Identifying a Lease: Understanding Lease Criteria in Accounting

13.2 Identifying a Lease§

Identifying a lease is a fundamental aspect of accounting for leases, as it determines how a contract is recognized and measured in financial statements. In this section, we will delve into the criteria for identifying a lease under the International Financial Reporting Standards (IFRS) and the Accounting Standards for Private Enterprises (ASPE) in Canada. Understanding these criteria is crucial for both lessees and lessors to ensure accurate financial reporting and compliance with accounting standards.

Understanding the Definition of a Lease§

A lease is defined as a contract, or part of a contract, that conveys the right to control the use of an identified asset for a period of time in exchange for consideration. This definition is consistent with IFRS 16 and ASPE 3065, which govern lease accounting in Canada. The key components of this definition include:

1. Identified Asset: The asset must be explicitly or implicitly specified in the contract. It can be a physically distinct asset or a portion of a larger asset if it is physically distinct and the lessee has the right to use it.

2. Right to Control: The lessee must have the right to obtain substantially all of the economic benefits from the use of the identified asset and the right to direct the use of the asset throughout the lease term.

3. Period of Time: The lease must cover a specific period during which the lessee has the right to use the asset.

4. Consideration: There must be an exchange of consideration, typically in the form of lease payments, for the right to use the asset.

Identifying an Identified Asset§

The first step in identifying a lease is determining whether there is an identified asset. An asset is considered identified if it is explicitly specified in the contract or implicitly specified at the time the asset is made available for use. The asset must be physically distinct, meaning it can be separated from other assets and used independently.

Practical Example§

Consider a contract where a company leases a specific floor of an office building. The floor is physically distinct and specified in the contract, making it an identified asset.

Substitution Rights§

An asset is not considered identified if the supplier has a substantive substitution right. This means the supplier can substitute the asset with another asset of equal quality and utility without requiring the customer’s consent. The substitution right must be substantive, meaning the supplier has the practical ability to substitute the asset and would benefit economically from doing so.

Right to Control the Use of the Asset§

The right to control the use of an identified asset is a critical criterion for identifying a lease. The lessee must have both:

1. The Right to Obtain Economic Benefits: The lessee must have the right to obtain substantially all of the economic benefits from the use of the asset. This includes the ability to use the asset in a way that generates economic benefits, such as revenue or cost savings.

2. The Right to Direct the Use: The lessee must have the right to direct how and for what purpose the asset is used throughout the lease term. This includes making decisions about the use of the asset that affect the economic benefits derived from it.

Case Study: Equipment Lease§

A manufacturing company enters into a contract to lease a piece of machinery. The company has the right to operate the machinery and determine its output, maintenance schedule, and operating hours. This indicates that the company has the right to control the use of the machinery, satisfying the criteria for a lease.

Period of Time§

The lease must cover a specific period during which the lessee has the right to use the asset. This period can be defined in terms of time (e.g., months or years) or usage (e.g., number of production cycles).

Example: Vehicle Lease§

A company leases a fleet of vehicles for a period of three years. The lease agreement specifies the lease term, during which the company has the right to use the vehicles. This satisfies the period of time criterion for identifying a lease.

Consideration§

Consideration refers to the exchange of value, typically in the form of lease payments, for the right to use the asset. The consideration must be specified in the lease agreement and can take various forms, such as fixed payments, variable payments, or a combination of both.

Example: Office Space Lease§

A business leases office space for a monthly rent of $5,000. The lease agreement specifies the consideration in the form of fixed monthly payments, fulfilling the consideration criterion for identifying a lease.

IFRS 16 vs. ASPE 3065: Key Differences§

While IFRS 16 and ASPE 3065 share similar principles for identifying a lease, there are some key differences in their application:

• IFRS 16: Requires lessees to recognize all leases on the balance sheet, except for short-term leases and leases of low-value assets. This means that most leases are treated as finance leases, with a right-of-use asset and lease liability recognized.

• ASPE 3065: Allows for more flexibility in lease classification, with leases classified as either operating or capital leases based on specific criteria. This results in different accounting treatments for lessees.

Practical Application: Identifying a Lease in Practice§

To apply the criteria for identifying a lease in practice, consider the following steps:

1. Review the Contract: Examine the contract to determine if there is an identified asset. Look for explicit or implicit specifications of the asset.

2. Assess Control: Evaluate whether the lessee has the right to control the use of the asset. Consider the lessee’s rights to obtain economic benefits and direct the use of the asset.

3. Determine the Lease Term: Identify the period of time during which the lessee has the right to use the asset. This can be based on time or usage.

4. Analyze Consideration: Review the lease agreement to identify the consideration exchanged for the right to use the asset. Ensure that the consideration is specified and aligns with the lease term.

5. Consider Substitution Rights: Assess whether the supplier has substantive substitution rights that would prevent the asset from being identified.

Real-World Example: Identifying a Lease in a Retail Setting§

A retail company enters into a contract to lease a store location in a shopping mall. The contract specifies the exact location of the store, making it an identified asset. The company has the right to control the use of the store, including its layout, inventory, and operating hours, indicating control over the asset. The lease term is five years, and the company agrees to pay a fixed monthly rent, satisfying the consideration criterion. This contract meets the criteria for identifying a lease.

Common Pitfalls and Challenges§

Identifying a lease can be challenging due to the complexity of contracts and the need to assess control and substitution rights. Common pitfalls include:

• Misidentifying Assets: Failing to recognize an identified asset due to ambiguous contract terms or substitution rights.

• Overlooking Control: Not adequately assessing the lessee’s right to control the use of the asset, leading to incorrect lease classification.

• Ignoring Substitution Rights: Failing to consider substantive substitution rights that may prevent an asset from being identified.

Best Practices for Identifying a Lease§

To ensure accurate lease identification, consider the following best practices:

• Thorough Contract Review: Carefully review contract terms to identify assets and assess control.

• Collaboration with Legal and Financial Teams: Work closely with legal and financial teams to understand contract terms and assess substitution rights.

• Regular Training and Updates: Stay informed about changes in accounting standards and lease identification criteria through regular training and updates.

Conclusion§

Identifying a lease is a critical step in lease accounting, requiring a thorough understanding of the criteria for an identified asset, control, lease term, and consideration. By applying these criteria and following best practices, lessees and lessors can ensure accurate financial reporting and compliance with accounting standards. Understanding the differences between IFRS 16 and ASPE 3065 is also essential for Canadian accountants to navigate lease accounting effectively.

Ready to Test Your Knowledge?§