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The evaluation of whether a contract is (or contains) a lease is even more important under IFRS 16 than it was under IAS 17 and IFRIC 4 because substantially all leases will be recorded on-balance sheet. In practice, the main impact will be on contracts that are not in the legal form of a lease but involve the use of a specific asset and therefore might contain a lease (e.g., outsourcing, contract manufacturing, transportation and power supply agreements). Some contracts that do not contain a lease today will have embedded arrangements that meet the definition of a lease under IFRS 16, and vice versa.
Under IFRS 16 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.”
A contract can be (or contain) a lease only if the underlying asset is “identified”. Having the right to use the identified asset requires the lessee having the right to
- obtain all the economic benefits from use of the identified asset; and
- direct the use of the identified asset.
Applying the new definition involves three key evaluations (which are explained in further detail below):
1. Identified asset
The first question that an entity must answer when determining whether a contract is or contains a lease is whether there is an identified asset. An identified asset is defined as an asset that is either:
- explicitly identified in the contract or;
- implicitly specified by being identified at the time that the asset is made available for use by the customer.
Even if an asset is explicitly specified, if the supplier has a substantive substitution right throughout the period of use, then the customer does not have the right to use an identified asset. A substantive substitution right exists if the supplier has the practical ability to substitute alternative assets throughout the period of use and would benefit economically from doing so. The assessment of whether a supplier’s substantive substitution right exists is based on facts and circumstances at inception of the contract.
A customer is not required to perform an exhaustive search to determine if a supplier has a substantive substitution right. If the customer cannot readily determine whether a supplier has a substantive substitution right, the customer may conclude that a substantive substitution right does not exist.
Example – Rail cars
Supplier has a five-year contract with Customer to transport goods using a specified type of rail car. The transport timetable and quantity of goods to be shipped specified in the contract is equivalent to Customer having the use of 10 rail cars for five years. Supplier provides the rail cars, conductor and engine as part of the contract. Supplier has a large pool of similar rail cars that can be used to fulfill the requirements of the contract with Customer. The rail cars and engines are stored at Supplier’s premises when not being used to transport the goods.
Analysis – The contract does not contain a lease. The rail cars and the engine used to transport Customer’s goods are not identified assets because Supplier has a substantive substitution right to substitute the rail cars and engine (alternative cars and engines are readily available to Supplier and can be substituted without Customer’s approval. In addition, costs associated with substituting the cars and engines is minimal because Supplier has a large pool of similar rail cars and engines stored at their premises).
A portion of an asset is an identified asset if it is physically distinct (e.g., a floor of a building). Where a portion of an asset is not physically distinct (e.g., a fibre optic cable), the capacity portion of the asset is not an identified asset unless the capacity portion represents substantially all of the capacity of the asset.
2. Economic benefits from use of the identified asset
The second question that an entity must answer when determining whether a contract is or contains a lease is whether it has the right to obtain substantially all the economic benefits from use of the identified asset throughout the period of use. A customer can obtain the economic benefits of the asset by using, holding or sub-leasing the asset.
When evaluating whether a customer obtains substantially all the economic benefits from use of an asset, a customer considers its rights within the defined scope of the contract. For example, if a contract specifies that a customer can drive a motor vehicle only up to a particular number of kilometers during the period of use, the customer considers only the economic benefits from use of the motor vehicle for the permitted mileage and not beyond.
3. Right to direct the use of the identified asset
Last, an entity needs to determine if it has the right to direct the use of the identified asset throughout the period of use. To have the right to direct the use of an identified asset, a customer must have the right to direct how and for what purpose the asset is used (i.e., “how and for what purpose decisions”) throughout the period of use. In making this evaluation, a customer considers decisions that are most relevant (i.e., the decisions that affect the economic benefits derived from use of the asset).
Examples of how and for what purpose decisions:
- rights to change the type of output produced by the asset(s)
- rights to change when the output is produced
- rights to change where the output is produced
- rights to change whether the output is produced and the quantity of the output
Rights to operate an asset or maintain an asset do not give a customer the right to direct how and for what purpose the asset is used unless the how and for what purpose decisions are predetermined. In that case, the customer will control the asset if the customer has the right to operate the asset throughout the period of use or the customer designed the asset in a way that predetermines how and for what purpose the asset will be used throughout the period of use.
Example – Ship
Customer enters into a contract with a shipping company (Supplier) to transport cars from Rotterdam to Sydney. The contract specifies a particular ship and the cars to be transported, which will require the full capacity of the ship. Supplier operates and maintains the ship and is responsible for the safe passage of the cars. Customer is not able to make changes (e.g. to the destination or nature of the cargo) once the contract has been signed.
Analysis – The contract does not contain a lease. After signing the contract, Customer is not able to direct how and for what purpose the ship is used and does not, therefore, control the use of the asset. The contract pre-determines how and for what purpose the ship will be used and Customer neither operates nor designed the ship.
Determining whether a contract meets the definition of a lease can be difficult; however, your Grant Thornton advisors are here to help. We’ll work with you to analyze your arrangements and classify them under the new IFRS 16.