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Lease Identification under IFRS 16: How to Determine Whether a Contract Contains a Lease
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Lease Identification under IFRS 16: How to Determine Whether a Contract Contains a Lease

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Introduction

A contract 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 (IFRS 16.9). This deceptively simple statement hides several layers of judgement. In this article, we will analyse each part carefully.

This article forms part of our full IFRS 16 guide.

1. Is there an identified asset?

The starting point is whether the contract depends on the use of a specified asset. An asset can be explicitly specified in the contract, such as “Truck with registration ABC123”, or implicitly specified, where only one asset can realistically fulfil the contract.

However, even if an asset is specified, it is not identified if the supplier has a substantive right of substitution. Judgement is required, but the burden of proof is high—we cover how to assess this in detail in the next section.

2. Substantive substitution rights

A specified asset is still not an identified asset if the supplier holds a substantive right to substitute it throughout the period of use. Assessing whether a substitution right is substantive—rather than merely protective—requires both of the following to be true:

  • The supplier has the practical ability to substitute alternative assets throughout the period of use, and
  • The supplier would benefit economically from exercising that right.

Practical ability to substitute

This condition typically fails where:

  • Alternative assets are not readily available to the supplier, or would need to be sourced from a third party,
  • Substitution would require significant cost or operational disruption (for example, removing and reinstalling specialised equipment), or
  • The customer's consent is required before the supplier can substitute the asset.

Economic benefit from substitution

Even where substitution is practically possible, the supplier must also benefit economically from exercising that right—for example, through cost savings from optimising a shared asset pool, or improved utilisation across a fleet. A substitution right that would cost the supplier more than it saves is not substantive, regardless of how it is worded in the contract.

Assessing substitution rights at contract inception

The assessment is performed at inception, based on facts and circumstances at that date, and is not revisited unless the contract terms change. A customer is not required to identify every mechanism the supplier might use to substitute an asset; it only needs to be able to readily determine whether a substitution right is substantive. If the customer cannot readily determine this, the right is presumed not to be substantive, and an identified asset therefore exists.

In practice, many substitution rights are protective rather than substantive. A right to replace equipment only if it breaks down, or only during scheduled maintenance, does not remove the existence of an identified asset.

Did you know?

This is typically where software as a service (SAAS) or infrastructure as a service (IAAS) like cloud computing arrangements fail to meet the definition of a lease. Although the service may be delivered using specific servers or infrastructure in practice, the customer does not control a particular, dedicated piece of equipment. The supplier typically retains substantive substitution rights, meaning it can move workloads between servers, data centres, or environments whenever it chooses and would economically benefit from doing so through optimisation of capacity and performance.

Practical Example

A telecoms customer contracts for the use of a specific cabinet within a data centre. The supplier retains a contractual right to relocate the customer's equipment to another cabinet "for operational reasons." If exercising that right would cost the supplier more than it gains—through decommissioning, recabling, and service downtime—the right is protective rather than substantive, and the cabinet remains an identified asset.

3. Does the customer obtain substantially all of the economic benefits?

Once an identified asset exists, the next question is whether the customer obtains substantially all of the economic benefits from its use during the period of use (for example, through exclusive use of the asset). These benefits are not limited to direct outputs or cash flows. These include:

  • Primary outputs (for example, goods produced by a machine),
  • By-products,
  • Other economic benefits from use, such as subleasing or ancillary services.

This analysis focuses on use, not ownership. If the supplier can simultaneously derive meaningful economic benefits from using the same asset, the contract may be a service rather than a lease. For example, if a data centre provider can freely allocate server capacity between multiple customers, no single customer controls the asset or its economic benefits.

Where an asset is dedicated to one customer, and the supplier’s remaining benefits are insignificant, this condition is normally satisfied.

4. Who directs the use of the asset?

Control is not only about benefits; it is equally about decision-making. The customer must have the right to direct how and for what purpose the asset is used. This involves assessing which party makes the relevant decisions that most significantly affect the economic benefits derived from use.

There are two broad scenarios:

a) The customer makes the key decisions

This is the more straightforward case. If the customer can decide:

  • When the asset is used,
  • Where it is used,
  • How much output is produced,
  • What type of output is produced,

then the customer directs the use, and this condition is met.

b) The relevant decisions are predetermined

In many contracts, particularly for infrastructure or specialised equipment, the relevant decisions are set in advance. In such cases, control exists if either:

  • The customer has the right to operate the asset without the supplier having the right to change those operating instructions, or
  • The customer designed the asset in a way that predetermines how and for what purpose it will be used.

Even if the supplier physically operates the asset, the customer may still control its use if the supplier is effectively acting as an operator on the customer’s behalf.

The standard also distinguishes between:

  • Decision-making rights that convey control, and
  • Protective rights that merely protect the supplier’s interest in the asset.

Protective rights include limits on use to ensure regulatory compliance, health and safety requirements, or restrictions to prevent misuse. These do not prevent the customer from controlling the asset. They exist to safeguard the supplier’s ownership, not to direct the economic use of the asset.

This distinction is frequently misunderstood in practice and is a common source of incorrect “no lease” conclusions.

5. Period of time and consideration

The right to control must exist for a period of time, which can be defined in calendar terms or by reference to usage (for example, number of units produced). There must also be consideration, which includes fixed payments, variable payments, or other forms of economic compensation.

This ensures that the arrangement reflects a financing or usage transaction rather than a one-off service.

6. Putting it all together

A contract contains a lease when all of the following are present:

  • An identified asset exists.
  • The customer obtains substantially all of the economic benefits from use.
  • The customer directs how and for what purpose the asset is used.
  • The right exists for a period of time.
  • Consideration is exchanged.

If any one of these fails, the arrangement is a service, not a lease.

7. Contracts that contain both lease and non-lease components

Many real-world contracts bundle leasing and service elements together. Entities are required to identify each lease component separately and account for non-lease components under other standards, unless the lessee applies the practical expedient to treat them as a single lease component.

This separation step is crucial because it directly affects:

Poor component identification can materially distort reported leverage and EBITDA.

8. Reassessment

IFRS 16 requires reassessment only when the terms and conditions of the contract change. Changes in judgement, market conditions, or expectations alone do not trigger reassessment of whether the contract is or contains a lease. This consideration is distinct from lease modifications.

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Conclusion

Determining whether a contract is or contains a lease is not a mechanical checklist exercise. It is a structured assessment of control, grounded in economic substance and refined by the detailed guidance in Appendix B.

For clarification, guidance, or feedback on our article, please reach out to us at insight@leash.co.za.

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Frequently Asked Questions

Common questions about this topic

A contract contains a lease under IFRS 16 when it conveys the right to control the use of an identified asset for a period of time in exchange for consideration. Control exists only when the customer both obtains substantially all of the economic benefits from use and directs how and for what purpose the asset is used.

An identified asset is an asset that is explicitly or implicitly specified in a contract and is not subject to substantive substitution rights held by the supplier. If the supplier can practically and economically substitute the asset, the asset is not considered identified.

Substitution rights are substantive only when the supplier has the practical ability to substitute the asset throughout the period of use and would benefit economically from doing so. Protective or theoretical substitution rights do not prevent an asset from being identified.

Most cloud computing, SAAS, and IAAS arrangements do not contain a lease because the customer does not control a specific, identified asset and the supplier retains substantive substitution rights over servers and infrastructure.

Substantially all of the economic benefits means that the customer receives almost all of the benefits from using the asset, including primary outputs, by-products, and other benefits such as subleasing or ancillary services, and that the supplier cannot derive significant benefits simultaneously.

Control exists when the customer has both the right to obtain substantially all of the economic benefits from use of the asset and the right to direct how and for what purpose the asset is used.

Decision-making rights convey control over how and for what purpose an asset is used, while protective rights merely safeguard the supplier’s interest in the asset, such as compliance with laws, health and safety, or prevention of misuse.

Relevant decisions are predetermined when the contract or asset design already specifies how and for what purpose the asset will be used. In such cases, the customer still controls the asset if it has the right to operate it or if it designed the asset in a way that predetermines its use.

Separating lease and non-lease components is crucial because it affects the measurement of the lease liability, the size of the right-of-use asset, and profit and loss patterns. Poor separation can materially distort leverage and EBITDA.

Reassessment is required only when the terms and conditions of the contract change. Changes in judgement, market conditions, or expectations alone do not trigger reassessment.