A European example of issues in separating lease and non-lease components of a contract
Here’s another of the issues arising from extracts of enforcement decisions issued in the past by the European Securities and Markets Authority (ESMA); this is from their 24th edition:
- The issuer is a commercial real estate company whose core business covers the management and development of properties. Most of its income is generated by its lessor and asset manager activities. Gross revenue comprises rental income and operating costs charged to tenants. Examples of operating costs are waste disposal, property management, costs for communal facilities, gas, electricity and warm water.
- According to local laws and regulations, the lessor bears all costs that occur when using and operating the property. The lessor and the tenant can specify the operating costs of the building as a whole (e.g. chimney sweeper, elevator service) and of the specific rental unit (e.g. warm water supply, gas and electricity for the specific unit) that will be charged to the tenant.
- For some utilities (gas and electricity) the tenant can enter into direct purchase agreements for operating services for the rental unit with third parties. In the specific case at hand, if the lessor enters into an agreement with a provider, it charges the costs to the tenants based on the tenant’s consumption. These costs are operating costs of the rental unit and not of the building. In most cases, the issuer itself enters into purchase agreements after concluding the rental agreement, without bearing any consumption risk.
- Rental income arising from the lease component falls within the scope of IFRS 16. However, the issuer identified the non-lease components stipulated in the lease contracts and assessed whether they should be split out and accounted for separately in accordance with IFRS 15.
- For the operating costs of the building (e.g. chimney sweeper, elevator service) the issuer concluded that it acts as a principal. Therefore, the issuer applied IFRS 15 to operating costs of the building charged to its tenants.
- For operating costs of the rental unit (warm water supply, gas and electricity), the issuer determined that it acts as an agent. The issuer assessed that the considerations for warm water, gas and electricity did not constitute a separate non-lease component and thus allocated the consideration to the components identified under paragraph B33 of IFRS 16.
The enforcer (as ESMA likes to term it) disagreed on the last point, taking the view that the services of arranging for the operating services of the rental unit are separate non-lease components, to be accounted for under IFRS 15.
Plainly the issuer understood the principle involved and applied it satisfactorily with regard to the building as a whole. The implication seems to be that for operating costs where it acts as an agent, it saw them as being similar to charges for administrative costs – the cited paragraph B33 specifies that these kinds of charges indeed don’t give rise to a separate component of the contract. But the standard specifies that this only applies to activities and costs that don’t transfer a good or service to the lessee, and therefore excludes the kinds of items addressed here, where the lessee does obtain services. This portion of the arrangement falls then under IFRS 15. Once that assessment has been made, the distinction between a principal and agent becomes relevant in determining the appropriate presentation of the revenue. In this case it’s agreed that the issuer acts as an agent, so the recognized revenue is limited to any fee or commission to which it expects to be entitled in exchange for arranging the services (rather than recognizing the entire amount.
The fact pattern doesn’t specify whether the issuer actually charged any such fee or commission – if not, there may be nothing to recognize under IFRS 15. Lessor accounting still retains the distinction between finance and operating leases: presumably the arrangements described here would be operating leases, and the impact if any would be on the lessor’s pattern of recognition of the lease payments from these operating leases on a straight-line or other systematic basis. It would be good to have more information on this point, but as far as one can figure it out, it seems the impact would have been negligible, if there was any at all. You’ll recall that IFRS 16 contains a practical expedient for lessees, whereby a lessee can elect by class of underlying asset not to separate non-lease components from lease components. The IASB didn’t make the same concession for lessors, concluding a lessor should always be capable of separating the components because it “would need to have information about the value of each component, or a reasonable estimate of it, when pricing the contract.” That’s true enough, but instances must surely exist where the impact of such separation on the lessor’s financial statements would be immaterial by any quantitative or qualitative criterion…
The opinions expressed are solely those of the author.