IFRS 16 into the details

Recognition of a lease IFRS 16 into the details

To start for the first time a reporting entity has to review all contracts to see whether a specific contract is a lease only or contains a lease component.

Looking at the definition of a lease the reporting entity has to assess whether, throughout the period of use, the lessee has met the following two rights:

  1. the right to obtain substantially all of the economic benefits from the use of the identified asset, and IFRS 16 into the details
  2. the right to direct the use of the identified asset.

There may be a difference between the period of the contract and the period of right to direct the use, the contract contains a lease for the portion of the term of the contract that the customer has the right to control the use of the identified asset.

A few particularities:

  1. A supplier’s right to substitute an asset is substantive if two options are met (see identified asset). However in situations where the asset is located at the lessee’s premises or elsewhere away from the lessor, the cost to substitute the asset may outweigh any perceived benefit to the lessor (the second option referred to above). Therefore the chance of a substitution right being substantive, and as a result a lease not having to be accounted for as a lease by a lessee, is considered quite remote.
  2. An asset has to be maintained and during that period a lessee might be considered to NOT have the right to control the asset. No, a supplier’s right to substitute an asset for the purposes of repairs (if the asset is not operating properly) and maintenance (‘preventive’ repairs) or to be upgraded when a technical update becomes due or available, does not mean the lessor has a substantive right of substitution. IFRS 16 into the details
  3. If it is not readily determinable whether the supplier has substantive substitution rights, a lessee must presume that any substitution right is not substantive.

These particularities show IFRS 16 assigns a priority treatment to inclusion of assets and liabilities in the balance sheet rather then going off-balance sheet.

As per IFRS 11 Joint Arrangements, a joint arrangement is the lessee if it is the party in the lease contract. So the joint arrangement may be the party that has the right to control the use of the identified asset throughout the period of use.IFRS 16 into the details

Portions of assets IFRS 16 into the details

Some contracts provide the customer with the right to use a capacity portion of an asset. For example, a customer has the right to use 30 percent of a fiber optic cable’s capacity. For a capacity portion of an asset to represent an identified asset, it must represent substantially all (for example 95%) of the cable’s capacity, although it is not distinct.

Other contracts provide a customer with the exclusive right to use a specific capacity portion of an asset. Examples of physically distinct portions of assets are the floor of a multilevel office building or a pipeline lateral that connects an oil-producing property to a main pipeline system.IFRS 16 into the details

A capacity portion of an asset depends on the remaining capacity of the asset to function (for example, the second floor of a building cannot function without the first floor) and represents only a portion of a larger asset (the second floor of a ten-story building represents approximately one-tenth of the building’s capacity). However, as long as the capacity portion is physically distinct, it could be an identified asset in a lease.

Separating components of a contract IFRS 16 into the details

Some contracts contain a lease coupled with an agreement to purchase or sell other goods or services (non-lease components). These non-lease components are identified and accounted for separately from the lease component. Under IFRS 16 there is a practical expedient that permits lesses to make an accounting policy election, by class of underlying asset, to account for each separate lease component of a contract and any associated non-lease components as a single lease component.

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However it is also possible to separate such lease and non-lease components. For example, a contract for a car may combine a lease with maintenance services. In addition, many contracts contain two or more lease components. For example, a single contract may include leases of land, buildings and equipment.

Separate lease components IFRS 16 into the details

IFRS 16 contains requirements for determining whether a contract that contains a lease has only one lease component or a number of lease components. The identification of separate lease components in a lease contract is similar to the identification of performance obligations in a revenue contract—in both circumstances, an entity is trying to identify whether a customer or a lessee is contracting for a number of separate deliverables or contracting for one deliverable that may incorporate a number of different assets. The indicators used to see if lease components need to be separated are based on the criteria relating to IFRS 15 Revenue from contracts with customers.

A promised good or service is ‘distinct’ if both of the following criteria are met:IFRS 16 into the details

  • the customer can benefit from the good or service either on its own or with other resources readily available to them. A readily available resource is a good or service that is sold separately (by the entity or by another entity) or that the customer has already obtained;
  • it is separately identifiable from other promises in the contract (i.e. the good or service is distinct within the context of the contract).

Indicators that an entity’s promises to transfer goods or services are not separately identifiable include:

  • significant integration services are provided (i.e. the entity is using the goods or services merely as inputs to produce the specific output called for in the contract);
  • the goods or services significantly modify or customise other promised goods or services in the contract (or are modified by them);
  • the goods or services are highly dependent on, or interrelated with, other promised goods or services in the contract.
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Separating non-lease components

Some contracts contain a lease coupled with an agreement to purchase or sell other goods or services (non-lease components). These non-lease components are identified and accounted for separately from the lease component. Under IFRS 16 there is a practical expedient that permits lessees to make an accounting policy election, by class of underlying asset, to account for each separate lease component of a contract and any associated non-lease components as a single lease component.

Lessees that do not make an accounting policy election to use this practical expedient are required to allocate the consideration in the contract to the lease and non-lease components on a relative stand-alone price basis. If observable stand-alone prices are not readily available, tenants estimate stand-alone prices, maximising the use of observable information.

Combine separate lease contracts

IFRS 16 is written in the context of accounting for the lease of a single asset. However, as a practical expedient to treating the unit of account as the lease of a single asset, an entity may apply IFRS 16 to a portfolio of leases with similar characteristics if the entity reasonably expects that the effects on the financial statements of applying the standard to the portfolio would not differ materiality from applying the standard to the individual lease contracts within the portfolio.

If it accounts on a portfolio basis, an entity is then able to make estimates and assumptions that reflect the size and composition of the portfolio.

Therefore, if an entity leases 1,000 vehicles under 1,000 separate contracts (i.e. each contract is for a single vehicle) it may be possible to consider the portfolio of leases as a single right to use 1,000 vehicles, rather than 1,000 rights to use a single vehicle.

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It will depend on how similar the features of each contract are (such as the specification of the vehicles) and the extent to which they were entered into at or around the same time.

IFRS 16 into the details

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