IFRIC Interpretation 4 - Determining whether an Arrangement contains a Lease (detailed review)

Monday, September 1, 2014 Print Email

Objective

It is a common part of business activities that an entity may enter into an arrangement in which it allows another entity the right of use for a specific asset (i.e. Property, Plant and Equipment) against rentals or series of rentals, together with the provision of other related services.

The objective of this interpretation is to prescribe the guide lines which are used by the entity in determining whether such arrangements are or includes a lease arrangement as laid out in IAS 17 Leases, and if it includes a lease arrangement how it will be accounted for in the financial statements of the entity.

References

● IAS 8 Accounting Policies, Changes in Accounting Estimates and Errors

● IAS 16 Property, Plant and Equipment (Revised in 2003)

● IAS 17 Leases (Revised in 2003)

● IAS 38 Intangible Assets (Revised in 2004)

● IFRS 13 Fair Value Measurement

● IFRIC 12 Service Concession Arrangements

Background

An entity may establish an arrangement with another entity, involving a single transaction or number of related transactions, which legally does not constitute to a lease arrangement but under such arrangement the entity allows another entity right of use of a particular asset (e.g. Property, Plant or Equipment) against rentals or series of rentals, together with the provision of other related services.

Following are the examples of such sort of arrangements under which one entity (supplier) may allows another entity (buyer), the right of use of a particular asset (e.g. Property, Plant or Equipment) together with the provision of other related services:

a) The outsourcing arrangements, under which supplier agrees to arrange and manage the related technology at buyers’ place, together with the management of data processing activities of the buyer entity

b) The contractual arrangements in telecommunication business industry, under which supplier will install and manage the related network technology and allows the buyer entity with right to use network capacity

c) The arrangements involving take-or-pay contracts, under which the supplier will install and manage the related technology and buyer entity is bound to make the specified agreed payments irrespective of whether they get the delivery of the products or services subject to the contract (e.g. contract to purchase the substantial volumn of the output of the supplier’s power generation facility).

The requirements of this Interpretation provides the guide lines which are used by the entity in determining whether such arrangements are or includes a lease arrangement as laid out in IAS 17 Leases, and if it includes a lease arrangement how it will be accounted for in the financial statements of the entity. However, it does not prescribe the requirements to classify the nature of the leases included in such arrangements. The entity will apply IAS 17 for the classification of lease contracts.

In certain contractual arrangements, the asset which is the subject to lease is a portion (part) of a larger asset. This Interpretation does not include the requirements to determine that when a portion (part) of a larger asset is itself the subject matter of the lease. However, the arrangements in which the underlying asset is identifiable unit either in accordance with IAS 16 Property, Plant and Equipment or IAS 38 Intangible Assets are covered within this Interpretation.

Scope

The requirements of this Interpretation are not applicable to the following:

a) The contracts which are, or include, leases but are not covered under IAS 17 Leases or

b) The contracts involving public-to-private service concession arrangements and are covered under IFRIC 12.

Issues

The requirements of this interpretation are applicable:

a) To establish that whether an arrangement is, or includes, a lease arrangement as laid out in IAS 17 Leases and

b) When an entity should assess or reassess whether an arrangement is, or includes a lease arrangement and

c) If an arrangement is, or includes a lease arrangement, how the entity will separate the lease payments from payments for any other component included in the arrangement.

Consensus

The entity will establish whether an arrangement is, or includes a lease arrangement on the basis of economic substance of the relevant arrangement and it should consider the following factors whether:

a) The performance and completion of the arrangement depends upon the use of a particular asset or assets and

b) The arrangement terms allows the right of use of the asset.

Performance and completion of the arrangement depends upon the use of a particular asset:

1) The asset will not be subject to the lease arrangement if performance and completion of the arrangement does not depend upon the use of particular asset, even though a particular asset is clearly identified in an arrangement. For example, if a supplier is required to provide a certain quantity of goods or services and the supplier can deliver those goods or services using any asset or other assets not identified in the terms of arrangement, then the arrangement is not, or include a lease arrangement because the performance and completion of the arrangement does not depend upon the use of particular asset.

2) If a contractual term requires or permits the replacement of the similar or same assets when the asset identified in the contract is not properly working or for any reason, it will not prevent the asset being classified under lease arrangement.

3) An asset will be specified in the contract implicitly if the supplier leases or owns a particular asset to perform and complete the obligation under arrangement and the use of any other alternative asset is not economically practicable or feasible for the supplier to fulfill its obligation.

Arrangement allows the right of use of the asset

An arrangement allows the right of use of the asset specified in the contract if the purchaser has the right to control or direct the use of such asset. The purchaser is deemed to have the right to control or direct the use of the asset if any one of the following is met:

a) The buyer has sufficient right or ability to use the asset specified in the arrangement or can direct any other parties to operate the asset in same manner as intended by the buyer and buyer has control over the substantial utility or output of the asset.

b) The buyer has sufficient right or ability to control the physical access to the asset specified in the arrangement and buyer has control over the substantial utility or output of the asset.

c) There are remote chances that one or more other parties can take up substantial utility or output of the asset specified in the arrangement during the period of arrangement

d) The price per unit of output of the asset specified in the arrangement is neither fixed in the contract terms nor it is the market value of the unit on the date of delivery of the output.

Assessment or reassessment whether an arrangement is or includes a lease arrangement

1. The entity should assess whether the arrangement is or includes a lease arrangement, upon the inception of the arrangement, which is the earlier of:

a) Agreement Date (when both parties agree on regarding the material terms and conditions of the arrangement)

b) Commencement Date of arrangement

2. The entity is required to reassess the arrangement whether it is or includes a lease arrangement after the commencement of the arrangement if and only if any one of the following is met:

a) The contractual terms are subject to significant changes, other than the renewal or extension of the arrangement.

b) There is change in the assessment of whether the performance and completion of the arrangement is dependent upon the particular asset identified in the arrangement

c) There are significant physical changes to the asset identified in the arrangement

d) The arrangement is subject to renewal or an extension with the mutual consent of the parties to the arrangement, until unless the renewal or extension terms had initially been incorporated in the lease term as defined in IAS 17 Leases. Additionally the renewal or extension of the arrangement does not result in changes to any terms of the original arrangement before the end of the period of the original arrangement.

3. The entity should reassess the arrangement on the basis of circumstances and facts existing on the date of reassessment, together with the remaining period of the arrangement.

4. If on reassessment an arrangement is assessed to include a lease arrangement (or not to include a lease arrangement), then the entity will apply or (ceases to apply) the lease accounting from:

a) The date when circumstances indicate the reassessment, in the case of (a) to (c) above

b) The date of renewal or extension, in case of (d) above

Separating payments for the lease from other payments

1. If an entity identifies, by applying the requirements of this interpretation that an arrangement is or includes a lease arrangement, then the entity should apply the requirements of IAS 17 Lease to the lease component of the arrangement, except when and only when it is exempt to apply the these requirements as laid out in paragraph 2 of IAS 17 Lease. Other component included in the arrangement which is not covered under IAS 17, will be accounted for as per the requirements of other relevant standards.

2. If an arrangement is or includes a lease arrangement, the entity will classify it as finance or an operating lease as per the requirements of IAS 17.

3. The entity will separate the payments and other consideration included in the arrangement into those for the lease component and those for other component, either upon the inception of the arrangement or on reassessment of the arrangement, on the basis of their relative fair values of each component.

4. The minimum lease payments as laid out in IAS 17 will include only the payments for the lease component and will not include payments for other elements in the arrangement

5. In certain cases, the buyer may use an estimation technique to separate the payments for the lease component from the payments for other component. For example, the buyer may determine the payments for lease component on the basis of a lease agreement for an equivalent asset which includes no other component, or by determining the payments for the other elements included in the arrangement comparing with the equivalent agreement and then deducting those payments from the total payments under the arrangement.

6. If it becomes impracticable to separate the payments for lease component and other component then the entity will account for such situation as follows:

a) If it is finance lease, then lease asset and lease liability will be recognize at fair value of asset subject to the lease arrangement and fair value of asset will be determined as per the requirements of IAS 17 Lease. The lease liability will be reduced subsequently when payments are made for the lease component and the entity will also recognize imputed finance cost on the recognized lease liability using incremental borrowing rate of interest of the buyers

b) If it is operating lease, then the entity should treat all payments relating to the arrangement as lease payments, but:

i) These payments will be disclosed separately from minimum lease payments of the other arrangements held by the entity and which do not entail payments for the non-lease components, and

ii) The entity should disclose that those payments also include payments for the non-lease elements included in the arrangement.

Effective date

The requirements of this interpretation are applicable for the annual accounting periods commencing on or after 1 January 2006. However, earlier application of this interpretation is encouraged. If the entity applies this Interpretation for an accounting period commencing before 1 January 2006, it should disclose such fact.


Application Examples:

Example 1

Facts:

A manufacturing entity (the buyer) entered into a contract with another party (the supplier) to provide a specified minimum quantity of gas required in its production process for a specified time period. The supplier designs and installs the required facility nearby the buyer’s production premises to supply the required gas and retaining the ownership and control over the substantial facets of operating the facility. However, the contractual terms of the agreement are as follows:

a) The facility to supply the required quantity of gas is specifically identified in the agreement. Under the contract, the supplier can also use other sources to supply the gas. However, it is not economically practicable and viable for the supplier to provide gas from other sources.

b) The supplier has the right to modify, replace or remove the facility’s equipment and can expand the facility to provide gas to other customers. However, the supplier has no intention to expand or modify the facility at inception of the arrangement and the facility is designed only to fulfill the specified demand of the buyer.

c) The supplier has responsibility for any ongoing repairs and maintenance, and capital expenditure if required.

d) The supplier is obliged to supply the specified minimum quantity of gas every month.

e) The payment arrangement is that the buyer is required to pay a fixed capacity charge every month and a variable charge on the basis of actual production consumed. The buyer is obliged to pay the fixed capacity charge regardless of whether it takes the delivery of the facility’s output. The variable charge contains the actual energy costs of the facility, which is 90 per cent of the total variable costs of the facility.

f) The supplier is liable to return all or a portion of the fixed capacity charge, if the facility does not produce the specified minimum quantity.

Assessment

The arrangement includes a lease arrangement which will be accounted for as per the requirements of IAS 17 Leases because an asset (the facility) is specifically identified in the arrangement and the performance and completion of arrangement obligation depends upon the specified asset (the facility). Although the supplier can also use other sources to supply the gas, but it is not economically practicable and viable for the supplier. The purchaser has implicit right to use the facility because, in accordance with the contract terms the facility is specifically designed only to fulfill the supply requirements of the buyer and the supplier has no intention to modify or expand the facility.

Furthermore, the possibility of the fact that one or more parties other than the buyer will take more than an insignificant quantity of the output of production facility is remote and the price per unit of output of the asset specified in the arrangement is neither fixed in the contract terms nor it is the market value of the unit on the date of delivery of the output.

Example 2

Facts:

A manufacturing entity (the buyer) entered into a contract with another party (the supplier) to provide a specified component of its product for a specified time period. The supplier designs and installs the required production plant nearby the buyer’s production premises to supply the required component, retaining the ownership and control over the substantial facets of operating the facility. However, the production capacity of the production plant installed by the supplier is higher than the buyers demand. The contractual terms of the agreement are as follows:

a) The production plant required to produce the specified component is identified in the agreement. Under the contract, the supplier can also use other plants owned by supplier at other locations to supply the components to the buyer. However, it is not economically practicable and viable for the supplier to supply the components from other sources.

b) The supplier has the right to modify, replace or remove the facility’s plant and can expand the facility to supply components to other customers. The supplier has the history of supplying component parts to the external markets and it is possible that one or more parties other than the buyer will take more than an insignificant quantity of the output of production plant

c) The supplier has responsibility for any ongoing repairs and maintenance, and capital expenditure if required.

d) The supplier is obliged to supply the specified minimum quantity of specified component every month.

e) The buyer is obliged to pay a fixed price per unit of the actual quantity delivered. Even if the buyer’s demand does not exceed the specified minimum quantity, they still pay only for the actual quantity delivered.

Assessment

The arrangement does not include a lease arrangement which will be accounted for as per the requirements of IAS 17 Leases. An asset (the plant) is specifically identified in the arrangement and the performance and completion of arrangement obligation depends upon the specified asset (the plant). Although the supplier can also use other sources to supply the gas, but it is not economically practicable and viable for the supplier.

However, the buyer does not have the sufficient right or ability to use the asset specified in the arrangement or can direct any other parties to operate the asset in same manner as intended by the buyer. Furthermore, the buyer does not have control over the substantial utility or output of the asset and the possibility that one or more parties other than the buyer will take more than an insignificant quantity of the output of production facility is not remote.

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