The assessment of whether a contract is or contains a lease is the biggest practical issue while applying Ind AS 116. This assessment is required right at the inception of the contract.
In most of the cases, the assessment is likely to be straightforward and contracts which are classified as lease contracts under Ind AS 17 are likely to continue as lease contracts under Ind AS 116 as well.
In few cases, the assessment is likely to be more complex and would require thorough analysis of all the contracts entered into by the company and is the most critical judgement to be made on day one of application of this standard.
The key factors to be considered while applying the definition of lease are as follows:
a. Whether the assets covered in the contract are identifiable assets
b. Who has the right to obtain substantially all of the economic benefits from use of the identified assets
c. Who has the right to direct the use of the identified assets
All the above three factors need to be considered both by the supplier and the customer at the inception of the contract and will be revisited if and only if the terms and condition of the contract changes thereafter.
Let us evaluate each factor in detail:
a. Identified Asset:
The asset is typically identified by being explicitly specified in a contract (e.g. Specific serial number and make). However, an asset can also be identified by being implicitly specified at the time the asset is made available to use in a contract (e.g. when there is only one asset that is capable of being used to meet the terms defined in the contract)
The asset covered in a contract need not be specified right at the inception of the contract, but should be specified when it is made available for use to the customer.
In most of the cases, the contracts would cover entire underlying asset and therefore, easy to identify (e.g. building or a particular machinery). However, even a portion of the asset covered in a contract can be identified asset if:
> It is physically distinct (e.g. a particular floor in a building)
> It is not physically distinct but the customer has the right to receive substantially all the capacity of the asset. If all the capacity of the asset is not available to the customer, then the asset is not an identified asset (e.g. A storage tank to store gas/liquids).
Substantive substitution rights
The very important criteria to establish that the asset is an identified asset is the substantive substitution rights available to the supplier throughout the period of the contract. A supplier’s substitution right is substantive if the supplier:
- Has the practical ability to substitute alternative assets throughout the period of use (i.e. the customer cannot prevent the supplier form substituting the asset and alternate assets are readily available with the supplier or could be sourced by the supplier within a reasonable time); and
- The supplier would benefit economically from the exercise of its right to substitute the asset (i.e. the economic benefits associated with substituting the asset are expected to exceed the costs associated with substituting the asset)
The assessment of whether the substitution rights are substantive or not is to be done right at the inception of the contract. For this assessment, the company considers all of the facts and circumstances currently available but not future events that are unlikely to occur.
If the substitution rights or obligation is only on or after a particular date or on occurrence of specified event, the supplier’s substitution right is not substantive as the same is not available throughout the period of use of the asset.
If the asset is located at the customer’s premises or elsewhere, the costs associated with substitution are generally higher than when located at the supplier’s own premises and, therefore, the cost will exceed the benefits associated with substituting the asset and hence the substitution right though available is unlikely to be exercised and hence not substantive.
The supplier’s right to substitute the asset for repair and maintenance, if the asset is not operating properly or if a technical upgrade becomes available does not fit into the definition of substantive substitution rights.
If the customer at the inception cannot readily determine whether the supplier has a substantive substitution right or not, it shall be presumed that any substitution right is non substantive in nature.
b. Right to obtain economic benefits from use
In order to demonstrate control over the identified asset, the customer is required to have the right to obtain substantially all of the economic benefits from use of the asset throughout the period covered in the contract. The economic benefits can be obtained in many ways like using, holding or sub leasing the asset.
The economic benefits need to be considered in line with customer’s right to use an asset. For e.g. If the customer is permitted to use a vehicle only in one particular city or territory during the tenure of the contract, then the customer considers only the economic benefits from use of the vehicle within that city or territory and not beyond. Similarly, if the customer has right to use a motor vehicle for a specified miles say 100,000 miles during the period of contract say 3 years, then while assessing whether the customer has right to obtain substantially all the economic benefits from use of the motor vehicle, only the economic benefits of the permitted mileage is to be considered.
The simple test to be considered is whether the benefits arise from the ownership of the asset or use of the asset. All the benefits from the use of the assets should be evaluated to conclude whether the customer has the right to obtain substantially all of the economic benefits from the assets. Benefits derived from ownership of assets e.g. Income Tax credits, etc. are excluded while evaluating the lessee right to obtain all the economic benefits from use of the asset.
Evaluating whether a customer has the right to obtain substantially all of the economic benefits from use of an asset throughout the period of use is straightforward in many situations because the customer in a lease frequently has exclusive right to use the asset.
Variability attached to the lease rental in the form of lease rent calculated as a percentage of sales, etc. does not in any way effect the evaluation criteria of substantial economic benefits. For example, if the customer is required to pay the supplier a percentage of sales from use of retail space as consideration for that use, that requirement does not prevent the customer from having the right to obtain substantially all of the economic benefits from use of the retail space. This is because the cash flows arising from those sales are considered to be economic benefits that the customer obtains from use of the retail space, a portion of which it then pays to the supplier as consideration for the right to use that space.
3. Right to direct the use of the identified assets:
A customer has the right to direct the use of an identified asset throughout the period of use only if either:
A. The customer has the right to direct how and for what purpose the asset is used throughout the period of use
B. The relevant decisions about how and for what purpose the asset is used are predetermined and:
- the customer has the right to operate the asset (or to direct others to operate the asset in a manner that it determines) throughout the period of use, without the supplier having the right to change those operating instructions; or
- the customer designed the asset (or specific aspects of the asset) in a way that predetermines how and for what purpose the asset will be used throughout the period of use.
A customer considers the decision-making rights that are most relevant to changing how and for what purpose the asset is used – the term ‘relevant’ means that they affect the economic benefits derived from use.
Examples of relevant decisions that, depending on the circumstances, grant the right to change how, when and for what purpose the asset is used:
- What: rights to change the type of output that is produced by the asset (e.g. deciding whether to use a shipping container to transport goods or for storage or to decide upon the mix of products to be sold from retail space)
- When: rights to change when the output is produced (e.g. deciding when an item of machinery or power plant will be used)
- Where: rights to change where the output is produced (e.g. deciding on the destination of a truck or a ship or to decide on where an item of equipment is to be used)
- Whether and how much: rights to change whether the output is produced, and the quantity of that output (e.g. deciding whether to produce energy from a power plant and how much energy to produce from that power plant)
In assessing whether a customer has the right to direct the use of an asset, a customer considers only the rights to make decisions during the period of use of the identified asset.
One also needs to evaluate whether the rights retained by the supplier are protective or substantive in nature. Protective rights are rights designed to protect the supplier’s interest in the asset or other assets, to protect its personnel, or to ensure the supplier’s compliance with laws or regulations.
Examples of protective rights are:
i. specify the maximum amount of use of an asset or limit where or when the customer can use the asset
ii. require a customer to follow particular operating practices
iii. require a customer to inform the supplier of changes in how an asset will be used.
Protective rights typically define the scope of the customer’s right of use but do not, in isolation, prevent the customer from having the right to direct the use of an asset and hence does not impact the customer rights to direct the use of identified assets.
In retrospection
The above three criteria of identified asset, substantial economic benefits and right to direct the use of an asset are litmus test which needs to be performed by both the supplier and the customer to evaluate whether a contract is, or contains, a lease.
If the contract satisfies to be a lease contract, then recognition, measurement, presentation and disclosures as laid down in Ind AS 116 needs to be followed.
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Very helpful article