IFRS 16 sets out the rules for recognizing leases in financial statements, both for lessees and lessors. The first step in applying IFRS 16 is identifying whether a contract contains a lease. Let's break this down.
1. What is a Lease?
A lease is a contract that gives one party (the lessee) the right to use an asset owned by another party (the lessor) for a specific period in exchange for payment. Under IFRS 16, the lessee recognizes the lease as a Right-of-Use (ROU) asset and a corresponding lease liability on its balance sheet.
2. How to Identify a Lease?
To determine if a contract contains a lease, IFRS 16 requires you to check for two key criteria:
A. Right to Control the Use of an Asset
For a contract to be considered a lease, the customer (lessee) must have the right to control the use of a specific asset for a period of time. This means two things:
Identified Asset: The contract must involve a specific, identifiable asset. This could be a building, equipment, a vehicle, etc. The asset can be identified explicitly (e.g., a specific vehicle) or implicitly (if only that particular asset can fulfill the contract).
Example: Imagine a company, ABC Ltd., signs a contract with a rental company to lease a specific delivery truck. The contract states that ABC Ltd. will use Truck #102 for its deliveries over the next three years. The truck is explicitly identified as Truck #102 in the contract. It’s a unique asset assigned solely to ABC Ltd., so the company knows it will be using that exact truck.
Let’s say ABC Ltd. instead signs a contract with the rental company for any delivery truck in their fleet, without specifying which one. The rental company can switch out the truck as they see fit. In this case, the asset is not identifiable under IFRS 16 because the contract does not specify a particular truck.
Right to Control the Asset's Use: The lessee must have the right to direct how the asset is used and receive almost all the economic benefits from its use.
Example: If you lease a machine and can decide how, when, and where it operates, and you get all the economic benefit from its use, you control the asset.
However, if the supplier decides how the machine is used or services multiple customers with it, you do not have control.
B. Supplier's Substantive Substitution Rights
The contract might not contain a lease if the supplier (lessor) has the right to substitute the asset at any time and this right is substantive. This means the lessor can replace the asset with another of similar type and functionality without needing permission from the lessee and without affecting the contract's terms.
Example: If you lease a car from a rental company, but the rental company can swap the car for another similar car at any time, it’s less likely to be classified as a lease.If the above criteria are met, the contract is considered a lease under IFRS 16.
3. Practical Example of Lease Identification
Example 1: Renting an Office Building
- Identified Asset: Yes, the contract is for a specific office building.
- Right to Control: Yes, you decide how to use the office (its layout, purpose, and activities) and receive the benefits from its use (conducting business).
- Lease: This is a lease.
Example 2: Using Shared Warehouse Space
- Identified Asset: No, the warehouse is shared by many users, and the space you use might change over time.
- Right to Control: No, the warehouse operator decides how the space is used and manages it.
- Lease: This is not a lease.
4. Non-Lease Components in Contracts
Sometimes, a contract may include both lease and non-lease components. For example, a contract for leasing a piece of equipment might include maintenance services. Under IFRS 16, you need to separate these components:
- Lease component: The equipment lease itself.
- Non-lease component: The maintenance services.
You account for each component separately. For example, the lease payments would go on the balance sheet as a lease liability, while the service fees for maintenance would be treated as an expense.
5. Summary of Steps for Lease Identification
- Check for an Identified Asset: Is there a specific asset in the contract?
- Right to Control the Asset: Does the lessee control how the asset is used and get the benefits from it?
- Check for Substitution Rights: Does the supplier have the right to replace the asset, and is it substantive?
- Separate Lease and Non-Lease Components: If the contract has both lease and service components, account for them separately.
6. Special Cases
- Service Contracts: Not every contract that involves an asset is a lease. For example, if you hire a transportation company to deliver goods using their trucks, this is a service contract—not a lease—because you don't control the trucks.
- Short-Term and Low-Value Leases: IFRS 16 allows lessees to apply a simplified treatment for leases that are short-term (less than 12 months) or involve low-value assets (e.g., laptops). Instead of recognizing them on the balance sheet, you can expense them as they occur.