IFRS 16: Identifying a lease

 

Welcome to IFRS is easy's flash term for the week

Unpopular opinion: There is often trouble with appropriately identifying whether a contract is truly a lease contract

You may be wondering why the above is difficult. Shouldn't a lease contract be easy to identify, considering that all you need to do is to know if the company has leased an asset and has agreed to pay for that asset over a period of time or better still, show you a "lease" document that backs it up?

In reality, this is far from the case. 

IFRS 16 Leases prescribes a number of checklists to consider before affirming that truly a lease exists. In fact, it doesn't matter the legality of the contract, if the contract does not meet the checklists that we will discuss very soon, then there is no lease contract, and as such the contract will not be accounted for under the requirements of IFRS 16.

But before we start, let's look at the definition of a lease contract in line with IFRS 16.

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.

If you look at the above definition, you will see that there is an emphasis on the right to control the use of an identified asset. That will be the theme for our checklist. 

So let's get into it.

There are three main questions to ask. The questions make up the checklist.

• Is there an identified asset?
• Does the customer obtain substantially all economic benefits?
• Who has the right to direct the use of the asset?

Is there an identified asset?

To have a lease, there must be an identified asset. The following are important to determine if there is an identified asset.

The identified asset must be specified either implicitly or explicitly in the contract. 

The asset can be a physically distinct portion such as the floor of a building or may not be physically distinct but occupies substantially all of the total capacity such as leasing 80% of an oil tank farm.

The supplier must not have the substantive right to substitute the asset throughout the period of use.

Does the customer obtain substantially all economic benefits?

The customer must obtain substantially all economic benefits from using the asset over the period of the contract. 

The economic benefit from using an asset include its primary output, by-products, and other economic benefits from using the asset.

Who has the right to direct the use of the asset?

There are 3 angles to determining this. 

The customer 

As predetermined in the contract

The supplier

If the customer makes the decision of how to use the asset and for what purpose the asset is to be used, then the contract is a lease. 

If both the customer and the supplier has predetermined in the contract agreement about how the customer is to use the asset and for what purpose the asset is to be used, then there is a high chance that the contract is a lease especially if the customer operates the asset or directs others to do so.

If the supplier makes the decision of how to use the asset and for what purpose the asset is to be used, then the contract is not a lease. 

Now let's see if you can solve this?

Mary entered into an agreement with a mall operator to sell coffee in the mall for a two-year period. Mary uses a moveable kiosk and is permitted to sell the coffee at any free space on the floor of the mall. Mary has correctly assessed that she can obtain substantially all economic benefits from the use of the space occupied by the moveable kiosk. Also, Mary has decided to make coffees only on Mondays, Wednesdays, and Saturdays and can decide to change this schedule as she deems fit.

The mall operator has the right to change the location of the space allocated to Mary at any time during the period of use. However, there are many areas in the mall that are available and that would meet the specifications for the space in the contract.

Does this contract contain a lease?

Newsflash!!! Before we address the question together. Kindly read below.

For more additional practical examples and to watch an explanatory video on identifying leases, see below YouTube video. 

PS: Among other examples within, there's an interesting practical example for you to solve at the end of the video. Join the conversation in the comment section of the video. 

Alright! So back to our question.

Do you think Mary has entered into a lease agreement? Now let's look at the necessary things to consider.

1. Is there an identified asset? 

No. This is because the agreement does not satisfy the first question of whether there is an identified asset. You see, Mary's kiosk can be placed anywhere within the mall. There is no specific space that has been identified for her kiosk. Also, remember that the mall operator has a substitution right and can change the location of the space allocated to Mary at any time.

2. Does the customer obtain substantially all economic benefits?

Yes. It was stated that Mary has correctly assessed this.

3. Who has the right to direct the use of the asset?

The customer. Only Mary can decide on the days when coffee will be made and other factors attributable to using the kiosk within the space allocated.  

Conclusion: Because a contract must satisfy all the 3 conditions, the above contract does not contain a lease, as such, it should be accounted for as a service contract.

Yes! You made it to the end.

I will be happy to receive any questions you may have that are not addressed in the article/video.

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Written by:

Adedamola Otun

For: IFRS IS EASY