Definition of a lease
IFRS 16 ‘Leases’ is a standard that impacts most reporting entities that apply IFRS Accounting Standards and are involved in leasing assets, and can have a substantial impact on the financial statements of lessees of property and high-value equipment. Although IFRS 16 has been in effect since 2019, there are still a number of areas that can be challenging in practice.
Our ‘Insights into IFRS 16’ series summaries key areas of the Standard and aims to demystify those key requirements that are challenging to apply in practice. This article considers the definition of a lease when applying IFRS 16.
Since accounting for leases under IFRS 16 results in substantially all leases being recognised on a lessee’s statement of financial position, the evaluation of whether a contract is (or contains) a lease is critical. And this evaluation must be made at the inception of a contract. In practice, a key area of judgement relates to 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 – such as outsourcing, contract manufacturing, transportation and power supply agreements. Such contracts are often structured to provide a product or a service and include various components, amongst which include the use of a specific asset that might need to be separated from the other components. IFRS 16 contains guidance to help reporting entities make this assessment.
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 control the use of an identified asset means having the right to direct, and obtain substantially all of the economic benefits from, the use of that asset. These rights must be in place for a period of time, which may also be determined by a specified amount of use. Put simply, if the customer controls the use of an identified asset for a period of time, then the contract contains a lease. This is the case if the customer can make the important decisions about the use of the asset in a similar way it makes decisions about the use of assets it owns outright. In such cases, the customer (ie the lessee) is required to recognise these rights on its statement of financial position as a ‘right-of-use asset’. In contrast, in a service contract, the supplier controls the use of any assets used to deliver the service and so there is no right-of-use asset to recognise.
