## Learning Outcomes

- Identify when a contract contains both lease and non-lease components.
- Distinguish a lease component from related services such as maintenance, cleaning, security or support.
- Allocate contract consideration between lease and non-lease components using relative stand-alone prices.
- Explain the lessee practical expedient to account for lease and non-lease components together.
- Describe how separation affects the right-of-use asset, lease liability, profit or loss and disclosures.
- Avoid common ACCA FR errors in lease component calculations and presentation.

## ACCA Financial Reporting (FR) Syllabus

IFRS 16 Leases is examined in ACCA FR through short objective test questions and as part of wider financial statement preparation or interpretation questions. This subtopic focuses on contracts that contain more than one element, such as use of an asset plus servicing. You must be able to decide what is capitalised as a lease and what is accounted for separately as a service expense.

- Identify whether a contract contains a lease using the IFRS 16 control model.
- Recognise that many lease contracts include non-lease components.
- Separate lease payments from payments for services unless the practical expedient is used.
- Allocate consideration using stand-alone prices where the contract gives a single combined charge.
- Understand the effect on the initial right-of-use asset and lease liability.
- Present right-of-use assets and lease liabilities appropriately in the financial statements.
- Explain the disclosure impact of separating or not separating lease and non-lease components.

## Test Your Knowledge

\_Attempt these questions before reading this article. If you find some difficult or cannot remember the answers, look more closely at that area during your revision.\_1. A company leases a building and pays one annual amount that includes cleaning and security services. Which parts are lease components and which are non-lease components? 2. Under IFRS 16, what basis should a lessee normally use to allocate consideration between lease and non-lease components? 3. What is the effect on the lease liability if a lessee elects not to separate non-lease components from lease components? 4. How should a lessee present right-of-use assets and lease liabilities in the statement of financial position? 5. Why is it wrong to automatically include all payments made under a contract in the lease liability?

## Introduction

IFRS 16 requires most lessees to recognise a right-of-use asset and a lease liability. This means that identifying the amount that relates to the lease is a key step. In practice, many contracts do not only give the customer the right to use an asset. They may also include services such as maintenance, repairs, cleaning, security, insurance administration or technical support.

For ACCA FR, the usual exam issue is simple but easy to mishandle: decide which payments relate to the right to use the asset and which relate to services. The lease part is included in the IFRS 16 lease accounting model. The service part is normally accounted for separately, often as an expense as the service is received.

> **Key Term: Lease**
> A contract, or part of a contract, that conveys the right to control the use of an identified asset for a period of time in exchange for consideration.

A lease exists only where the customer controls the use of an identified asset. This means the customer obtains substantially all of the economic benefits from using the asset and has the right to direct how and for what purpose the asset is used. Once a lease has been identified, the next question is whether the contract also includes non-lease components.

### Identifying components in a combined contract

A contract may contain one lease component, several lease components, one or more non-lease components, or all of these together. IFRS 16 requires an entity to analyse the contract at the start so that each component is accounted for in the correct way.

> **Key Term: Lease component**
> A part of a contract that gives the lessee the right to use an underlying asset and is accounted for under IFRS 16.

Examples of lease components include:

- the right to use a specific floor of an office building;
- the right to use a specified vehicle for three years;
- the right to use a named item of plant or machinery;
- the right to use identified warehouse space.

A single contract may include more than one lease component. For example, a company may enter into one contract for the use of a factory building and an item of production equipment. If the company can benefit from using the building and the equipment separately, and they are not highly dependent on each other, the contract may contain two lease components.

> **Key Term: Non-lease component**
> A part of a contract that transfers a good or service to the lessee but does not give the lessee the right to use an underlying asset.

Common non-lease components include:

- maintenance or servicing of leased equipment;
- cleaning services in a property contract;
- security services for leased premises;
- provision of an operator or support staff;
- routine repairs;
- helpdesk or technical support;
- facilities management services.

For example, assume a retailer leases a shop unit for five years. The annual charge includes the right to use the shop, cleaning of shared areas and security at the shopping centre. The right to use the shop is a lease component. The cleaning and security are non-lease components because they are services.

Some payments in a contract do not transfer a separate good or service to the lessee. Administrative charges, reimbursement of the lessor’s costs, and some taxes or insurance arrangements may not be separate components. In an exam, focus on the wording: if the payment is for an identifiable service received by the lessee, it is likely to be a non-lease component.

> **Test Tip:**
> Look for words such as “maintenance”, “servicing”, “cleaning”, “security” and “support”. These usually point to non-lease components and should not automatically be included in the lease liability.

The first stage is always to confirm whether a lease exists at all. A contract contains a lease only if there is:

- an identified asset;
- no substantive right for the supplier to substitute the asset;
- the customer’s right to obtain substantially all of the economic benefits from use; and
- the customer’s right to direct the use of the asset.

If the supplier controls how and for what purpose the asset is used, the arrangement may be a service rather than a lease. For example, a contract for transportation from a supplier using its own fleet may not be a lease if the supplier chooses which vehicles are used and controls the operation of those vehicles.

### Allocating consideration between lease and non-lease components

Once lease and non-lease components have been identified, the lessee normally allocates the consideration in the contract between them. The allocation is based on relative stand-alone prices.

> **Key Term: Stand-alone price**
> The price at which an entity would purchase a lease component or non-lease component separately.

If a contract states separate prices for the right to use the asset and for the service, the allocation may be straightforward. However, the stated prices are not always equal to true stand-alone prices. If a contract gives only one bundled payment, the lessee must estimate stand-alone prices using observable information where possible.

The general allocation formula is:

$$
\text{Amount allocated to a component} =
\text{Total consideration}
\times
\frac{\text{Stand-alone price of that component}}
{\text{Total stand-alone prices of all components}}
$$

Consider the following example.

> **Question:**
> Lento Co enters into a three-year contract for equipment. It pays $120,000 per year. The contract includes use of the equipment and annual maintenance. If purchased separately, the equipment lease would cost $100,000 per year and the maintenance would cost $20,000 per year. How much of the annual payment is allocated to the lease component?

The total stand-alone price is:

$$
100,000 + 20,000 = 120,000
$$

The lease component is:

$$
120,000 \times \frac{100,000}{120,000} = 100,000
$$

The maintenance component is:

$$
120,000 \times \frac{20,000}{120,000} = 20,000
$$

In this case, the contract price matches the total stand-alone prices, so the allocation is simple. The $100,000 annual lease amount is used in measuring the lease liability. The $20,000 annual maintenance amount is accounted for separately, normally as a service expense as maintenance is received.

Now change the facts. Suppose the bundled annual payment is only $108,000, while the stand-alone prices remain $100,000 for the lease and $20,000 for maintenance. The discount must be allocated proportionately:

$$
\text{Lease allocation} =
108,000 \times \frac{100,000}{120,000} =
90,000
$$

$$
\text{Maintenance allocation} =
108,000 \times \frac{20,000}{120,000} =
18,000
$$

Only $90,000 per year is treated as a lease payment for IFRS 16 measurement. The $18,000 per year is treated as a service cost.

This matters because the initial lease liability is measured using the present value of future lease payments. If service payments are wrongly included, the liability will be overstated. The right-of-use asset will usually also be overstated because it is initially measured with reference to the lease liability, adjusted for items such as payments made at or before commencement, initial direct costs and lease incentives received.

> **Key Term: Lease liability**
> The lessee’s obligation to make lease payments, measured initially at the present value of lease payments not paid at the commencement date.

For ACCA FR, you may need to calculate:

- the initial lease liability;
- the initial right-of-use asset;
- depreciation of the right-of-use asset;
- finance cost on the lease liability;
- current and non-current lease liability presentation.

Separation affects each of these. If the lease component is lower, the liability and finance cost will be lower. The right-of-use asset and depreciation charge will also often be lower.

> **Exam Warning:**
> Do not include maintenance, cleaning or servicing charges in the lease liability unless the question states that the lessee uses the IFRS 16 practical expedient not to separate components.

### Practical expedient and effects on measurement

IFRS 16 gives lessees a practical expedient. A lessee may choose, by class of underlying asset, not to separate non-lease components from lease components. If this election is made, the lessee accounts for each lease component and the related non-lease components as a single lease component.

> **Key Term: Practical expedient**
> A permitted simplification in IFRS 16 allowing a lessee, by class of underlying asset, to account for lease and related non-lease components together as one lease component.

For example, a company may choose this simplification for all property leases, but not for all vehicle leases. The election is made by class of underlying asset, not contract by contract. This prevents selective treatment designed to achieve a preferred accounting result.

If the practical expedient is used, more of the contract payment is treated as a lease payment. This usually causes:

- a higher lease liability at commencement;
- a higher right-of-use asset;
- higher depreciation;
- higher finance costs;
- lower separate service expense.

The total cash paid does not change, but the pattern and presentation of expenses changes. IFRS 16 lease accounting produces depreciation and finance costs rather than a straight service expense. The finance cost is higher in the earlier years of a lease because it is calculated on the outstanding lease liability.

Assume Lento Co from the earlier example pays $120,000 per year, including $100,000 for equipment use and $20,000 for maintenance. If Lento Co separates components, only $100,000 per year is included in the lease liability. If it applies the practical expedient, the full $120,000 per year is included.

This can be attractive because it simplifies accounting. However, it also increases reported assets and liabilities. In ratio analysis, this may affect gearing, asset turnover and return on capital employed. In FR interpretation questions, be ready to explain that IFRS 16 can make companies with more leased assets appear more asset-heavy and more highly geared.

> **Test Tip:**
> Read the question wording carefully. Phrases such as “the company elects not to separate lease and non-lease components” mean the full combined payment is treated as a lease payment.

The practical expedient is separate from the recognition exemptions for short-term leases and low-value assets. Under IFRS 16, a lessee may elect not to recognise a right-of-use asset and lease liability for:

- short-term leases, generally leases with a term of 12 months or less; and
- leases of low-value underlying assets.

For these exempt leases, payments are generally charged to profit or loss over the lease term. Do not confuse this with separating components in a lease that is recognised on the statement of financial position.

> **Key Term: Short-term lease**
> A lease that, at commencement, has a lease term of 12 months or less and does not contain a purchase option.
>
> **Key Term: Low-value asset lease**
> A lease of an underlying asset with low value when new, for which IFRS 16 permits a lessee recognition exemption if the relevant conditions are met.

### Presentation and disclosure effects of separation

Separating lease and non-lease components affects both the statement of financial position and the statement of profit or loss.

> **Key Term: Right-of-use asset**
> An asset representing the lessee’s right to use an underlying asset during the lease term.

In the statement of financial position, a lessee presents right-of-use assets either separately from other assets or within the same line item that would be used if the underlying asset were owned. For example, a leased machine may be included within property, plant and equipment if owned machines are presented there. If right-of-use assets are not shown separately on the face of the statement of financial position, the lessee discloses which line items include them.

Lease liabilities are presented either separately from other liabilities or disclosed if included within another liability line item. In many FR questions, lease liabilities are split between current liabilities and non-current liabilities. The current portion is the amount due within 12 months after the reporting date; the balance is non-current.

In profit or loss, separating components means the lease part gives rise to:

- depreciation of the right-of-use asset; and
- finance cost on the lease liability.

The non-lease component gives rise to service expense, such as maintenance expense or cleaning expense, as the service is received. These amounts are not part of the lease liability unless the practical expedient is applied.

In the statement of cash flows, lease payments are also affected by classification. The principal element of lease payments is commonly presented within financing activities. Interest paid is presented according to the entity’s accounting policy under IAS 7. Payments for services, such as cleaning or maintenance, are normally operating cash flows.

The disclosure objective in IFRS 16 is to provide information that gives users a basis to assess the effect that leases have on the financial position, financial performance and cash flows of the lessee. For ACCA FR, you are unlikely to be asked for long lists of disclosures, but you should understand the types of information that may be relevant.

Disclosures may include information about:

- depreciation charge for right-of-use assets;
- interest expense on lease liabilities;
- expenses for short-term leases;
- expenses for low-value asset leases;
- expenses for variable lease payments not included in lease liabilities;
- total cash outflow for leases;
- additions to right-of-use assets;
- carrying amount of right-of-use assets by class of underlying asset;
- maturity analysis of lease liabilities.

Separation links directly to these disclosures. If service components are excluded from lease accounting, they do not form part of lease liabilities, lease finance costs or right-of-use asset depreciation. Instead, they are shown within relevant operating expenses.

A lessor also considers lease and non-lease components. A lessor applies IFRS 16 to the lease component and applies the revenue standard to non-lease components. For example, a lessor of office space may account for the property lease under IFRS 16 and cleaning services as revenue from services. In ACCA FR, lessee accounting is more commonly tested, but the principle is the same: do not mix asset-use rights and services without checking the IFRS treatment.

A useful exam approach is:

1. Read the contract details and identify all promised items.
2. Decide whether there is an identified asset controlled by the customer.
3. Identify the lease component or components.
4. Identify services or other non-lease components.
5. Check whether the question states that the practical expedient is used.
6. If not, allocate consideration using relative stand-alone prices.
7. Use only the lease allocation in the lease liability calculation.
8. Present the right-of-use asset, lease liability, depreciation, finance cost and service expense correctly.

> ** Exam Warning:**
> A common error is to treat a single invoice as proof that there is one accounting component. IFRS 16 looks at the substance of what is being provided, not just how the supplier bills the customer.

## Key Point Checklist*This article has covered the following key knowledge points:*

- A contract contains a lease if it gives control over the use of an identified asset for a period of time in exchange for consideration.
- Control requires the right to obtain substantially all economic benefits and the right to direct use of the asset.
- Many contracts include both a lease component and one or more non-lease components.
- Maintenance, cleaning, security, servicing and support are common non-lease components.
- A lessee normally separates lease and non-lease components.
- Consideration is allocated using relative stand-alone prices.
- Only the lease component is included in the lease liability unless the practical expedient is applied.
- The practical expedient allows a lessee, by class of underlying asset, to account for lease and related non-lease components together.
- Using the practical expedient usually increases the right-of-use asset and lease liability.
- Right-of-use assets and lease liabilities are presented separately or disclosed within the line items where they are included.
- Separation affects profit or loss because lease components produce depreciation and finance costs, while service components produce operating expenses.
- Short-term lease and low-value asset exemptions are separate from the component separation rules.

## Key Terms and Concepts

- Lease
- Lease component
- Non-lease component
- Stand-alone price
- Lease liability
- Practical expedient
- Short-term lease
- Low-value asset lease
- Right-of-use asset


Presentation and disclosures - Separating lease and non-lease components