As we discussed here, the IASB has issued IFRS 16 Leases, effective for annual reporting periods beginning on or after January 1, 2019.
We’ve already discussed some of the issues attaching to the first step in the new standard’s lease accounting model, to identify at inception of a contract whether that contract is a lease, or contains a lease. This is the case “if the contract conveys the right to control the use of an identified asset for a period of time in exchange for consideration.” The assessment requires determining whether, throughout the period of use, the customer has both the right to obtain substantially all of the economic benefits from use of the identified asset, and the right to direct the use of the identified asset.
Last time, we covered some of the issues relating to assessing the customer’s right to obtain substantially all the economic benefits from using the asset. Moving on, a customer has the right to direct how and for what purpose the asset is used if, within the scope of its right of use defined in the contract, it can change that purpose throughout the period of use. In making this assessment, it considers the decision-making rights that are most relevant to changing this – that is, those that affect the economic benefits to be derived from use.
Here are some of the standard’s examples of decision-making rights that, depending on the circumstances, grant the right to change how and for what purpose the asset is used, within the defined scope of the customer’s right of use:
- (a) rights to change the type of output that is produced by the asset (for example, to decide whether to use a shipping container to transport goods or for storage, or to decide upon the mix of products sold from retail space);
- (b) rights to change when the output is produced (for example, to decide when an item of machinery or a power plant will be used);
- (c) rights to change where the output is produced (for example, to decide upon the destination of a truck or a ship, or to decide where an item of equipment is used); and
- (d) rights to change whether the output is produced, and the quantity of that output (for example, to decide whether to produce energy from a power plant and how much energy to produce from that power plant).
These are in contrast to rights that are limited to operating or maintaining the asset. For example, an entity might have the ability to prevent anyone else from using a particular asset during a contractual period, but if its own use requires the lessor to sign off on the kinds of decisions set out above, then it doesn’t likely constitute a right to direct the use of the asset. In some cases though, the relevant decisions about how and for what purpose the asset is used may have been predetermined. If the customer designed the asset (or specific aspects of it) in a way that predetermines how and for what purpose the asset will be used throughout the period of use, then it has the right to direct the use of that asset, even if it can’t subsequently amend the predetermined specifications it agreed to.
It’s interesting to note some alternative approaches to identifying a lease which the IASB considered and rejected, if only because they may help focus on the approach they did adopt. These include:
Financing component: the IASB considered requiring a lease to be a financing arrangement, but focused instead on whether the customer has obtained control of a right-of-use asset. Under this approach a right-of-use asset exists even if there’s no financing arrangement and no lease liability (for example, when lease payments are fully prepaid).
IFRS 15: the IASB considered whether to link the definition of a lease more closely to the requirements in IFRS 15, in particular the requirements on whether a good or service is ‘distinct’. However, the IASB concluded that the concepts in IFRS 15 were developed for a different purpose, and that anyway, going down that road in the context of leases would add unnecessary complexity.
Stand-alone utility: the IASB considered whether to specify that a customer controls the use of an asset only if that asset has stand-alone utility to the customer, but concluded among other things that such a criterion isn’t applied elsewhere in IFRS in assessing control.
Substantial services: the IASB considered whether to require an entity to account for a contract with lease and service components entirely as a service if the service components are substantial and make up the predominant portion of the overall contract, but concluded that the presence of services doesn’t change the nature of a right-of-use asset if one exists.
More to come…
The opinions expressed are solely those of the author