A new approach to lease accounting - determination of whether contracts contain a lease

IFRS news

It may sometimes be straightforward to identify a lease, but some arrangements may be more problematic. 
A lease is defined as a contract where:

  • There is a specifically identified asset
  • The contract conveys the right to control the use of that asset for a period of time
  • There is a right to substantially all of the economic benefits from the asset during the term of the contract

Determining whether a contract contains a lease may involve significant judgment.  An asset may be identified either explicitly within the contract, or implicitly, where only one asset is realistically available to fulfil the terms of the contract.

A right to control the use of the asset may arise in two circumstances.  The right may be explicit through the contract, where it gives the customer the right to determine how or where the asset is used.  Alternatively, where the use of an asset is predetermined (such as a power plant, for example), the right to control would exist if either:

  • The customer has the right to operate the asset throughout the period of use; or
  • The asset was designed by the customer, or to the customer’s specifications, in a way that predetermines its use.

The key determination of a right to control an asset is the ability to determine how and when it is used.  While lease contracts often give the lessor “protective” rights in respect of maintenance or operation of the assets, for example, restrictions on using the asset in certain locations or in an unsafe manner, this is less important than the ability to direct how and for what purpose the asset is used.

Example 1 – A Transport Fleet

The XYZ supermarket chain enters into an agreement with a haulage company to deliver groceries from its distribution centres to its retail stores.  The agreement specifies that the deliveries must be made in trucks which have XYZ branding painted onto the side, which will be purchased for the purposes of this contract, and that the deliveries will be made according to a schedule set by XYZ.  The haulage company will supply the trucks and drivers, and will operate and maintain the trucks.

This arrangement is considered to contain a lease.  This is because there is an identified asset – even if the trucks are not explicitly specified in the lease, this is implicit through the branding requirements in the contract.  The trucks deliver according to the instructions of XYZ, which determines the timing of deliveries and the cargo carried.  The branding requirement is also likely to restrict the haulage company from using the trucks for other customers, and therefore XYZ will have the right to substantially all of the economic benefits for the term of the lease.

If the agreement was for delivery services in plain-marked vehicles, and did not specify which vehicles were to be used, then it would be considered a service contract rather than a lease, as the assets would not be specifically identified, since the haulage company would have the right to substitute vehicles.  Furthermore, XYZ would not necessarily be entitled to all of the benefit of the trucks during the lease, as they could be used for other deliveries when not used for XYZ.

Example 2 – Capacity at a Manufacturing Facility

Leopard Motor Corporation is a manufacturer of motor vehicles.  They contract with BB Inc, a component supplier, to supply a specified quantity and type of brake cables.  BB has only one factory capable of manufacturing the required components, and the contract will require about 75% of the capacity at this factory.

This arrangement is not considered to be a lease, because, while there is an identified asset:

  • Leopard does not have the right to direct the use of the factory.  It is up to BB Inc to determine when, how, and at what production level to run the factory in order to fulfil the contract.
  • Leopard does not have the right to substantially all the economic benefit from the factory, as the remaining capacity can be used to fulfil orders for other customers of BB Inc.

Example 3 – A wind farm

ElectricCo, a utilities provider, enters an arrangement with GeneratorCo, a power company, to purchase all of the power produced by a new wind farm.  The arrangement lasts for 10 years, and specifies that the electricity must be produced by the wind farm.  GeneratorCo is responsible for operating and maintaining the wind farm.

The nature of the asset means that how and for what purpose the asset will be used is predetermined – it can only be used for electricity generation, and the amount of electricity generated is determined by wind conditions.  Whether the arrangement contains a lease is therefore determined by who designed the facility.  If it was designed by ElectricCo, the arrangement would be considered a lease.  Similarly, if ElectricCo had the right to operate the plant during the contract period, it would be considered a lease. 

If the plant had been designed by GeneratorCo without input from ElectricCo, and GeneratorCo also managed the operation of the plant, then the arrangement would not be a lease, and would be treated as an arrangement for the supply of goods (electricity).

Learn more:

 Summary of the new standard AASB >> 

 what is part of the lease contract >> 

 Accounting for the lease >> 

 download the full article as a pdf >>