (cleaning, security, advertising) do not give it the right to decide how and for what purpose the retail space is used. Yes – lease of specific retail unit. Customer enters into a contract with Supplier for the use of a truck for one week to transport cargo from New York to San Francisco. Yes. Specific truck identified in the contract. No. Yes. Customer has exclusive use and has the right to obtain all of the economic benefits from use of the truck during the contract period. Although how and for what purpose the truck is used is predetermined, Customer operates the truck and, therefore, has the right to direct the use of the truck). Yes – lease of truck. Because the duration of the lease is one week, it is a short-term lease. Customer enters into a contract with a ship owner (Supplier) for the transportation of cargo from Rotterdam to Sydney on a specified ship. Yes. Specific ship identified in the contract. No. No. Customer occupies substantially all of the capacity of the ship and therefore has the right to substantially all of the economic benefits from use of the ship during the contract period. However, how and for what purpose the ship is used is predetermined and Supplier operates the ship. Therefore, Customer does not have the right to direct the use of the ship. No. Customer is purchasing transport service. Customer enters into a contract with Supplier for the use of a specified ship for a five-year period. Yes. Specific ship identified in the contract. No. Yes. Customer occupies substantially all of the capacity of the ship and therefore has the right to substantially all of the economic benefits from use of the ship during the contract period. Customer makes the relevant decisions about whether, where and when the ship sails (subject to contractual restrictions designed to protect Supplier’s investment and personnel). Although Supplier operates the ship, it is in accordance with Customer’s decisions regarding how and for what purpose the ship is used. Yes – lease of ship for the contract period. Customer enters into a contract with an aircraft owner (Supplier) for the use of an explicitly specified aircraft for a two-year period. The contract details the interior and exterior specifications for the aircraft. Yes. Specific aircraft identified in the contract. No. Although Supplier has the right to substitute another aircraft, the costs of outfitting any substitute to the standard specified in the contract mean that Supplier would not be expected to benefit economically from substitution. Yes. Customer has exclusive use and has the right to obtain all of the economic benefits from use of the aircraft during the contract period. Contractual and legal restrictions define the scope of the Customer’s right of use. Within that defined scope, Customer makes the relevant decisions about how and for what purpose the aircraft is used. Although Supplier operates the aircraft, it is in accordance with Customer’s decisions regarding whether, where and when the aircraft travels. Yes – lease of aircraft for the contract period. Customer enters into a contract with a manufacturer (Supplier) to purchase a particular type, quality and quantity of shirts for a three-year period. Yes. Factory implicitly specified because Supplier can fulfil the contract only through the use of its one factory. No. No alternative factory available. No. Customer does not have the right to obtain all of the economic benefits from use of the factory during the contract period because its output does not represent substantially all of the output of the factory and Supplier can use spare capacity to supply other customers. Also, Supplier directs the use of the factory (Customer has the same rights as other customers). No. Customer is purchasing shirts (goods). A utility company (Customer) enters into a contract with a power company (Supplier) to purchase all of the electricity produced by a new solar farm for 20 years. Customer designed the solar farm. Yes. Specific solar farm identified in the contract. No. Yes. Customer has exclusive use and has the right to obtain all of the economic benefits from use of the solar farm during the contract period (Supplier’s benefits in the form of tax credits are economic benefits from ownership rather than use). Although how and for what purpose the solar farm is used is predetermined, Customer’s design of the farm has given it the right to direct the use of the farm. Yes – lease of solar farm for the contract period. Customer enters into a contract with Supplier to purchase all of the power produced by an explicitly specified power plant for three years. Supplier designed the power plant and operates it. Yes. Specific power plant identified in the contract. No. No. Customer has exclusive use and has the right to obtain all of the economic benefits from use of the power plant during the contract period. However, how and for what purpose the plant is used is predetermined and Customer did not design the plant and Supplier operates the plant. Therefore, Customer does not have the right to direct the use of the plant. No. Customer is purchasing a power supply (service). Customer enters into a contract with Supplier to purchase all of the power produced by an explicitly specified power plant for 10 years. Customer determines timing and quantity of power produced. Yes. Specific power plant identified in the contract. No. Yes. Customer has exclusive use and has the right to obtain all of the economic benefits from use of the power plant during the contract period. Customer makes the relevant decisions about how and for what purpose the plant is used. Although Supplier operates the plant, it is in accordance with Customer’s decisions regarding the timing and quantity of power produced. Yes – lease of power plant for the contract period. Customer enters into a contract with a telecommunications company (Supplier) for network services for two years. Not considered. Not considered. No. Customer does not control the use of the servers. Supplier is the only party that can make relevant decisions about the servers during the period of use – it decides how data is transported using the services, whether to reconfigure the servers and whether to use the servers for another purpose. No. Customer is purchasing network services. Customer enters into a contract with an information technology company (Supplier) for the use of an identified server for three years. Yes. Specific server identified in the contract. No. Server can only be substituted if it malfunctions. Yes. Customer has exclusive use and has the right to obtain all of the economic benefits from use of the server during the contract period. Customer makes the relevant decisions about how and for what purpose the server is used. Yes – lease of the server for the contract period.
Protective rights
A contract may include terms and conditions designed to protect the supplier’s interest in the asset or other assets, to protect its personnel, or to ensure the supplier’s compliance with laws or regulations. These are examples of protective rights. For example, a contract may: [IFRS 16: B30]
- specify the maximum amount of use of an asset or limit where or when the customer can use the asset; or
- require a customer to follow particular operating practices; or
- require a customer to inform the supplier of changes in how an asset will be used.
Rights of this nature typically define the scope of the customer’s right of use but do not, in isolation, prevent the customer from having the right to direct the use of an asset.
Distinguishing between a lease and a service contract
A contract may not be wholly a lease or wholly a service; it is not uncommon for some service arrangements to contain a right to control the use of an asset. For example, an entity may enter into a service arrangement that requires use of an asset to deliver the service promised in the contract. The importance of the asset to the overall delivery of the service may vary depending on the type of arrangement.
In accordance with IFRS 16, an entity is required at contract inception to identify whether a contract contains a lease. Not all leases will be labelled as such, and leases may be embedded in a larger arrangement. If the arrangement involves use of an identified asset, either explicitly or implicitly, it must be determined whether the customer controls the use of the asset throughout the period of use. This determination is based on facts and circumstances, and reasonable judgement may need to be applied, particularly when both the customer and the supplier make decisions about the use of the underlying asset. Examples of these more complex arrangements include those that involve cloud computing services (i.e., if there is a lease of the supporting equipment, such as mainframes and servers) and media services (e.g., a cable television set top box or router).
Customer has control for only a portion of the term of a contract
If the customer has the right to control the use of an identified asset for only a portion of the term of a contract, the contract contains a lease for that portion of the lease term.
Assessment required for each potential separate lease component
The assessment as to whether a contract contains a lease should be made for each potential separate lease component.
Identifying a lease in a contract conveying multiple assets
Some arrangements may identify several assets that will be dedicated to a customer. When this is the case, the question may arise as to whether the analysis to conclude if the arrangement is, or contains a lease, should be made at the contract level (group of assets) or at the individual asset level. IFRS 16 requires that the assessment is made for each potential separate lease component. IFRS 16 explains that a separate lease component exists if a lessee can benefit from the use of an asset in the contract on its own, or together with other readily available resources, and if the asset is neither highly dependent on, nor highly interrelated with, other assets in the contract.
One of the conditions for a lease to exist is that the customer must have the right to direct the use of the identified asset. This is generally the case when the customer has the right to direct how, and for what purpose, the asset is used throughout the period of use. A contract between a customer and a supplier may contemplate that both parties will make a number of decisions which may affect how and for what purposes the assets are used.
If a lease includes multiple assets and one or more individual assets are identified as potential separate lease components (using the criteria in IFRS 16), a lease exists for the separate lease component(s) if the customer has the right to direct the use of the specific individual asset(s). If instead, the supplier has the right to make the decisions that most significantly affect the economic benefits to be derived from use of the individual asset(s) identified as potential separate lease component(s) and the customer’s decision-making power relates to the assets as a group (rather than the individual asset(s)), the contract does not include a lease.
The following scenarios illustrate application of these concepts.
Scenario 1
A customer may have the right to make decisions regarding how, and for what purpose, the assets are used as a group. Through the decisions made at the level of the group of assets, the customer also determines how, and for what purposes, the individual assets are used. Although a supplier has a right to make certain decisions regarding the use of each specific asset to satisfy the overall requirement set by the customer, these decisions do not affect the economic benefits to be derived from use of the individual assets (i.e., the decisions to be made by the supplier are not relevant decisions as defined in IFRS 16).
For example, a contract conveys to a lessee the exclusive use of three identified assets – a bus, a plane and a ship – to transport the lessee’s employees from one destination to another. Each week the lessee issues an instruction on where its employees are to be transported, and implicitly these instructions define which asset will be used to transfer each specific group of employees because each specific destination is only accessible by one of the above means of transport. Applying IFRS 16: B12, the assessment of whether the contract includes a lease is made at the individual asset level (each of the bus, plane and ship represents a potential separate lease contract). This is because the customer has the right to direct how, and for what purpose, the assets are used by providing the transportation instructions, at both an individual and group level and, therefore, the contract is determined to include three lease components.
Scenario 2
Multiple assets conveyed in a contract may have multiple functionalities and although a customer issues overall instructions on how and for what purpose the assets should be used as a group, a supplier may, at its discretion, decide how many assets within a pool of explicitly identified assets dedicated to the customer are necessary and how each specific asset should be deployed to satisfy the overall instructions in a way that enables the supplier to maximize the benefits of the arrangement from these decisions. In this case, the facts and circumstances of an arrangement should be assessed to determine the nature of the relevant decision-making rights and to what extent they affect the economic benefits derived from the use of the assets within the scope of the contract, and which party obtains them.
For example, Homebuilder B enters into a contract with Vendor C to provide demolition and construction services for two years. Under the arrangement, Vendor C will use three pieces of heavy construction equipment – an excavator, a crane and a skid loader – in the demolition of real estate purchased by Homebuilder B and the construction of a new suburban housing development at Homebuilder B’s direction.
Each piece of equipment has multiple functionalities. For example, the crane can be used to lift heavy materials when a hook is attached or to demolish existing structures when a wrecking ball is attached. Vendor C’s own employees are deployed to operate the equipment, and Homebuilder B is contractually precluded from operating the equipment itself or from hiring a third party to do so.
Each week, Homebuilder B issues instructions within a stated project to Vendor C. For example, Homebuilder B may instruct Vendor C in the first week to demolish an existing structure on the northern parcel of the purchased land and, in the second week, it may instruct Vendor C to lay the foundation for a new home on the southwest parcel of the purchased land.
Vendor C retains the discretion to deploy each individual piece of equipment in whatever manner it decides will best fulfil the demolition and construction services it is providing to Homebuilder B. For example, to accomplish the first week’s project, Vendor C may choose not to use the skid loader and instead, to save fuel, may be able to complete the first week’s project solely by using the demolition-related functions of the crane and the excavator. Because each piece of equipment on its own can perform different functions, Vendor C has the right to make relevant decisions about which pieces of equipment should be used to satisfy each week’s project. Therefore, Vendor C’s decision-making rights go beyond basic decisions about operating and maintaining the equipment.
Homebuilder B cannot decide how and for what purpose each piece of equipment is used to complete each week’s project, and Homebuilder B cannot prevent Vendor C from making those decisions. Homebuilder B’s decisions are limited to how it will use the services provided by Vendor C and do not extend to the individual pieces of equipment.
Applying IFRS 16, the excavator, the crane and the skid loader are identified as three potential separate lease components. Vendor C (the lessor) retains the right to direct how, and for what purpose, each piece of equipment is used in a way that most significantly impact the benefits to be derived from use of the assets. Therefore, the contract does not contain a lease.
A similar scenario may be observed when the supplier, at its discretion, may individually deploy each server for such tasks as filing, e-mail or printing to provide the customer with network services of a certain capacity and quality.
Scenario 3
Multiple assets conveyed for the customer’s use may operate in a highly integrated and interrelated way such that there are no decision-making rights at an individual asset level.
An extreme example of such a scenario may be an arrangement whereby a customer obtains all of the output of a power plant operated by a supplier. The power plant is constructed to function as a single asset. Applying IFRS 16, the individual assets (component pieces) that make up the power plant do not represent potential separate lease components as the component pieces are both highly dependent upon, and interrelated with, the other assets used in the power plant such that they cannot be used separately, and the customer cannot benefit from a component piece on its own. Therefore, the assessment of whether the arrangement is a lease is performed at the power plant level considering the decision-making rights over the power plant as a whole.
However, if the power plant was constructed to contain two or more turbines, each capable of generating electricity separately, the facts and circumstances of the arrangement may indicate that each of them is a separate lease component and it would be necessary to assess the decision-making rights affecting the separate lease component.
Assessing whether a contract contains a lease when the customer is a joint arrangement
When a contract to receive goods or services is entered into by, or on behalf of, a joint arrangement (as defined in IFRS 11), the joint arrangement is considered to be the customer in the contract. Accordingly, when assessing whether such a contract contains a lease, an entity should assess whether the joint arrangement has the right to control the use of an identified asset throughout the period of use.
IFRS 16 clarifies that this is the case, irrespective of which entity signed the contract. Accordingly, if the parties to the joint arrangement collectively have the right to control the use of an identified asset throughout the period of use through their joint control of the arrangement, the contract contains a lease. It is not appropriate to conclude that a contract does not contain a lease on the grounds that each of the parties to the joint arrangement either obtains only a portion of the economic benefits from use of the underlying asset or does not unilaterally direct the use of the underlying asset.
This guidance is particularly relevant for joint operations where each of the parties has direct rights and obligations for the lease and for which, in the absence of this guidance, it might not have been clear whether control should be viewed from the perspective of the joint operation.
Recognition of lease liabilities in respect of a joint operation that is not a separate vehicle
As discussed, if one of the joint operators (‘the obligor’) in a joint operation conducted through a contractual arrangement (i.e., when there is no separate legal vehicle that can enter into contracts on its own account) is the sole party with direct responsibility for a contractual obligation to a third party, that obligor should recognize the resulting liability in full (this conclusion was confirmed by the IFRS Interpretations Committee in the March 2019 IFRIC Update). One example of such an arrangement is a joint operator entering into a lease contract on behalf of a joint operation that is not a separate vehicle and having sole direct responsibility for the lease obligation. In such circumstances, the requirement for an obligor to recognize its lease liability in full is not affected by the guidance in IFRS 16: B11 which, as described in IFRS 16: BC126 (see above), exists only to avoid an inappropriate conclusion that a contract does not contain a lease. Once it has been established that a lease exists, IFRS 16: B11 has no impact on the recognition or measurement of right-of-use assets and lease liabilities, nor on the general requirements for recognition of the assets and liabilities relating to a joint operation under IFRS 11.
It will also be necessary to determine whether the right-of-use asset obtained through the lease is under the sole control of the obligor (who may determine whether to use this asset as part of the activities of the joint operation or to use it elsewhere in its business) or whether it is under the joint control of the joint operators. The former would be an asset of the obligor and should be recognized in full by that entity. The latter would be ‘an asset held jointly’ under IFRS 11, with each party to the joint operation recognizing its share.
Reassessment as to whether a contract is, or contains, a lease
An entity should reassess whether a contract is, or contains, a lease only if the terms and conditions of the contract are changed.
Portfolio exemption
Both a lessee and a lessor can apply IFRS 16 to a portfolio of leases with similar characteristics if they reasonably expect that the resulting effect is not materially different from applying the standard on a lease-by-lease basis.
Pipeline laterals and first- and last-mile connections
Assessing whether a midstream oil and gas contract using pipeline laterals or first- and last-mile connections contains a lease
Pipelines are generally constructed and operated in sprawling, integrated systems that transport natural gas, oil, and refined products from supply regions to demand regions. Some customers are connected to the pipeline system via dedicated pipes through which they receive deliveries of transported commodities. These dedicated pipes are often referred to as pipeline laterals and connect the customers’ property to the main supply system. Other customers may be connected to the pipeline system at its starting or ending points, through what is often referred to as first- or last-mile connections.
The pipeline laterals and first- or last-mile connections are physically distinct portions of the larger pipeline systems and as such represent identified assets in accordance with IFRS 16.
In order to assess whether a transportation agreement that is fulfilled using a pipeline lateral or first- or last-mile connection to the larger pipeline system contains a lease, it is necessary to determine whether the customer has the right to control the use of the pipeline lateral, or first- or last-mile connection.
Whilst the specific facts and circumstances of each arrangement must be considered, two types of pipeline laterals are commonly encountered in the midstream oil and gas industry sector.
Type 1
Pipeline laterals are connected to an integrated pipeline system and cannot operate on their own (they share supply sources with the main line and other customers). In a typical integrated pipeline system:
- the pipeline owner retains the ability to change the compression in the pipeline lateral to manage pressure in both the pipeline lateral and in the larger system. Pressure moves the commodity within the system, so changing the pressure in the pipeline lateral can affect the pressure in the larger system, thus affecting the speed at which other customers’ inventory moves through the system (and the speed at which the pipeline owner is able to provide its transportation services to others); and
- the pipeline owner retains the ability to store its own commodity in the pipeline lateral, and by doing so, the pipeline owner also manages the pressure in the lateral and in the larger system.
Accordingly, the pipeline owner retains:
- economic benefits from the asset’s use that are more than insignificant through its rights to store commodity in the pipeline lateral and to use the compression in the pipeline lateral to manage the pressure in the larger system, even though the customer decides when to receive service and at what volumes; and
- the right to direct the use of the asset throughout the period of use because of its rights to change when, whether, and to what extent the pipeline lateral is used to manage the pipeline owner’s larger system.
In such agreements, the pipeline lateral contracts do not contain a lease.
Type 2
Pipeline laterals that are connected to a pipeline system but are fully capable of operating using their own dedicated assets. Typically:
- the customer has the right to substantially all the pipeline lateral’s capacity;
- the customer is able to close off this type of lateral from the remainder of the pipeline system (by closing a valve or a similar mechanism), thus preventing the pipeline owner from directing the use of the asset; and
- closing the lateral off from the larger system allows the customer to use the lateral independently from the larger system.
In such agreements, the right to use the pipeline lateral contract contains a lease since the customer has “the right to obtain substantially all of the economic benefits . . . and the right to direct the use” of the pipeline lateral throughout the period of use.
Assessing whether contracts for other first- and last-mile connections contain a lease
First- and last-mile connections also arise in other industries, as illustrated in the list below.
- Electric distribution lines that run (either overhead or underground) from the street, transformer, etc. to a customer’s home or facility.
- Telephone wires that run (either overhead or underground) from the street to a customer’s home.
- Coaxial and fiber-optic cables (i.e., for cable television and internet) that run (either overhead or underground) from the street to a customer’s office building.
- Train tracks that connect a customer’s facility to the larger rail network.
In a manner consistent with the discussion above, even if the arrangement depends on an identified asset because the first- or last-mile is considered physically distinct, the contract will include a lease only if the customer has the right to direct the use of the first- or last-mile. In particular, unless the customer is able to functionally and tangibly close off the first- or last-mile asset from the larger system, the customer may be unable to control the use of this asset. In other words, when there is no such “cut-off point”, or when the cut-off point is so near to the customer’s facility that no substantive first or last-mile asset remains after that point, the related arrangement is unlikely to contain a lease.
Electric and telecommunications (i.e., wire and cable that deliver telephone, cable television, and Internet services)
Wires and cables of this nature less commonly function as Type 2 pipeline laterals because
(1) they are less likely to have a cut-off point after which the customer has the right to use the wires and cables independently from the larger system, and
(2) if a cut-off point exists, it is most likely to be very close to the customer’s facility.
Whilst they may not function as Type 1 pipeline laterals because the supplier generally cannot use the first- or last-mile connection to manage its larger network, they rarely function alone, without the assistance of the larger system. Accordingly, it is unlikely that the customers will have the right to control the use of first- or last-mile connections of electric and telecommunications wires and cables.
Rail tracks
Such first- or last-mile connections may function as Type 1 pipeline laterals if the owner of the larger rail network is able to store cars on the first- or last- mile (or miles) that connects the rail network to the customer’s facility. However, a rail track may also function as a Type 2 pipeline lateral if the customer is able to functionally and tangibly close off the portion of track that connects to its facility from the rest of the rail network. In such cases, an entity should carefully consider the relevant facts and circumstances as well as the customer’s and the supplier’s decision-making rights in related arrangements.
Subsurface rights
Subsurface rights – example
Entity A, a pipeline operator, enters into a contract with Entity B, a landowner, to obtain the right to place an oil pipeline in the underground space of the land owned by Entity B for 20 years in exchange for consideration. The contract specifies the exact location and dimensions (path, width and depth) of the underground space within which the pipeline will be placed. Entity B retains the right to use the surface of the land above the pipeline, but it has no right to access or otherwise change the use of the specified underground space throughout the 20-year period of use. Entity A has the right to perform inspection, repairs and maintenance work (including replacing damaged sections of the pipeline when necessary). Entity B does not have the right to substitute the underground space throughout the 20-year period of use.
The contract contains a lease as defined in IFRS 16 due to the following characteristics.
- The specified underground space is an identified asset because it is physically distinct from the remainder of the land and Entity B does not have the right to substitute the underground space. The contract’s specifications include the path, width and depth of the pipeline, thereby defining a physically distinct underground space. The space being underground does not in itself affect whether it is an identified asset – the specified underground space is physically distinct in the same way that a specified area of space on the land’s surface would be physically distinct in accordance with IFRS 16.
- Under the terms of the contract Entity A, has the right to obtain substantially all of the economic benefits from use of the specified underground space throughout the 20-year period of use. Entity A has exclusive use of the specified underground space throughout that period of use. Therefore, Entity A has the right to obtain substantially all of the economic benefits from use of the identified asset.
- The terms of the contract predetermine how and for what purpose the specified underground space will be used (i.e., to locate the pipeline with specified dimensions through which oil will be transported). Entity A has the right to operate the specified underground space by having the right to perform inspection, repairs and maintenance work. Entity A makes all the decisions about the use of the specified underground space that can be made of during the 20-year period of use. Therefore, Entity A has the right to direct the use of the identified asset.
This conclusion was confirmed by the IFRS Interpretations Committee in the June 2019 IFRIC Update.
Smart meters producing data on energy usage
Right to obtain substantially all economic benefits from use of the asset – smart meters producing data on energy usage
‘Smart meters’ are devices that automatically collect and regularly transmit data on energy usage at a property. That data can be made available to a number of different parties for a number of different reasons, including:
- the energy supplier for billing purposes;
- the consumer, to enable them to better monitor their energy usage and to use that information to make savings on their energy bills;
- the grid operator for grid capacity management purposes; and
- the government or the general public for policymaking or statistical purposes.
Network operators or energy suppliers replacing older ‘dumb meters’ (i.e., those that require periodic manual collection of data) with smart meters might enter into an agreement with a third party (the ‘asset owner’) under which the network operator or energy supplier pays a monthly fee per smart meter in operation at their customers’ premises. These costs are typically recovered by the operator or supplier via their normal charges to customers rather than by additional charges for data or for use of a smart (rather than dumb) meter.
In determining whether such a contract with the asset owner confers the right to obtain substantially all of the economic benefits from use of the smart meters it is necessary to consider the arrangement carefully to assess whether:
- the entity is directly receiving the data (primary output from use) and using it both for its own purposes and to deliver it (either by choice or due to a legal obligation) to other parties; or
- the primary output from use (the data) is received by another party and the entity is only one of multiple parties receiving (and paying for) data from that third party.
The economic benefits to be considered in the assessment are specified in IFRS 16 as including not just the primary output, but other benefits from use that can be realized through a commercial transaction with a third party. The provision of data for free to the general public, or other specified parties, does not represent the realization of benefits in a commercial transaction and therefore does not represent benefits to be included in the assessment. This distinction is illustrated in the following examples.
Example 1 – Data received directly from the smart meters
Entity A (a network operator) receives data directly from the smart meter (which is incorporated into its existing infrastructure) but is then obliged by regulation to transmit data to authorized parties such as metering point operators, other network operators, grid coordinators, energy suppliers, the end users and any party that was granted access by an end user and complies with legal data privacy requirements.
In this case, Entity A does obtain substantially all of the economic benefits from use of the smart meters as it alone receives data which it can then use both for its own purposes and to fulfil its legal or contractual obligations to provide data for free to other parties.
Assuming the other criteria for identification of a lease are met, Entity A should account for its arrangement with the asset owner as a lease, consistent with an analysis that the smart meters are assets that the entity controls and uses to generate economic benefits.
Example 2 – Data received along with other parties via the asset owner
The asset owner receives data from the smart meters and has a legal responsibility to provide that data to a central body set up by government. Entity B (an energy supplier who pays a monthly fee to the asset owner per meter in use by its customers) accesses data from the central body and uses it for billing purposes. Each consumer can also access detailed data on their energy usage from that central body, which also provides data to other authorized participants in the industry and collates data for statistical purposes.
In this case, Entity B does not obtain the primary output, it is only one of the parties to which the asset owner is obliged by regulation or contract to provide or sell metering data and which can benefit economically from using that data.
Entity B should not, therefore, account for its arrangement with the asset owner as a lease but instead as a contract under which it receives metering services.