IFRS 16 – When does an agreement contain a lease?

In this article we shall focus our attention on an important question of IFRS 16. When does an agreement contain a lease?

Under the new standard, a lease is 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.

To be a lease, a contract must convey the right to control the use of an identified asset, which could be a physically distinct portion of an asset such as a floor of a building.

A contract conveys the right to control the use of an identified asset if, throughout the period of use, the customer has the right to:

  • Obtain substantially all of the economic benefits from the use of the identified asset
  • Direct the use of the identified asset (i.e., direct how and for what purpose the asset is used).

Determining when a customer has the right to direct the use of an identified asset may require significant judgment, particularly for arrangements that include significant services.

A lessee does not control the use of an identified asset if the lessor can substitute the underlying asset for another asset during the lease term and would benefit economically from doing so.

Example 1

ABC Ltd provides tours around places of interest in the tourist Xcity. ABC Ltd has entered into a 3 year contract with DEF Ltd for the use of one of its coaches for this purpose. The coach must seat 40 people, but DEF Ltd can use any of its 40-seater coaches when required.

Solution 1

This is not a lease. There is no identifiable asset. DEF Ltd can substitute one coach for another, and would derive economic benefits from doing so in terms of convenience.

Therefore ABC Ltd should account for the rental payments as an expense in profit or loss.

Example 2

Xtown Council has entered into a 4 year contract with ABC Ltd, under which ABC Ltd supplies the Council with 8 vehicles for the purposes of community transport. ABC Ltd owns the relevant vehicles, all 8 of which are specified in the contract.

Xtown Council determines the routes taken for community transport and the charges. The Council can choose to use the vehicles for purposes other than community transport.

When the vehicles are not being used, they are kept at the Council’s offices and cannot be retrieved by ABC Ltd, unless Xtown Council defaults on payment.

If a vehicle needs to be serviced or repaired, ABC Ltd is obliged to provide a temporary replacement vehicle of the same type.

Solution 2

This is a lease. There is an identifiable asset, the 8 vehicles specified in the contract. The Council has a right to use the vehicles for the period of the contract.

ABC Ltd does not have the right to substitute any of the vehicles unless they are being serviced or repaired.

Therefore Xtown Council would need to recognize an asset and liability in its statement of financial position.