Leases – Distinguishing between a lease contract and a service contract

As part of the IASB and FASB redeliberations on the proposals in their Exposure Draft, Leases, the Boards plan to discuss the definition of a lease, the lessor accounting model, the lease term, variable lease payments and profit or loss recognition patterns. (A summary of constituent feedback on the Exposure Draft can be found in the Deloitte (United States) publication Heads Up Boards Consider Feedback on Leases ED (PDF 165k)).

How to distinguish between a lease contract and a service contract

During this meeting, the Boards discussed defining a lease and how a lease should be distinguished from a service.

The principles in defining a lease under the right-of-use model in the exposure draft include distinction of contracts which specify:

• fulfilment of the contract is dependent upon the supplier (lessor) providing a specified asset or assets, and
• conveyance of the right to control the use of specified assets is provided to the purchaser (lessee).

Respondents to the exposure draft had initially indicated that further clarity was needed in application of the above right-of-use model principles in the following environments:

Specified asset:

• the supplier can substitute the assets used to fulfil a contract, and
• the specified asset is a component or portion of a larger asset.

Right to control the use of a specified asset:

• the supplier provides additional services relating to the specified asset, and
• the purchaser obtains all but an insignificant amount of the output or other utility of a specified asset.

The IASB and FASB staff asked the Boards to consider which factors help determine how the principles of a specified asset and the right to control the use of a specified asset should be applied in determining whether an arrangement contains a lease.

Specified asset:

• Identification: When asked to consider whether specific identification of an individual asset (e.g., asset serial number) was required to satisfy the criterion outlined above, the Boards generally agreed that specific asset identification was not a requirement. The Boards did note that asset specificity would generally be expected to consider the functionality, homogeneity and value of the asset to the lessee in any asset substitution environment. The Boards also questioned whether any contractually specified asset is required to take the form of a specific tangible asset, in contrast to an intangible asset, in which no uniform conclusion was reached.

• Substantive: When asked to consider the substantive terms of an arrangement in the form of customer indifference to use of a pool of assets in satisfaction of lessee requirements, certain members of the Boards noted consideration to the lessee's dependency on specific assets; noting that a termed 'equivalent' asset of consistent functionality, homogeneity and value to the lessee would not result in classification as a service contract when viewed in isolation
• Componentisation: When asked to consider distinction of specified assets when use of a 'specified' asset is componentised for use by multiple parties (e.g., fibre-optic data cable), the Boards were unable to develop a consensus view on whether such componentisation would result in an inability to control physical access to a specified asset.

• Right to direct the operation: When asked to consider the right to direct the operation, the Boards considered whether the ability to direct the operation required direct performance by the lessee to the contract at all levels of functionality, or whether contract specificity as to the lessee's ability to direct the functionality of the lessor served in fulfilling this requirement. No consensus view was reached on this topic
• Right to control physical access: When asked to consider the right to control physical access, the Boards considered whether restriction of physical access required total unrestricted use of the assets, such that componentised asset use would serve to restrict recognition of a contract as a lease. No consensus view was reached on this topic.

In addition to the above, the Boards considered whether contracts which contain an embedded asset and service elements should be bifurcated and accounted for separately, and if so, how such components should be evaluated when considering value and importance of such elements to functionality; however, a conclusion was not reached on this topic during the respective Boards' meeting.

No tentative decisions were reached during this session. The staff intended to use the information obtained in these discussions in developing formal proposals to bring to the Boards during a future meeting.