IFRS 16 – a couple of words about the new standard. Definition of a lease contract (part 8)

Piotr STASZKIEWICZ
Audit Partner at RSM Poland

Much has been said so far about possible exclusions from the new standard, the valuation of assets and liabilities, discount, implementation of the new standard or lease components. Another issue that should be considered on the so-called inception date is the definition of a lease contract. According to IFRS 16, a contract is a lease if, in return for payment, it has the right to exercise control, including but not limited to obtaining economic benefits, over the use of an identified asset for an agreed period of time.

The words that are of key importance to our further discussion and have been purposefully marked as these are the conditions for a lease to arise. One could say, a contrario: if an asset is not identified, there is no lease. The same applies to control or no payment. Therefore, if it transpires from the contract that its conditions are satisfied in relation to a specified asset (1) which is explicitly or implicitly identifiable, the lessor may not have a substantive right of substitution, and the lessee has the right to obtain substantially all economic benefits from using the asset (2) and the right to direct the asset (3), then, this is a lease in accordance with IFRS 16.

Example 1

Entity A signed a 2-year contract for the use of 10 sqm of space around the stadium to sell gadgets and sports press every two weeks during the matches of a premier league team. The stadium operator decides each time on where it will provide the space for the tenant. There are many alternative places.

In this case the asset is not identifiable and, furthermore, the supplier can easily substitute the leased asset.

Example 2

Entity A signed a 2-year contract for the use of 10 sqm of space in front of the main entrance, right next to the stairs, marked with red lines, to sell gadgets and sports press every two weeks during the matches of a premier league team. The stadium operator is not able to designate any other place for the tenant.

In such a case, the asset is identifiable and, furthermore, the supplier cannot substitute the leased asset.

The second point raised here is the right to obtain substantially all economic benefits from using the asset (2).

Example 3

Entity A signed a 5 year contract for discharging liquid production waste using a special pipeline owned by Entity Z to a treatment plant outside the city. Together with Entity A, four other entities are equally entitled to use the pipeline, each with their own facilities next to Entity A.

As it follows from the above, Entity A does not have the right to obtain substantially all benefits from the asset – the condition of IFRS 16 is not met, there is no lease. However, at the time when the other four entities/pipeline users cease their operations, it may turn out that it is Entity A which obtains substantially all the benefits from the pipeline and lease will be identified.

The third aspect is the right to control the use of the asset in return for payment (3), which translates into the lessee having the right to direct the use and the right to obtain substantially all economic benefits from the use of the asset.

Example 4

Entity A signed a contract for the use of a car for 3 years.

Insofar as Entity A has the right to use the vehicle, to decide whether and when and for which orders/projects it will use it, the condition of having the right to control is fulfilled. Certain limitations contained in the contract may seem problematic such as: prohibition to use the car abroad or a monthly mileage/kilometre limit, etc. However, these are most often the lessor's protective measures which do not affect the lessee's assessment as regards the asset’s management. Furthermore, Entity A would have certainly considered not signing such a contract if it had concluded that such restrictions were material and did not allow it to make appropriate use of the asset.

The decision-making algorithm for establishing whether a contract contains a lease under IFRS 16 is shown below.