To determine whether a contractual arrangement contains a lease under Ind AS 116 Leases, can be very tricky and complex. This is particularly true for equipment installed at the customer’s premises such as a solar panel or a set-top box. This article includes an example of a set-top box to explain the concept in a simple and lucid manner.
The provisions in Ind AS 116 Leases relevant to analysing whether an arrangement contains a lease are given below:
9 At inception of a contract, an entity shall assess whether the contract is, or contains, a lease. A contract is, or contains, a lease if the contract conveys the right to control the use of an identified asset for a period of time in exchange for consideration.
B9 To assess whether a contract conveys the right to control the use of an identified asset for a period of time, an entity shall assess whether, throughout the period of use, the customer has both of the following:
(a) the right to obtain substantially all of the economic benefits from use of the identified asset; and
(b) the right to direct the use of the identified asset.
B14 Even if an asset is specified, a customer does not have the right to use an identified asset if the supplier has the substantive right to substitute the asset throughout the period of use. A supplier’s right to substitute an asset is substantive only if both of the following conditions exist:
(a) the supplier has the practical ability to substitute alternative assets throughout the period of use (for example, the customer cannot prevent the supplier from substituting the asset and alternative assets are readily available to the supplier or could be sourced by the supplier within a reasonable period of time); and
(b) the supplier would benefit economically from the exercise of its right to substitute the asset (i.e., the economic benefits associated with substituting the asset are expected to exceed the costs associated with substituting the asset).
B17 If the asset is located at the customer’s premises or elsewhere, the costs associated with substitution are generally higher than when located at the supplier’s premises and, therefore, are more likely to exceed the benefits associated with substituting the asset.
B24 A customer has the right to direct the use of an identified asset throughout the period of use only if either:
a. the customer has the right to direct how and for what purpose the asset is used throughout the period of use; or
b. the relevant decisions about how and for what purpose the asset is used are predetermined and:
i. the customer 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 supplier having the right to change those operating instructions; or
ii. the customer designed the asset (or specific aspects of the asset) in a way that predetermines how and for what purpose the asset will be used throughout the period of use.
B25 A customer has the right to direct how and for what purpose the asset is used if, within the scope of its right of use defined in the contract, it can change how and for what purpose the asset is used throughout the period of use. In making this assessment, an entity considers the decision-making rights that are most relevant to changing how and for what purpose the asset is used throughout the period of use. Decision-making rights are relevant when they affect the economic benefits to be derived from use. The decision-making rights that are most relevant are likely to be different for different contracts, depending on the nature of the asset and the terms and conditions of the contract.
B26 Examples of decision-making rights that, depending on the circumstances, grant the right to change how and for what purpose the asset is used, within the defined scope of the customer’s right of use, include:
a. rights to change the type of output that is produced by the asset (for example, to decide whether to use a shipping container to transport goods or for storage, or to decide upon the mix of products sold from retail space);
b. rights to change when the output is produced (for example, to decide when an item of machinery or a power plant will be used);
c. rights to change where the output is produced (for example, to decide upon the destination of a truck or a ship, or to decide where an item of equipment is used); and
d. rights to change whether the output is produced, and the quantity of that output (for example, to decide whether to produce energy from a power plant and how much energy to produce from that power plant).
B 30 A contract may include terms and conditions designed to protect the supplier’s interest in the asset or other assets, to protect its personnel, or to ensure the supplier’s compliance with laws or regulations. These are examples of protective rights. For example, a contract may (i) specify the maximum amount of use of an asset or limit where or when the customer can use the asset, (ii) require a customer to follow particular operating practices, or (iii) require a customer to inform the supplier of changes in how an asset will be used. Protective rights typically define the scope of the customer’s right of use but do not, in isolation, prevent the customer from having the right to direct the use of an asset.
EXAMPLE – SET-TOP BOX
In the telecom industry, assets such as mobile phones and set-top boxes would generally be considered as low value and therefore the telecom entities can avail the recognition exemption under Ind AS 116. This example is used to merely illustrate the concept of ‘how and for what purpose’ with regard to equipment installed at customer premises. Additionally, it is also relevant to entities where it is determined that the assets are not low in value, for example, a solar panel or where the entity chooses not to avail the low value exemption.
FACT PATTERN
Telco, a well-integrated internet, telephony and content services provider, installs a set-top box to be placed in the customer’s premises. Telco offers two kinds of set-top boxes which in turn are dependent on the services required by the customer:
(a) The set-top box has no use to the customer other than to receive the requested television, internet, or telephony services. Telco has pre-programmed the set-top box to deliver the specified services and controls what content or internet speed is delivered. The set-top box has no additional functionality and the customer cannot use it to receive any other services from any other service provider.
(b) Other set-top boxes have multiple features. The most sophisticated ones offer a wide range of functionality, including the ability to record and replay, reminders for programmes or to access content and services provided by third parties.
The asset is an identified asset as per paragraph 9 of Ind AS 116. The customer obtains substantially all of the economic benefits from the use of the set-top box as per paragraph B9 of Ind AS 116. Assume that either the set-top is not low value, or the customer does not avail the low value exemption. In such a case, whether the arrangement above contains a lease as defined under Ind AS 116?
ANALYSIS
Firstly, the asset is an identified asset in accordance with Ind AS 116.9. Secondly, the supplier does not have a substantial substitution right in accordance with paragraph B14 and B17, because it would not be economically beneficial for the supplier to replace the equipment located in the premises of the customer. Lastly, the customer obtains substantially all of the economic benefits from the use of the set-top box as per paragraph B9.
We now proceed to consider whether or not the customer directs how and for what purpose the equipment is used.
Whether or not the customer directs how and for what purpose the equipment is used in accordance with Ind AS 116.B24(a) depends on its functionality. For simple set-top boxes, with no functionality for the customer other than to receive the requested services, it can be argued that the customer does not direct how and for what purpose they are used. The customer has no more control over the set-top box than he would over similar equipment located elsewhere, including at the operator’s premises. Can it be argued that the customer has the right to direct the use of the equipment because its use is predetermined, and the customer has a right to operate the asset, because the customer can switch it on or off and can choose which programmes to watch [see Ind AS 116.B24(b)]? The author believes that merely being able to switch on or switch off the set-top box does not mean that the customer is operating the identified asset. Therefore, he believes that there is no lease in the extant case.
The more functionality the set-top box has for the customer, the more likely it is that the customer has the right to direct its use, and therefore the arrangement contains a lease. However, there is no ‘bright-line’ test and judgement will need to be applied in determining the point at which the customer is considered to direct how and for what purpose the equipment is used, and therefore whether the arrangement contains a lease.
CONCLUSION
The author believes that the arrangements involving set-top boxes with limited functionality will not constitute a lease. On the other hand, an arrangement where the underlying asset is a set-top box with multiple functionalities may constitute a lease. Each entity will need to apply judgement to make that determination.
