Embedded leases : The scope under IFRS is much wider (IFRIC 4)

It is not uncommon for enterprises to have contracts with
service providers for providing goods/services on a dedicated basis to these
enterprises. As certain assets may be dedicated for use only for a particular
enterprise, binding procurement commitments may be provided to the service
provider to the extent of entire production capacity of the assets. In certain
other cases, the enterprise may provide minimum procurement guarantee whereby it
pays a fixed price per unit of shortfall in procurements. Through these
arrangements the service provider is assured of compensation for the capital
cost incurred.

An entity may enter into an arrangement, comprising a
transaction or a series of related transactions, that does not take the legal
form of a lease but conveys a right to use an asset (e.g., an item of
property, plant or equipment) in return for a payment or series of payments.
Examples of arrangements in which one entity (the supplier) may convey such a
right to use an asset to another entity (the purchaser), often together with
related services, include :

(1) Outsourcing arrangements, and

(2) take-or-pay and similar contracts in which purchasers
must make specified payments regardless of whether they take delivery of the
contracted products or services (e.g., a take-or-pay contract to
acquire substantially all of the output of a supplier’s power plant).

IFRIC 4 provides guidance on determining whether an
arrangement is or contains a lease. The following example illustrates
take-or-pay contracts that would be classified as embedded lease :

An entity has a contract with its supplier (job worker)
whereby the entity is contractually bound to get 100,000 units of goods
manufactured by the supplier. The supplier has installed dedicated machinery to
manufacture and supply the goods only to serve the entity. The supplier has no
other machinery that can manufacture these goods.

Price terms are as under :

In the above case, the assets are deployed for use only for
the entity. Further, irrespective of the actual purchase from the supplier, the
entity is bound to pay a fixed charge in the form of per unit charge and
penalty, if applicable (Rs.200,000 in the above example i.e., even if the
purchaser does not purchase at all, a penalty on 100,000 units would be levied
at Rs.2 per unit). This fixed charge, in substance, is a lease arrangement where
the supplier’s machinery is taken on lease for a lease rent of Rs.200,000.

Guidance in IFRIC 4 helps the entity to assess if
outsourcing/service contract is a simple supply contract or whether in substance
there is actually a lease embedded in the contract. The assessment whether the
above arrangement is or contains a lease is based on whether :

For classifying an arrangement as a lease, one needs to
assess whether the arrangement is dependent on the use of a specific/identified
asset. For an arrangement to be determined as an embedded lease, there needs to
be reasonable certainty at inception of the contract that the same asset would
be used throughout the term of the contract. In other words, the asset needs to
be a ‘specified asset’.

The asset may be a ‘specified asset’ either explicitly by way
of a contract or could be identified impliedly, based on the facts and
circumstances of the case.

An asset may be explicitly specified in the contract when,
for instance, the service provider’s plant/ warehouse is mentioned in the
agreement along with the address. Thus it is reasonably certain that the same
plant/warehouse shall be used throughout the contract period.

Although a specific asset may be explicitly identified in an
arrangement, it is not the subject of a lease if fulfilment of the arrangement
is not dependent on the use of the specified asset.

An asset has been implicitly specified if, for instance, the
supplier owns or leases only one asset with which to fulfil the obligation and
it is not economically feasible or practicable for the supplier to perform its
obligation through the use of alternative assets.

The entity will have to use its judgment in determining
whether it is economically feasible or practicable to perform obligations
through use of alternative assets, based on the facts and circumstance in each
case. Assessing whether the use of alternative asset is economically feasible
and practical will not always be straightforward.

If the supplier is obliged to deliver a specified quantity of
goods or services and has the right and ability to provide those goods or
services using other assets not specified in the arrangement, then fulfilment of
the arrangement is not dependent on the specified asset and the arrangement does
not contain a lease.

An arrangement conveys the right to use the asset if the arrangement conveys to the purchaser (lessee) the right to control the use of the underlying asset. The right to control the use of the underlying asset is conveyed if any one of the following conditions is met?:

    a) The purchaser has the ability or right to oper-ate the asset or direct others to operate the asset in a manner it determines.
    b) The purchaser has the ability or right to control physical access to the underlying asset.
    c) Facts and circumstances indicate that it is re-mote that one or more parties (other than the purchaser) will take more than an insignificant amount of the output or other utility that will be produced or generated by the asset during the term of the arrangement, and the price that the purchaser will pay for the output is not contractually fixed per unit of output, nor equal to the current market price per unit of output. In the conditions (a) and (b) above, the lessee obtains the right to operate the asset or restrict the physical access of third parties to the asset by way of an explicit contract. In such cases, the lessee need not take the entire output generated from the asset for an arrangement to be a lease.

In the condition (c) above, a purchaser controls the usage of an asset and a lease exists only when the purchaser is taking substantially all of the output i.e., others cannot obtain the output from the specified asset.

However, an exemption was incorporated in the condition (c), so that arrangements in which the price is either contractually fixed per unit of output or equal to the market price per unit of output at the time of delivery of the output should not be ac-counted for as leases, since the payments in such arrangements are considered as a consideration only for ‘use of an asset’ and not for the ‘availabil-ity of an asset’. This exemption should be applied narrowly and only for arrangements in which a pur-chaser clearly pays for the actual output. Thus, if any variability is introduced to the price per unit, such an arrangement contains a lease. There is a strong presumption that any variability in the price per unit that depends on the output of the asset means that the arrangement conveys the right to use the asset.

If the arrangement is based upon a specific asset, the entity must determine whether the arrange-ment conveys a right to use the asset, based on the above guidance. It is often a challenge to determine whether a right to use the item has been conveyed. Consider the terms ‘fixed price per unit of output’ or‘current market price per unit of output at the time of delivery’. In practice, interpretations of these terms widely vary. Some entities interpret the term ‘fixed price’ as absolutely fixed with no variance per unit, based on costs or volumes. However, other en-tities accept certain adjusted prices as fixed, such as fixed price per unit adjusted for inflation or a fixed percentage increase, etc.

Typical clauses that indicate a lease arrangement:
An illustrative list of contract features that indicate lease arrangement is as under:

    a) a contract whereby the purchaser agrees to buy the entire output of a specified asset and requires the asset to be operated at full capacity, then there is a strong presumption that the purchaser has effective control over the use of assets and therefore the arrangement contains a lease.
    b) If in case of dedicated assets, any variability is introduced to the price per unit, then such an arrangement contains a lease. There is a strong presumption that any variability in the price per unit that depends on the output of the asset means that the arrangement conveys the right to use the asset.

    c) If in case of dedicated assets, pricing arrangements include a minimum procurement guarantee (i.e., the purchaser shall pay a penalty if procurement is lower than minimum guaranteed volumes), the price cannot be termed as current market price. Hence these would be classified as leases.

Assessing or reassessing whether an arrangement is, or contains, a lease:

Initial assessment:

The assessment of whether an arrangement contains a lease shall be made at the inception of the arrangement on the basis of all of the facts and circumstances.

Subsequent reassessment:

A reassessment of whether the arrangement contains a lease after the inception of the arrangement shall be made only if any one of the following conditions is met:

    i) There is a change in the contractual terms, unless the change only renews or extends the arrangement.
    ii) A renewal option is exercised or an extension is agreed to by the parties to the arrangement, unless the term of the renewal or extension had initially been included in the lease term in accordance with paragraph 4 of IAS 17 — Leases.

    iii) There is a change in the determination of whether fulfilment is dependent on a specified asset.

    iv) There is a substantial change to the asset, for example, a substantial physical change to property, plant or equipment.

A reassessment of an arrangement shall be based on the facts and circumstances as of the date of reassessment, including the remaining term of the arrangement. Changes in estimate (for example, the estimated amount of output to be delivered to the purchaser or other potential purchasers) would not trigger a reassessment.

Classification of embedded leases — operating or finance:
If an arrangement contains a lease as per guidance provided under IFRIC 4, the parties to the arrangement shall apply the requirements of IAS 17 — Leas-es to the lease element of the arrangement.

Separation of lease payments from other elements of the contract:
For the purpose of applying the requirements of IAS 17 — Leases, payments and other consideration required by the arrangement shall be separated at the inception of the arrangement (or upon a reassessment of the arrangement) into those for the lease and those for other elements on the basis of their relative fair values.

In some cases, separating the payments for the lease from payments for other elements in the arrangement will require the purchaser to use an estimation technique. For example, a purchaser may estimate the lease payments by reference to a lease agreement for a comparable asset that contains no other elements, or by estimating the payments for the other elements in the arrangement by reference to comparable agreements and then deducting these payments from the total payments under the arrangement to determine the lease component.

For instance, a contract for warehouse management services, whereby the vendor shall manage a warehouse on a dedicated basis for a single customer against a fixed monthly fees. The inputs of the vendor includes warehouse premises, assets deployed therein and warehouse labour. Thus, the arrangement may contain a lease of warehouse and warehouse assets. The overall consideration shall be separated into lease rentals for warehouse, lease rentals for warehouse assets and consideration for warehouse management (labour). In practice separation of individual components pose significant challenges to entities.

Impracticality in separation of lease components: If a purchaser concludes that it is impracticable to separate the payments reliably, it shall:

    a) in the case of a finance lease, recognise an asset and a liability at an amount equal to the fair value of the specified asset under the lease. Subsequently the liability shall be reduced as payments are made and an imputed finance charge on the liability recognised using the purchaser’s incremental borrowing rate of interest

    b) in the case of an operating lease, treat all payments under the arrangement as lease payments for the purposes of complying with the disclosure requirements (i.e., applicable to disclosures only) of IAS 17 — Leases, but
    i) disclose those payments separately from minimum lease payments of other arrangements that do not include payments for non-lease elements, and

    ii) state that the disclosed payments also include payments for non-lease elements in the arrangement.

Terms of arrangements:

Cancellation clause in embedded lease:

If an arrangement qualifies for recognition as an embedded lease and the arrangement is cancellable, the assets under such arrangement shall be accounted as taken on a cancellable operating lease. Hence the payments made need to be separated between lease payments and other elements of the contract for recognition purposes.

However, as the arrangement is cancellable, the entity need not provide disclosures in relation to the lease.

Absence of binding contract:

If the entity neither contractually require the job worker to use the asset exclusively for the company, neither does it contractually restrict the access of third parties to the asset, nor has obtained any contractual right to operate the asset, such arrangement shall not be classified as a lease. This would be a normal purchase of goods/services.

Thus, it is essential that there should be contractual arrangement that provides the right to use a specified asset. If there is only a mutual understanding between the two contracting parties relating to minimum guarantee commitments or adjustment to price based on level of output, without a binding contract, then it would not be classified as an embedded lease.

Financial statement impact:

Once, an arrangement is covered under IFRIC 4, an entity needs to determine whether the underlying embedded lease is an operating lease or a finance lease in accordance with IAS 17 — Leases and apply the accounting principles as set out in that standard.

    a) Accounting by lessee — Finance lease:

Initial recognition and measurement:

If the arrangement is or contains a finance lease, the lessee shall recognise finance lease as assets and li-abilities in their statements of financial position at amounts equal to the fair value of the leased property or, if lower, the present value of the minimum lease payments, each determined at the inception of the lease.

Subsequent measurement:

As mentioned above, the total lease component shall be separated from the non-lease component.

The lease component in case of finance lease would be further separated into payments towards the lease obligation and interest on lease obligation.

The leased asset is depreciated over the asset’s useful life or over the lease period whichever is shorter.

The payments made would be adjusted against the lease obligation and interest thereon.

Impact on Indian companies on adoption of IFRS?: Indian GAAP does not have specific guidance on embedded leases. Thus, the contract payments are recognised, in most cases, as revenue expen-diture (say, job work expenses) on accrual basis. On adoption of IFRS by the Indian companies, such arrangements may be classified as embedded finance leases. Thus the charge to the income statement would be in the form of depreciation on assets taken on finance lease, interest expense on finance lease obligation and job worker charges; instead of the entire amount being treated as job work charges. This may impact the asset base (as the assets are capitalised) and income statement classification of the lessee.

    b) Accounting by lessor — Finance lease:

Initial recognition and measurement:

Lessor shall derecognise assets given under an em-bedded finance lease in their balance sheet and present them as a receivable at an amount equal to the net investment in the lease.

Subsequent measurement:

As mentioned above, the total lease component shall be separated from the non-lease component. The lease component in case of finance lease would be further separated into payments towards the lease receivable and interest on lease receivable.

The recognition of finance income on lease receivable shall be based on a pattern reflecting a con-stant periodic rate of return on the lessor’s net in-vestment in the finance lease.

The receipts from the lessee would be adjusted against the lease receivable and interest thereon.

Impact on Indian companies on adoption of IFRS?: Indian GAAP does not have specific guidance on em-bedded leases. Thus, the actual contract receipts are recognised, in most cases, as revenue (say, job work income) on accrual basis. On adoption of IFRS by the Indian companies, such arrangements may be classified as embedded finance leases.

Thus, such transactions will be treated as sale of as-set with a corresponding debit to lease receivable asset. Unlike Indian GAAP, there will be no impact on the income statement on account of deprecia-tion on fixed assets as they were never recognised. The receipts out of the lease component received from the lessee shall be adjusted against the lease receivable to the extent of the principal and interest income.

This may significantly impact the fixed asset base (as the fixed assets are not recognised), the timing of revenue recognition and the EBIT (on account of in-terest income on lease receivable) of the lessor.

    c) Accounting by lessee and lessor — Operating lease:

Recognition and measurement:

As mentioned above, the lease component would be recognised separately from the non-lease component. Thus, the lessor and lessee shall recognise lease income/expense separately from other revenue/expense, respectively.

Impact on Indian companies on adoption of IFRS: The lessor shall present lease income separately within revenue from non-lease revenue. Similar presentation would be required by the lessee for its payments. However, this would impact only the in-come statement presentation.

The operating lease payments would be required to be recognised on a straight-line basis. This may lead to additional impact on the profits for the year on account of adoption of IFRS.

First-time adoption of IFRS:

IFRIC 4 shall have to apply retrospectively to all agreements existing as on the date of transition. Hence, entities shall have to assess all agreements existing as on the date of transition, irrespective of the year in which the same has been entered into i.e., either before or after the date of applicability of IFRIC 4.

Conclusion:

An entity can expect significant changes to its balance sheet and income statement due to application of IFRIC 4 and it is thus essential for an entity to carefully evaluate its implications at the time of entering into arrangements with dedicated vendors.