9 Essential Leases and No leases examples

9 Essential Leases and no leases examples

– shows the difference between cases of entities involved in contracts containing a lease under IFRS 16 Leases and similar but different cases of entities involved in contracts NOT containing a lease under IFRS 16 Leases.

To start setting the stage, the definition of a lease: 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.

1. Lease Rail cars

The case
A contract between Customer and a freight carrier (Supplier) provides Customer with the use of 10 rail cars of a particular type for five years. The contract specifies the rail cars; the cars are owned by Supplier. Customer determines when, where and which goods are to be transported using the cars. When the cars are not in use, they are kept at Customer’s premises. Customer can use the cars for another purpose (for example, storage) if it so chooses.

However, the contract specifies that Customer cannot transport particular types of cargo (for example, explosives). If a particular car needs to be serviced or repaired, Supplier is required to substitute a car of the same type. Otherwise, and other than on default by Customer, Supplier cannot retrieve the cars during the five-year period.

The contract also requires Supplier to provide an engine and a driver when requested by Customer. Supplier keeps the engines at its premises and provides instructions to the driver detailing Customer’s requests to transport goods. Supplier can choose to use any one of a number of engines to fulfil each of Customer’s requests, and one engine could be used to transport not only Customer’s goods, but also the goods of other customers (ie if other customers require the transportation of goods to destinations close to the destination requested by Customer and within a similar timeframe, Supplier can choose to attach up to 100 rail cars to the engine).

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Conclusion

The contract contains leases of rail cars. Customer has the right to use 10 rail cars for five years.

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The reasoning
There are 10 identified cars. The cars are explicitly specified in the contract. Once delivered to Customer, the cars can be substituted only when they need to be serviced or repaired (see Identified asset – The supplier’s right or obligation to substitute the assets for repairs and maintenance)). The engine used to transport the rail cars is not an identified asset because it is neither explicitly specified nor implicitly specified in the contract.

Customer has the right to control the use of the 10 rail cars throughout the five-year period of use because:

  1. Customer has the right to obtain substantially all of the economic benefits from use of the cars over the five-year period of use. Customer has exclusive use of the cars throughout the period of use, including when they are not being used to transport Customer’s goods.
  2. Customer has the right to direct the use of the cars because the conditions in Rights to direct the use sub (a) exist. The contractual restrictions on the cargo that can be transported by the cars are protective rights of Supplier and define the scope of Customer’s right to use the cars. Within the scope of its right of use defined in the contract, Customer makes the relevant decisions about how and for what purpose the cars are used by being able to decide when and where the rail cars will be used and which goods are transported using the cars. Customer also determines whether and how the cars will be used when not being used to transport its goods (for example, whether and when they will be used for storage). Customer has the right to change these decisions during the five-year period of use.

Although having an engine and driver (controlled by Supplier) to transport the rail cars is essential to the efficient use of the cars, Supplier’s decisions in this regard do not give it the right to direct how and for what purpose the rail cars are used. Consequently, Supplier does not control the use of the cars during the period of use.

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2. Not a lease Rail cars

The case
The contract between Customer and Supplier requires Supplier to transport a specified quantity of goods by using a specified type of rail car in accordance with a stated timetable for a period of five years. The timetable and quantity of goods specified are equivalent to Customer having the use of 10 rail cars for five years. Supplier provides the rail cars, driver and engine as part of the contract.

The contract states the nature and quantity of the goods to be transported (and the type of rail car to be used to transport the goods). Supplier has a large pool of similar cars that can be used to fulfil the requirements of the contract. Similarly, Supplier can choose to use any one of a number of engines to fulfil each of Customer’s requests, and one engine could be used to transport not only Customer’s goods, but also the goods of other customers. The cars and engines are stored at Supplier’s premises when not being used to transport goods.

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Conclusion

The contract does not contain a lease of rail cars or of an engine.

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The reasoning
The rail cars and the engines used to transport Customer’s goods are not identified assets. Supplier has the substantive right to substitute the rail cars and engine because:

  1. Supplier has the practical ability to substitute each car and the engine throughout the period of use (see Identified assets, Substantive substitution rights sub (a). Alternative cars and engines are readily available to Supplier and Supplier can substitute each car and the engine without Customer’s approval.
  2. Supplier would benefit economically from substituting each car and the engine (see Identified assets, Substantive substitution rights sub (b). There would be minimal, if any, cost associated with substituting each car or the engine because the cars and engines are stored at Supplier’s premises and Supplier has a large pool of similar cars and engines. Supplier benefits from substituting each car or the engine in contracts of this nature because substitution allows Supplier to, for example:
    1. use cars or an engine to fulfil a task for which the cars or engine are already positioned to perform (for example, a task at a rail yard close to the point of origin), or
    2. use cars or an engine that would otherwise be sitting idle because they are not being used by a customer.

Accordingly, Customer does not direct the use, nor have the right to obtain substantially all of the economic benefits from use, of an identified car or an engine. Supplier directs the use of the rail cars and engine by selecting which cars and engine are used for each particular delivery and obtains substantially all of the economic benefits from use of the rail cars and engine. Supplier is only providing freight capacity.

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3. No lease Contract for shirts

The case
Customer enters into a contract with a manufacturer (Supplier) to purchase a particular type, quality and quantity of shirts for a three-year period. The type, quality and quantity of shirts are specified in the contract.

Leases and No leases examplesSupplier has only one factory that can meet the needs of Customer. Supplier is unable to supply the shirts from another factory or source the shirts from a third party supplier. The capacity of the factory exceeds the output for which Customer has contracted (ie Customer has not contracted for substantially all of the capacity of the factory).

Supplier makes all decisions about the operations of the factory, including the production level at which to run the factory and which customer contracts to fulfil with the output of the factory that is not used to fulfil Customer’s contract.

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Conclusion

The contract does not contain a lease.

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The reasoning
The factory is an identified asset. The factory is implicitly specified because Supplier can fulfil the contract only through the use of this asset.

Customer does not control the use of the factory because it does not have the right to obtain substantially all of the economic benefits from use of the factory. This is because Supplier could decide to use the factory to fulfil other customer contracts during the period of use.

Customer also does not control the use of the factory because it does not have the right to direct the use of the factory.

Customer does not have the right to direct how and for what purpose the factory is used during the three-year period of use. Customer’s rights are limited to specifying output from the factory in the contract with Supplier. Customer has the same rights regarding the use of the factory as other customers purchasing shirts from the factory. Supplier has the right to direct the use of the factory because Supplier can decide how and for what purpose the factory is used (ie Supplier has the right to decide the production level at which to run the factory and which customer contracts to fulfil with the output produced).

Either the fact that Customer does not have the right to obtain substantially all of the economic benefits from use of the factory, or that Customer does not have the right to direct the use of the factory, would be sufficient in isolation to conclude that Customer does not control the use of the factory.

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4. No Lease – Contract with a ship owner

The case
Customer enters into a contract with a ship owner (Supplier) for the transportation of cargo from Rotterdam to Sydney on a specified ship. The ship is explicitly specified in the contract and Supplier does not have substitution rights.

Contract with a ship owner

The cargo will occupy substantially all of the capacity of the ship. The contract specifies the cargo to be transported on the ship and the dates of pickup and delivery.Supplier operates and maintains the ship and is responsible for the safe passage of the cargo on board the ship.

Customer is prohibited from hiring another operator for the ship or operating the ship itself during the term of the contract.

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Conclusion

The contract does not contain a lease.

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The reasoning
There is an identified asset. The ship is explicitly specified in the contract and Supplier does not have the right to substitute that specified ship.

Customer has the right to obtain substantially all of the economic benefits from use of the ship over the period of use. Its cargo will occupy substantially all of the capacity of the ship, thereby preventing other parties from obtaining economic benefits from use of the ship.

However, Customer does not have the right to control the use of the ship because it does not have the right to direct its use. Customer does not have the right to direct how and for what purpose the ship is used. How and for what purpose the ship will be used (ie the transportation of specified cargo from Rotterdam to Sydney within a specified timeframe) is predetermined in the contract.

Customer has no right to change how and for what purpose the ship is used during the period of use. Customer has no other decision-making rights about the use of the ship during the period of use (for example, it does not have the right to operate the ship) and did not design the ship.

Customer has the same rights regarding the use of the ship as if it were one of many customers transporting cargo on the ship.

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5. Lease – Contract with a ship owner

The case
Customer enters into a contract with Supplier for the use of a specified ship for a five-year period. The ship is explicitly specified in the contract and Supplier does not have substitution rights.

Customer decides what cargo will be transported, and whether, when and to which ports the ship will sail, throughout the five-year period of use, subject to restrictions specified in the contract. Those restrictions prevent Customer from sailing the ship into waters at a high risk of piracy or carrying hazardous materials as cargo.

Supplier operates and maintains the ship and is responsible for the safe passage of the cargo on board the ship.

Customer is prohibited from hiring another operator for the ship of the contract or operating the ship itself during the term of the contract.

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Conclusion

The contract contains a lease. Customer has the right to use the ship for five years.

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The reasoning
There is an identified asset. The ship is explicitly specified in the contract, and Supplier does not have the right to substitute that specified ship.

Customer has the right to control the use of the ship throughout the five-year period of use because:

  1. Customer has the right to obtain substantially all of the economic benefits from use of the ship over the fInvestments in joint ventures joint controlive-year period of use. Customer has exclusive use of the ship throughout the period of use.
  2. Customer has the right to direct the use of the ship because the conditions in Identified assets, Substantive substitution rights sub (a) exist. The contractual restrictions about where the ship can sail and the cargo to be transported by the ship define the scope of Customer’s right to use the ship. They are protective rights that protect Supplier’s investment in the ship and Supplier’s personnel.Within the scope of its right of use, Customer makes the relevant decisions about how and for what purpose the ship is used throughout the five-year period of use because it decides whether, where and when the ship sails, as well as the cargo it will transport. Customer has the right to change these decisions throughout the five-year period of use.

Although the operation and maintenance of the ship are essential to its efficient use, Supplier’s decisions in this regard do not give it the right to direct how and for what purpose the ship is used. Instead, Supplier’s decisions are dependent upon Customer’s decisions about how and for what purpose the ship is used.

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6. No lease Concession space

The case
A coffee company (Customer) enters into a contract with an airport operator (Supplier) to use a space in the airport to sell its goods for a three-year period. Not a lease Concession spaceThe contract states the amount of space and that the space may be located at any one of several boarding areas within the airport. Supplier has the right to change the location of the space allocated to Customer at any time during the period of use.There are minimal costs to Supplier associated with changing the space for the Customer: Customer uses a kiosk (that it owns) that can be moved easily to sell its goods. There are many areas in the airport that are available and that would meet the specifications for the space in the contract.
Something else -   Leases capitalisation on the balance sheet

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Conclusion

The contract does not contain a lease.

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The reasoning
Although the amount of space Customer uses is specified in the contract, there is no identified asset. Customer controls its owned kiosk. However, the contract is for space in the airport, and this space can change at the discretion of Supplier.

Supplier has the substantive right to substitute the space Customer uses because:

  1. Supplier has the practical ability to change the space used by Customer throughout the period of use (see Identified assets, Substantive substitution rights sub (a). There are many areas in the airport that meet the specifications for the space in the contract, and Supplier has the right to change the location of the space to other space that meets the specifications at any time without Customer’s approval.
  2. Supplier would benefit economically from substituting the space (see Identified assets, Substantive substitution rights sub (b). There would be minimal cost associated with changing the space used by Customer because the kiosk can be moved easily. Supplier benefits from substituting the space in the airport because substitution allows Supplier to make the most effective use of the space at boarding areas in the airport to meet changing circumstances.

 

 

7. Lease of retail space

The case
Customer enters into a contract with a property owner (Supplier) to use Retail Unit A for a five-year period. Retail Unit A is part of a larger retail space with many retail units.

Customer is granted the right to use Retail Unit A. Supplier can require Customer to relocate to another retail unit. In that case, Supplier is required to provide Customer with a retail unit of similar quality and specifications to Retail Unit A and to pay for Customer’s relocation costs. Supplier would benefit economically from relocating Customer only if a major new tenant were to decide to occupy a large amount of retail space at a rate sufficiently favourable to cover the costs of relocating Customer and other tenants in the retail space. However, although it is possible that those circumstances will arise, at inception of the contract, it is not likely that those circumstances will arise.

Lease of retail spaceThe contract requires Customer to use Retail Unit A to operate its well-known store brand to sell its goods during the hours that the larger retail space is open. Customer makes all of the decisions about the use of the retail unit during the period of use. For example, Customer decides on the mix of goods sold from the unit, the pricing of the goods sold and the quantities of inventory held. Customer also controls physical access to the unit throughout the five-year period of use.

The contract requires Customer to make fixed payments to Supplier, as well as variable payments that are a percentage of sales from Retail Unit A.

Supplier provides cleaning and security services, as well as advertising services, as part of the contract.

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Conclusion

The contract contains a lease of retail space. Customer has the right to use Retail Unit A for five years.

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The reasoning
Retail Unit A is an identified asset. It is explicitly specified in the contract. Supplier has the practical ability to substitute the retail unit, but could benefit economically from substitution only in specific circumstances. Supplier’s substitution right is not substantive because, at inception of the contract, those circumstances are not considered likely to arise (see Identified asset, An entity’s evaluation of whether a supplier’s substitution right is substantive).

Customer has the right to control the use of Retail Unit A throughout the five-year period of use because:

  1. Customer has the right to obtain substantially all of the economic benefits from use of Retail Unit A over the five year period of use. Customer has exclusive use of Retail Unit A throughout the period of use. Although a portion of the cash flows derived from sales from Retail Unit A will flow from Customer to Supplier, this represents consideration that Customer pays Supplier for the right to use the retail unit. It does not prevent Customer from having the right to obtain substantially all of the economic benefits from use of Retail Unit A.
  2. Customer has the right to direct the use of Retail Unit A because the conditions in Right to direct the use sub (a). The contractual restrictions on the goods that can be sold from Retail Unit A, and when Retail Unit A is open, define the scope of Customer’s right to use Retail Unit A. Within the scope of its right of use defined in the contract, Customer makes the relevant decisions about how and for what purpose Retail Unit A is used by being able to decide, for example, the mix of products that will be sold in the retail unit and the sale price for those products. Customer has the right to change these decisions during the five-year period of use.

Although cleaning, security, and advertising services are essential to the efficient use of Retail Unit A, Supplier’s decisions in this regard do not give it the right to direct how and for what purpose Retail Unit A is used. Consequently, Supplier does not control the use of Retail Unit A during the period of use and Supplier’s decisions do not affect Customer’s control of the use of Retail Unit A.

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7. Lease  – Fiber-optic cable

The case
Customer enters into a 15-year contract with a utilities company (Supplier) for the right to use three specified, physically distinct dark fiber within a larger cable connecting Hong Kong to Tokyo. Customer makes the decisions about the use of the fiber by connecting each end of the fiber to its electronic equipment (ie Customer “lights” the fiber and decides what data, and how much data, those fiber will transport). If the fiber are damaged, Supplier is responsible for the repairs and maintenance. Supplier owns extra fiber, but can substitute those for Customer’s fiber only for reasons of repairs, maintenance or malfunction (and is obliged to substitute the fiber in these cases).

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Conclusion

The contract contains a lease of dark fiber. Customer has the right to use the three dark fiber for 15 years.

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The reasoning
There are three identified fiber. The fiber are explicitly specified in the contract and are physically distinct from other fiber within the cable. Supplier cannot substitute the fiber other than for reasons of repairs, maintenance or malfunction see Identified asset – The supplier’s right or obligation to substitute the assets for repairs and maintenance).

Customer has the right to control the use of the fiber throughout the 15-year period of use because:

  1. Customer has the right to obtain substantially all of the economic benefits from use of the fiber over the 15-year period of use. Customer has exclusive use of the fiber throughout the period of use.
  2. Customer has the right to direct the use of the fiber because the conditions in Identified assets, Substantive substitution rights sub (a) exist. Customer makes the relevant decisions about how and for what purpose the fiber are used by deciding:
    1. when and whether to light the fiber, and
    2. when and how much output the fiber will produce (ie what data, and how much data, those fiber will transport). Customer has the right to change these decisions during the 15-year period of use.

Although Supplier’s decisions about repairing and maintaining the fiber are essential to their efficient use, those decisions do not give Supplier the right to direct how and for what purpose the fiber are used. Consequently, Supplier does not control the use of the fiber during the period of use.

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8. No lease Portion of assets Fiber-optic cable

The case
Customer enters into a 15-year contract with Supplier for the right to use a specified amount of capacity within a cable connecting Hong Kong to Tokyo. The specified amount is equivalent to Customer having the use of the full capacity of three fiber strands within the cable (the cable contains 15 fiber with similar capacities). Supplier makes decisions about the transmission of data (ie Supplier lights the fiber, makes decisions about which fiber are used to transmit Customer’s traffic and makes decisions about the electronic equipment that Supplier owns and connects to the fiber).

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Conclusion

The contract does not contain a lease. 

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The reasoning
Supplier makes all decisions about the transmission of its customers’ data, which requires the use of only a portion of the capacity of the cable for each customer. The capacity portion that will be provided to Customer is not physically distinct from the remaining capacity of the cable and does not represent substantially all of the capacity of the cable (see Identified asset, Portions of assets). Consequently, Customer does not have the right to use an identified asset.

 

 

9.  Short-term lease Truck rental

A case, the question is if a contract is or contains a lease or not a lease, obtain a thorough understanding on how to assess and identify a lease in line with IFRS 16 Leases.

The Case
Customer enters into a contract with Supplier for the use of a truck for one week to transport cargo from New York to San Francisco. Supplier does not have substitution rights. Only cargo specified in the contract is permitted to be transported on this truck for the period of the contract. The contract specifies a Short-term lease Truck rentalmaximum distance that the truck can be driven. Customer is able to choose the details of the journey (speed, route, rest stops, etc.) within the parameters of the contract. Customer does not have the right to continue using the truck after the specified trip is complete.

The cargo to be transported, and the timing and location of pick-up in New York and delivery in San Francisco, are specified in the contract.

Customer is responsible for driving the truck from New York to San Francisco.

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Conclusion

The contract contains a lease of a truck. Customer has the right to use the truck for the duration of the specified trip. Because the duration of the contract is one week, this lease meets the definition of a short-term lease (see below). The term is of importance because short-term lease stay off-balance.

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The reasoning
The contract contains a lease of a truck. Customer has the right to use the truck for the duration of the specified trip.

There is an identified asset. The truck is explicitly specified in the contract, and Supplier does not have the right to substitute the truck.

Customer has the right to control the use of the truck throughout the period of use because:

  1. Customer has the right to obtain substantially all of the economic benefits from use of the truck over the period of use. Customer has exclusive use of the truck throughout the period of use.
  2. Customer has the right to direct the use of the truck because the conditions in Right to direct the use sub (b)(i) exist. How and for what purpose the truck will be used (ie the transportation of specified cargo from New York to San Francisco within a specified timeframe) is predetermined in the contract. Customer directs the use of the truck because it has the right to operate the truck (for example, speed, route, rest stops) throughout the period of use. Customer makes all of the decisions about the use of the truck that can be made during the period of use through its control of the operations of the truck.

IFRS 16 contains a practical expedient that allows a lessee the choice of keeping short-term leases ‘off-balance sheet’. Many entities are taking advantage of this practical expedient; however, entities may tend to have a ‘once short-term, always short-term’ mentality. In other words, once a lease is classified as a short-term lease, it tends to fall off management’s radar and subsequent changes thereto that might result in its failing the short-term lease definition are often overlooked.

Exercising an extension option

When a lease contains an extension option that is exercisable by the lessee, the lease term can change if there are changes to the reasonable certainty of exercise of the option (IFRS 16 20) or upon actual exercise of the option if it was not previously included in the determination of the lease term (IFRS 16 21(a)).

A lessee first assesses whether it is reasonably certain to exercise an extension option or a termination option on the commencement date of the lease. A lessee revisits the ‘reasonably certain’ assessment only upon the occurrence of a significant event or a significant change in circumstances that:

  1. is within the control of the lessee; and
  2. affects its previous assessment of the lease term.

‘Reasonable certainty’ is a high hurdle and its assessment may require significant judgement in some cases. Entities are encouraged to consult their auditors and accounting advisors in such cases.

When there is a change in the lease term of a short-term lease, the lease is accounted for as a new lease on the date of the change (IFRS 16 7(b)). This means the lessee must assess the lease term of the new lease on the date of change.

Lessee has a short-term lease that runs from 1 January 2019 to 31 December 2019 with an option to extend the lease for one year to 31 December 2020. On the commencement date of the lease (1 January 2019), Lessee is not reasonably certain to exercise the extension option. The lease term is therefore only 12 months and the lease meets the definition of a short-term lease.

On 1 October 2019, Lessee exercises the option to extend the lease.

Lessee elects to apply the short-term lease recognition exemption in accordance with IFRS 16 5 to all short-term leases.

Lease extension option

Analysis
Since the original lease is a short-term lease to which Lessee has elected to apply the short-term lease exemption, IFRS 16.6-8 applies. In accordance with IFRS 16.7(b), the lease is considered a new lease if there is a change in the lease term. There is a change in the lease term on 1 October 2019 because

Lessee exercises an extension option that was not previously included in the determination of the lease term. Consequently, the new lease for the purposes of IFRS 16.7(b) has a commencement date of 1 October 2019 and a lease term of 15 months, thus it does not meet the definition of a short-term lease.

As such, Lessee should recognise a RoU asset and a lease liability for the new 15-month lease on 1 October 2019. The RoU asset and the lease liability will appear in the 2019 annual financial statements.

Conclusion: the lease is a short-term lease and stays off-balance sheet from 1 January 2019 to 30 September 2019; it fails the short-term lease definition from 1 October 2019 and is recognised on-balance sheet from that date.

Also read: What makes you a renter?

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Something else -   IFRS 16 into the details

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