Identifying leases under IFRS 16: the three-step test Vietnamese entities often overlook

In practice in Vietnam, many service, processing, transportation and power purchase contracts, and even contracts with lease elements, are recognised primarily as expenses in the period under the current accounting approach, particularly when a transaction is not identified as a finance lease or does not give rise to assets and liabilities on the statement of financial position. On transition to IFRS 16, the focus of the assessment is not the title of the contract, but whether the contract conveys the right to control the use of an identified asset for a period of time in exchange for consideration. The discussion below focuses on the first step, which also determines the scope of the entire IFRS 16 conversion project: identifying which contracts contain a lease component, before addressing the measurement of the right-of-use asset and lease liability.

The three conditions for determining whether a contract contains a lease under IFRS 16

General principle: control over the use of an asset, not ownership of the asset

Under IFRS 16.9, a contract is, or contains, a lease if it conveys the right to control the use of an identified asset for a period of time in exchange for consideration. This definition has three elements: an identified asset, the right to control its use, and a period of use.

The key point in understanding the logic of the Standard is that the IASB based this definition on the concept of control rather than on the allocation of risks and rewards, as under the former IAS 17. A risks-and-rewards model requires an assessment along a continuum, which may result in two similar contracts being classified differently depending on the judgemental threshold applied and creates scope for contracts to be structured to avoid recognition on the statement of financial position. The control model produces a clearer outcome: either the lessee controls the use of the asset or it does not.

The assessment is made at the inception of the contract (IFRS 16.9). An entity reassesses the contract only if its terms and conditions are changed (IFRS 16.11).

A period of use may be described in terms of an amount of use rather than calendar time—for example, the number of operating hours of a machine or the number of units of production that the asset will be used to produce (IFRS 16.10). This has practical implications for processing and transportation contracts in Vietnam, which are often specified by output rather than by time.

First condition: there is an identified asset

An identified asset is typically explicitly specified in a contract, but it may also be implicitly specified at the time the asset is made available for use by the lessee (IFRS 16.B13). A common case of implicit specification is when the lessor owns only one asset capable of fulfilling the contractual obligation.

Substantive substitution right. Even if a contract explicitly specifies an asset, that asset is not an identified asset if the lessor has a substantive right to substitute the asset throughout the period of use. Under IFRS 16.B14, a substitution right is substantive only when both of the following conditions are met:

• The lessor has the practical ability to substitute an alternative asset throughout the period of use: that is, the lessee cannot prevent the substitution and the lessor has an alternative asset readily available or could source one within a reasonable period of time; and
• The lessor would benefit economically from exercising its right to substitute the asset: that is, the economic benefits associated with substituting the asset would exceed the costs associated with substitution.

The second condition is the one most often overlooked in practice. A contractual term allowing a landlord to relocate a tenant to another space in the same building may appear to be a substitution right. However, if the costs of relocation, fitting out the new space and compensating for business interruption exceed the benefits obtained by the landlord, the right is not substantive and the asset remains an identified asset.

The logic behind this two-part condition is that the IASB intended to distinguish between a substitution right designed to enable the lessor to optimise the use of its asset, in which case the lessor genuinely controls the asset, and a substitution right that exists only on paper but would never be exercised because it provides no benefit. If only practical ability were considered, without considering economic benefits, any contract could be kept outside the scope of IFRS 16 merely by including a nominal substitution clause.

The Standard expressly identifies several circumstances that do not constitute a substantive substitution right:

• A right or obligation to substitute the asset only when the asset is not operating properly, or when a technical upgrade becomes available, does not preclude the asset from being an identified asset (IFRS 16.B18).
• A substitution right that arises only on or after a specified date, or on the occurrence of a specified event, is not substantive because the lessor does not have the ability to substitute the asset throughout the period of use (IFRS 16.B15).
• If the lessee cannot readily determine whether the lessor has a substantive substitution right, the lessee presumes that the right is not substantive (IFRS 16.B19). This is an important default rule when the contract documentation is incomplete.

The assessment is based on the facts and circumstances at the inception of the contract and excludes consideration of future events that, at inception, are not considered likely to occur (IFRS 16.B16).

Portions of an asset's capacity. Under IFRS 16.B20, a capacity portion of an asset is an identified asset only if the portion is physically distinct, for example, a floor of a building, a separate warehouse or a cold-storage chamber with physical boundaries. Conversely, a capacity portion that is not physically distinct, such as part of the capacity of a fibre-optic cable or pipeline, is not an identified asset unless it represents substantially all of the asset's capacity and thereby provides the lessee with the right to obtain substantially all of the economic benefits from use of the asset.

This rule explains why a contract for the use of a floor of an office building is a lease, whereas a contract for a specified percentage of transmission capacity generally is not.

Second condition: the right to obtain substantially all of the economic benefits from use of the asset

To control the use of an identified asset, the lessee must have the right to obtain substantially all of the economic benefits from use of the asset throughout the period of use (IFRS 16.B9(a)).

Economic benefits include the primary output and by-products produced by the asset, as well as other potential cash flows derived from using the asset, such as income from subleasing the asset to a third party (IFRS 16.B21). The scope of the economic benefits considered is limited to the lessee's defined right of use under the contract. For example, if the contract restricts a vehicle to operation within a particular province, the economic benefits considered are those arising from use of the vehicle within that territory (IFRS 16.B22).

One point to note in the assessment is that payments made by the lessee to the lessor as a percentage of use—for example, a percentage of sales generated at leased retail premises—do not reduce the economic benefits obtained by the lessee. Such payments are consideration for the right to use the asset, not a sharing by the lessor of the benefits derived from use of the asset (IFRS 16.B23). This point is often misunderstood in retail leases in shopping centres, where rent commonly comprises a fixed amount plus a percentage of sales.

Third condition: the right to direct how and for what purpose the asset is used

This is the most complex condition and the source of most technical debate. Under IFRS 16.B24, the lessee has the right to direct how and for what purpose the asset is used in one of two circumstances.

Case (a): the relevant decisions are not predetermined. The lessee has the right to direct how and for what purpose the asset is used throughout the period of use. This right is evidenced by relevant decision-making rights that affect the economic benefits to be derived from use of the asset, such as decisions about the type of output to be produced, when the output is produced, where the asset is used, and whether the asset is used and how much of its capacity is used (IFRS 16.B25–B26).

Decisions that are not relevant decision-making rights include decisions about operating and maintaining the asset, which are often held by the lessor and do not, in isolation, prevent the lessee from controlling the use of the asset (IFRS 16.B27).

Case (b): the relevant decisions are predetermined. When the relevant decisions about how and for what purpose the asset is used are predetermined at the inception of the contract, the lessee nevertheless has the right to direct the use of the asset if either of the following conditions is met:

• (i) The lessee 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 lessor having the right to change those operating instructions; or
• (ii) The lessee designed the asset in a way that predetermines how and for what purpose the asset will be used throughout the period of use.

Case (b) is decisive for the conclusions reached on most infrastructure and energy contracts in Vietnam. A rooftop solar power plant designed solely to sell electricity to a single customer under a fixed generation profile is a typical example: how and for what purpose the asset will be used is predetermined, so the analysis turns to who operates the plant and who designed it.

The logic of case (b) reflects the IASB's view that control may be exercised when the asset is designed and need not be exercised continuously throughout the period of use. If the lessee has determined all operating parameters through the design of the asset, the fact that no decisions remain to be made during the period of use is a consequence of decisions already made, not evidence of a lack of control.

Protective rights. Contracts often include terms designed to protect the lessor's interest in the asset, protect personnel or ensure compliance with laws—for example, limits on maximum operating distance, restrictions on where the asset may be used, requirements to notify changes in use or requirements for scheduled maintenance. Under IFRS 16.B30, those protective rights define the scope of the lessee's right of use but do not, in isolation, prevent the lessee from having the right to direct how and for what purpose the asset is used.

The boundary between protective rights and substantive decision-making rights is a grey area that arises frequently in practice and requires professional judgement. A commonly applied principle is that if a term merely establishes an outer boundary within which the lessee is free to make decisions, it is a protective right; if the term enables the lessor to change the purpose of use or the operating instructions during the period of use, the relevant decision-making right is held by the lessor.

Sequence for applying the three conditions

The three conditions are applied sequentially and operate as filters: if the conclusion at an earlier step is negative, there is no need to assess the subsequent step. This sequence is important for documentation purposes because the assessment file must clearly show which step led to the conclusion.

When all three steps are satisfied, the contract is, or contains, a lease. The next step is to separate the lease component from the non-lease components and allocate the consideration in the contract on the basis of their relative stand-alone prices (IFRS 16.12–17), unless the entity applies the practical expedient not to separate non-lease components by class of underlying asset (IFRS 16.15).

Comparison of VAS and IFRS

Applying the three-step test: practical scenarios

Detailed analysis of selected practical scenarios

Scenario 1: Office lease containing a landlord substitution clause

Joint Stock Company A leases the entire 8th floor of an office building in Hanoi for a 5-year term. The contract states that the landlord may relocate the tenant to another floor of equivalent size in the same building on 60 days' notice, with the tenant bearing its own relocation costs.

Step 1. Identified asset. The contract explicitly specifies the 8th floor, and a floor of a building is a physically distinct portion and therefore an identified asset under IFRS 16.B20. The issue is the substitution clause. The landlord has the practical ability to substitute the floor if equivalent vacant space is available, satisfying the first condition in IFRS 16.B14. However, the second condition is not met: the landlord would incur the costs of fitting out the new premises, bear the vacancy risk during the transition and obtain no benefit exceeding those costs. There is no substantive substitution right. An identified asset exists.

Step 2. Economic benefits. The tenant uses the entire 8th floor throughout the term and has a contractual right to sublease it. The condition is met.

Step 3. Right to direct the use. The tenant determines the layout, the number of personnel working at the premises and the hours of use. The landlord's terms governing access hours and fire-safety standards are protective rights under IFRS 16.B30. The condition is met.

Conclusion: the contract contains a lease component

Note: the conclusion might be reversed if the landlord operates several buildings, routinely has vacant equivalent space, bears all relocation costs under the contract and can lease the 8th floor at a higher rent. The assessment depends on the specific contractual terms and requires professional judgement.

Scenario 2: Transportation contract with dedicated vehicles

Joint Stock Company A enters into a 5-year freight transportation contract with a transport operator. The contract requires the operator to provide 10 tractor units identified by registration number, painted in the lessee's colours and bearing its logo, and parked at the lessee's warehouse. The lessee determines the daily schedule, routes and volume of freight. The operator provides the drivers and is responsible for maintenance.

Step 1. The vehicles are specified by registration number. The transport operator has no contractual right to substitute them other than when a vehicle is not operating properly—a circumstance that does not constitute a substantive substitution right under IFRS 16.B18. An identified asset exists.

Step 2. The vehicles are used exclusively for the lessee throughout the term; the transport operator cannot use them for other customers. The lessee obtains substantially all of the economic benefits. The condition is met.

Step 3. The lessee determines when the vehicles are used, their routes and the volume transported. These are relevant decisions that affect the economic benefits under IFRS 16.B26. The transport operator's provision of drivers and maintenance relates to operating and maintenance decisions and does not prevent the lessee from controlling the use of the vehicles under IFRS 16.B27. The condition is met.

Conclusion: the contract contains a lease component

The operating services component (drivers and maintenance) is a non-lease component that must be separated and allocated on the basis of relative stand-alone prices (IFRS 16.12–17), unless the entity has elected the practical expedient in IFRS 16.15 for the relevant class of underlying transport assets.

Scenario 3: Colocation arrangement at a data centre

An entity enters into a 3-year contract for server space at a data centre. The conclusion depends entirely on how the subject of the arrangement is described in the contract.

Variation (a): the contract specifies a particular numbered rack with a separate lock, and the lessee holds the key. The rack is physically distinct and is therefore an identified asset under IFRS 16.B20. The lessee uses the rack's entire capacity and determines the equipment installed and its configuration. Conclusion: the contract contains a lease component.

Variation (b): the contract promises a specified amount of computing power and storage capacity; the supplier selects the equipment and may move the workload between server clusters. No asset is specified, and the promised capacity is neither physically distinct nor substantially all of the data centre's capacity. Conclusion: the contract does not contain a lease component and is accounted for as a service contract.

Scenario 4: Processing contract with a dedicated production line

A consumer goods entity enters into a 4-year processing contract with a manufacturer. The contract provides that a specified packaging line is dedicated to the customer's products and cannot be used for other customers. The customer places monthly production orders and supplies the packaging materials. The manufacturer determines the production shifts, line speed, staffing and operating parameters within the agreed quality standards.

Step 1. The production line is explicitly specified and there is no substantive substitution right. The condition is met.

Step 2. The customer receives all output from the production line. The condition is met.

Step 3. The customer determines the quantity and delivery dates but does not determine how the production line is operated. How and for what purpose the line is used is not fully predetermined—the manufacturer retains the right to determine the speed, production shifts and configuration. Those decisions affect the economic benefits derived from the asset and are made by the manufacturer. The condition is not met.

Conclusion: the contract does not contain a lease component and is accounted for as a processing service contract.

The conclusion would be reversed if the customer specified all operating parameters and the detailed production schedule and the manufacturer merely followed instructions that it could not change—in that case, IFRS 16.B24(b)(i) would apply. This is a narrow boundary, and the technical appendices to the contract, not merely the main terms, must be reviewed carefully.

Scenario 5: Power purchase agreement for a rooftop solar power plant

A manufacturing entity enters into a 20-year power purchase agreement with an investor that installs a solar power system on the roof of the entity's factory. The entity agrees to purchase all output generated at a fixed unit price. The investor owns, operates and maintains the system.

Step 1. The system is permanently installed on the roof of the entity's factory and cannot be substituted. An identified asset exists.

Step 2. The entity purchases all output and therefore obtains substantially all of the economic benefits. The condition is met.

Step 3. This is the decisive point. How and for what purpose a solar power system will be used is predetermined when it is installed: the system has only one function to generate electricity; output depends on solar irradiance; and no operating decision can change the economic benefits. Applying IFRS 16.B24(b), the test turns to two questions:

• Does the entity have the right to operate the system? No-the investor operates it.
• Did the entity design the system in a way that predetermines how and for what purpose it will be used? This depends on the project documentation. If the entity specified the installed capacity, location and grid-connection configuration based on the factory's load requirements, there is a basis for arguing that it has control. If the investor designed the system independently in accordance with its own standards, the conclusion would tend towards there being no lease component.

Conclusion: this is a grey area that depends on the design documentation and operating terms. How and for what purpose a solar power system will be used is predetermined when it is installed, so the decisive analysis shifts to the two questions in IFRS 16.B24(b): does the power purchaser have the right to operate the system without the investor having the right to change those operating instructions, or did the power purchaser design the system in a way that predetermines how and for what purpose it will be used? In practice, the answer depends significantly on the project design documentation, rights to the electricity output and rights to operate the system. Contracts in which the purchaser is significantly involved in determining the scale and configuration of the system generally require deeper analysis. This is a grey area requiring professional judgement on each set of documentation; the assessment file should retain the project's technical specifications, the construction contract and the minutes documenting agreement on the installation parameters.

Other common practical scenarios

The table below identifies the decisive point in each scenario. The conclusions in the table apply to the specific set of terms described and are not general conclusions for the contract type. Unless otherwise stated, each scenario is analysed from the lessee's perspective.

Selected complex scenarios

Scenario 16: Warehouse lease with bundled services for a single combined fee

A retail entity enters into a 3-year contract for a separate warehouse together with loading and unloading, stocktaking and inventory management services, for a combined fee of VND 600 million per month. The contract does not specify a price for each component.

Identification is straightforward: the warehouse is physically distinct, the lessee controls the goods stored and their layout, and the contract contains a lease component. The complexity arises at the next step. Under IFRS 16.12–17, the entity must separate the lease component from the service components and allocate the consideration in the contract in proportion to the stand-alone price of each component. If the lessor does not provide stand-alone prices, the entity must estimate them, maximising the use of observable information—for example, rents for comparable warehouses in the area and market rates for loading and unloading services.

The entity may elect the practical expedient in IFRS 16.15 not to separate non-lease components and to account for the entire contract as a lease. This election is made by class of underlying asset, not on a contract-by-contract basis, and increases the recognised right-of-use asset and lease liability. This is an accounting policy decision that should be established before implementation and should not be left to individual business units.

Scenario 17: Lease of a vehicle fleet with substitution rights within a registered pool

An entity leases 30 trucks. The contract lists specific registration numbers but permits the lessor to substitute trucks from a pool of 45 registered vehicles, provided the replacement vehicle is of the same type and age.

The complexity lies in the unit of account for the assessment. The substitution right must be assessed for each asset, not for the portfolio as a whole. For each specific truck, the lessor has the practical ability to substitute it because 15 spare vehicles are available. The remaining question is economic benefit: would the lessor obtain a benefit exceeding the cost of substitution? If substitution is solely to balance the maintenance schedule and produces no economic benefit, there is no substantive substitution right under IFRS 16.B18. If the lessor actively rotates vehicles among customers to optimise fleet utilisation, a substantive substitution right may exist.

If the contract is concluded to contain a lease component, the entity may apply the practical expedient in IFRS 16.B1 to account for a portfolio of contracts with similar characteristics as a group, provided that the effect does not differ materially from accounting for the individual contracts.

Scenario 18: Lease of a factory with part of its capacity allocated to a third party

An entity leases a factory for 5 years. The conclusion depends on the nature of the third party's rights to the capacity not used by the entity.

Case (a): residual right. The contract permits the entity to determine the production schedule. The lessor may allow a third party to use the factory during periods when the entity is not producing, but the third party must vacate when the entity requires the capacity. The entity retains the right to determine the use of the entire capacity throughout the period of use; the third party's use of spare capacity is a consequence of the entity's decisions about use, not a contractual restriction. The entity obtains substantially all of the economic benefits (IFRS 16.B9(a), B21). Conclusion: the second condition is met.

Case (b): fixed allocation. The contract specifies in advance that a third party may use the factory during the third shift on every working day, irrespective of the entity's needs; the entity may use only the first and second shifts. This is a genuine contractual restriction. Two matters must be considered in sequence. First, if the subject of the arrangement is a capacity portion that is not physically distinct, that portion is an identified asset only if it represents substantially all of the factory's capacity (IFRS 16.B20). Second, only if an identified asset is concluded to exist is the economic-benefits condition assessed. IFRS 16 does not prescribe a quantitative threshold for “substantially all”; the assessment requires professional judgement based on all facts and circumstances, and the assessment file should document the basis for the threshold applied. Conclusion: this is a grey area that depends on the proportion of capacity allocated to the third party.

The distinguishing question between the two cases is this: when the entity requires the entire capacity, must the third party vacate? If so, the third party has only a residual right. If not, it has a fixed allocation.

Scenario 19: Lease of land in an industrial park and sublease of a portion

An entity leases 5 hectares of land in an industrial park for 45 years and pays for the entire term in advance. It subsequently subleases 1 hectare, together with a warehouse constructed on it, to another entity for 10 years.

The transaction gives rise to two contractual relationships that must be identified separately. Under the head lease, the entity is the lessee: the land is specified by cadastral boundaries, there is no substitution right, and the entity determines its use within planning restrictions. The contract contains a lease component.

For the sublease, the entity is also an intermediate lessor. Under IFRS 16.B58, an intermediate lessor classifies the sublease by reference to the right-of-use asset arising from the head lease, not by reference to the underlying asset. The 10-year sublease term relative to the remaining term of the head lease is a decisive factor in classifying the sublease as a finance lease or an operating lease.

Scenario 20: Sale of an asset to a finance company and leaseback

An entity sells a production line to a finance company for VND 60,000 million and simultaneously enters into a 7-year leaseback of the same production line, with an option to repurchase it for a nominal amount at the end of the term.

A common error is to apply IFRS 16.98–103 on sale-and-leaseback transactions immediately. The correct sequence is the reverse: the entity must first determine whether the transfer of the asset qualifies as a sale under IFRS 15 - that is, whether the buyer obtains control of the asset.

Because of the nominal-price repurchase option, the buyer never obtains control of the asset in substance; the transaction does not qualify as a sale. The entity therefore does not derecognise the asset, continues to recognise the production line at its carrying amount, and recognises the proceeds received as a financial liability under IFRS 9 (IFRS 16.103). No right-of-use asset arises.

This is a material difference from Vietnamese accounting requirements. Under VAS 06 and Circular 99/2025/TT-BTC, a sale-and-leaseback transaction that results in a finance lease is accounted for as a sale of the asset together with recognition of a finance lease asset; the difference between the selling price and the asset's residual carrying amount is not recognised immediately in income but is deferred in the unearned revenue account and amortised over the lease term. Vietnamese requirements therefore account for the legal form of the transaction (a sale followed by a leaseback), together with a profit-adjustment mechanism, whereas IFRS 16 first asks whether the transaction qualifies as a sale.

When preparing the conversion differences schedule, the entity must also reconcile the remaining unearned revenue balances arising from sale-and-leaseback transactions completed before the transition date.

Common errors and implementation issues in Vietnam

1. Confusing an administrative substitution right with a substantive substitution right. In the files we have reviewed, entities often stop at the first condition in IFRS 16.B14, the lessor has a contractual right to substitute the asset, and immediately conclude that there is no identified asset. A typical example is an office lease containing a clause permitting the landlord to relocate the premises. When both conditions are considered, the costs of fitting out the new premises, business interruption costs and vacancy risk mean that the landlord receives no economic benefit from substitution. There is no substantive substitution right, and the contract still contains a lease component. The consequence of overlooking this point is that the contract is incorrectly excluded from the project scope at the population-building stage.

2. Overlooking an embedded lease component in a service contract. A manufacturing entity enters into a long-term transportation contract with a dedicated fleet, recognises the entire amount as a selling expense and omits the contract from the review population because its title is not “lease contract”. Similar cases arise with contracts for standby generators, warehousing infrastructure and power purchases. The preventive measure is to build the initial review population from expense categories in the general ledger, outsourcing costs, purchased service costs and transportation costs, rather than from the contract register maintained by the legal department.

3. Assessing operating rights based on form rather than substance. In processing contracts, entities often conclude that there is no lease component merely because the personnel operating the machinery are employed by the processor. The relevant question under IFRS 16.B24(b)(i) is who determines how the asset is operated. If all technical parameters, the production line speed and the production schedule are specified by the customer in a contract appendix and the processor cannot change them, the conclusion is reversed. The decisive information is often in the technical appendices rather than the main terms, so the assessment file must include a review of the complete contract package.

4. Applying the short-term lease and low-value asset exemptions outside their proper scope.

There are two common errors. First, an 11-month property lease with an extension option that the lessee is reasonably certain to exercise is treated as qualifying for the short-term lease exemption. Under IFRS 16.18, the lease term comprises the non-cancellable period together with periods covered by an extension option if the lessee is reasonably certain to exercise that option. Once that conclusion has been reached, the lease term must include the extension period and the lease is no longer a short-term lease. It is important to note that the IFRS 16 threshold is “reasonably certain”, not “virtually certain”, the higher threshold used in other contexts. In addition, a lease that contains a purchase option is not a short-term lease, irrespective of its term.

Second, eligibility for the low-value asset exemption is assessed based on the total contractual value of a lease for a large portfolio of office equipment rather than on the value of each individual underlying asset when new. Under IFRS 16.B5, the exemption applies only when the lessee can benefit from use of the underlying asset on its own or together with other resources that are readily available to it, and the underlying asset is neither highly dependent on, nor highly interrelated with, other assets. A lease does not qualify if the lessee subleases, or expects to sublease, the asset.

The two exemptions are elected at different levels (IFRS 16.8): the short-term lease exemption is elected by class of underlying asset, whereas the low-value asset exemption is elected on a lease-by-lease basis.

5. Contract data are fragmented and insufficient both to support a conclusion and to provide audit evidence. A retail entity has hundreds of property leases entered into separately by individual branches, with no central contract repository. Addenda amending asset-substitution clauses are stored separately and are not linked to the original contracts. During an audit review, the recurring question is often not whether the conclusion is correct, but which documentation demonstrates that the entity assessed all three conditions for each contract. If it cannot readily be determined whether the lessor has a substantive substitution right, IFRS 16.B19 requires the lessee to presume that the right is not substantive. The conclusion therefore leans towards the existence of a lease component, rather than excluding the contract from the scope.

Frequently asked questions

How should the economic-benefits condition be assessed for a rooftop solar power purchase agreement when output depends on weather conditions?

Variability in output does not affect the conclusion on the second condition. The relevant question is whether the purchaser has the right to obtain substantially all of the output generated, not how much output is generated. A contract under which the purchaser commits to take all output satisfies this condition even when actual output fluctuates significantly from month to month. The real issue for this type of contract lies in the third condition and in measuring lease payments when the electricity price is linked to variable output.

The IFRS Interpretations Committee considered a related fact pattern in its agenda decision Economic Benefits from Use of a Windfarm (IFRS 16 Leases), published in December 2021. (https://www.ifrs.org/projects/completed-projects/2021/economic-benefits-from-use-of-a-windfarm-ifrs-16/). In that fact pattern, an electricity retailer paid only the difference between a fixed price and the spot price for the amount of electricity supplied by the windfarm to the grid, and received only renewable energy credits. The Committee concluded that the retailer did not have the right to obtain substantially all of the economic benefits from use of the windfarm because it had no right to the electricity itself—the primary output of the asset (IFRS 16.B9, B21). This conclusion illustrates the distinguishing factor in the second condition: the right to the physical output of the asset, rather than the right to cash flows associated with the asset. A rooftop solar power purchase agreement is therefore different in substance because the purchaser receives all of the electricity actually generated.

If multiple customers use the same data centre, is the server space a portion of an identified asset?

That depends on the extent to which it is physically distinct. A numbered rack with a separate lock and clearly defined physical boundaries is an identified asset under IFRS 16.B20. A promised amount of computing power or storage capacity that the supplier allocates among equipment clusters is not an identified asset, unless that portion represents substantially all of the data centre's capacity: an outcome that is rare in practice.

Is a cloud computing service contract within the scope of IFRS 16?

A standard Software-as-a-Service (SaaS) contract is generally outside the scope of IFRS 16 because the customer receives only a right to access the supplier's software and does not control an identified asset. Based on the IFRS Interpretations Committee's analyses of cloud computing arrangements, common SaaS contracts are viewed as service contracts rather than leases. A distinction is required when the customer has the right to use a specifically identified server or infrastructure; in that case, the contract may contain a lease component and must be assessed under IFRS 16.

Is a land use right paid for in full for the entire term accounted for under IFRS 16 or under IAS 16 and IAS 40?

The starting point of the analysis is the manner in which the right is held, not the form of payment.

When an entity is allocated land by the State in exchange for a land use fee, or acquires a land use right by transfer, the entity is not in the position of a lessee and there is no lease relationship under IFRS 16.9. The item falls within the scope of IAS 16 if the land is used in the production or supply of goods or services or for administrative purposes; it falls within the scope of IAS 40 if the property is held to earn rentals or for capital appreciation. The practical difficulty is that Vietnamese land law grants the land user a bundle of rights that does not correspond fully to either the concept of ownership or the concept of a lease under IFRS, and there is no official interpretation specific to this context. Accordingly, another possible view is to recognise an intangible asset. This is a grey area requiring professional judgement. An entity should establish its approach as an accounting policy, apply it consistently to its entire portfolio of land use rights, and disclose the basis for its conclusions for material land use rights.

When an entity leases land from the State and pays for the entire lease term in advance, a lease relationship exists and the analysis begins with IFRS 16. If the contract meets the three conditions in IFRS 16.9, the entity recognises a right-of-use asset. The lump-sum payment is a lease payment made at or before the commencement date and is included in the initial measurement of the right-of-use asset. If the property meets the definition of investment property and the entity elects the fair value model, IAS 40.34 requires the right-of-use asset to be measured using the fair value model.

Must a contract previously concluded not to contain a lease component be reassessed?

Under IFRS 16.11, an entity reassesses a contract only if its terms and conditions are changed. The initial conclusion is not revisited merely because the facts and circumstances change or because the lessor does not exercise a substitution right as expected. This requirement creates a new internal control obligation: the entity must have a process to identify all contract addenda and amendments that trigger reassessment, rather than performing a one-time review only at the conversion date.

How should an entity account for a bundled-fee contract when the stand-alone price of the service component cannot be separately determined?

The entity must estimate the stand-alone price, maximising the use of observable market information and using internal information only when market information is unavailable. If the estimate is not sufficiently reliable, the remaining option is to apply the practical expedient in IFRS 16.15 and account for the entire contract as a lease. This election increases the recognised right-of-use asset and lease liability and must be applied consistently to the entire class of underlying assets rather than on a contract-by-contract basis.

What documentation do auditors generally require to support a lease-identification conclusion?

Three categories of documentation are generally required: a complete population of the contracts reviewed, together with the basis used to compile it (usually reconciled from expense categories in the general ledger); a three-condition assessment for each contract, including the conclusion and cross-references to specific contractual terms; and supporting documentation for contracts excluded from the scope, because an exclusion conclusion carries greater review risk than an inclusion conclusion. For contracts in grey areas, the file should also document the rationale for the alternative conclusion that was not selected.

Determining the population of contracts within the scope of IFRS 16 determines the overall amount of right-of-use assets and lease liabilities in the conversion financial statements and is the most difficult step to reverse if an error is identified at a later stage. Our IFRS conversion advisory team assists entities in reviewing their contract populations, developing three-condition assessment schedules and establishing control processes to identify contract amendments.

This article has been prepared to provide general information and technical guidance and does not constitute accounting, audit, tax or legal advice for any specific transaction or entity. The figures, assumptions and journal entries in the article are illustrative only and must be adapted to each entity's facts, professional judgements and documentation. We accept no responsibility for any loss arising from the use of the information in this article without appropriate professional advice. For assistance with a specific matter, please contact our IFRS conversion advisory team.