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the arrangement and fulfilment of the arrangement is dependent on the facility. While the supplier has the
right to supply gas from other sources, its ability to do so is not substantive. The purchaser has obtained the
right to use the facility because, on the facts presented – in particular, that the facility is designed to meet
only the purchaser’s needs and the supplier has no plans to expand or modify the facility – it is remote that
one or more parties other than the purchaser will take more than an insignificant amount of the facility’s
output and the price the purchaser will pay is neither contractually fixed per unit of output nor equal to the
current market price per unit of output as of the time of delivery of the output.
(b) Take-or-pay contract that depends on a specific asset (indefeasible right of use)
Entity A (supplier), a telecom company, owns a large fibre network and enters into an agreement with
Entity B (purchaser), another telecom company. The agreement specifies that fibre strands four, five and six
will be used to carry the traffic of Entity B’s customers for a 10-year period in exchange for a fixed up-front
capacity payment. Entity B will handle all transmissions by connecting its switching equipment to the ends
of the fibre strands. Entity A cannot substitute other fibre strands to fulfil the agreement. Entity A retains
physical control over the PP&E and the ability to operate the PP&E. However, Entity B will obtain
substantially all of the output and utility of the specified fibres during the term of the arrangement (i.e. no
other customers will be able to use the specified fibres). The price of the agreement is fixed, regardless of
how much Entity B uses the fibre.
The arrangement contains a lease within the scope of IAS 17. The agreement involves the use of explicitly
identified PP&E (i.e. fibre strands four, five and six). Entity B does not have the ability or right to direct the
operation of or control physical access to the PP&E. However, the contract conveys the right to use specified
PP&E because Entity B will take substantially all of the PP&E’s output (i.e. the likelihood is remote that one
or more parties other than Entity B will take more than a minor amount of the output), and the price it will
pay is neither fixed per unit of output nor equal to the market price per unit.
Leases (IAS 17) 1611
Having concluded that the arrangement contains a lease, it is then necessary to classify
it as an operating or a finance lease. Identifying the relevant lease payments is discussed
in 2.1.6 below.
The three scenarios in the next example illustrate arrangements that do not contain a
lease. Scenarios (a) and (b) describe circumstances in which an arrangement does not
contain a lease because no specific asset has been identified. The significance of the
control concept is shown in scenario (c) based on the second illustrative example in
IFRIC 4. [IFRIC 4.IE3-4].
Example 23.2: Arrangements that do not contain leases
(a) Take-or-pay contract that does not depend on a specific asset (gas supply)
A purchaser enters into a take-or-pay contract to buy industrial gases from a supplier. The supplier is a large
company operating similar plants at various locations. The amount of gas that the purchaser is committed to
buy is roughly equivalent to the total output of one of the plants. Because a good distribution network is
available, the supplier is able to provide gas from various locations to fulfil its supply obligation.
In this example, the arrangement does not depend on a specific asset. This is because it is economically
feasible and practical for the supplier to fulfil the arrangement by providing use of more than one plant. A
specific asset has therefore not been identified either explicitly or implicitly.
Payments under the contract may be unavoidable because it is a take-or-pay arrangement and the purchaser
may in fact take all of the output of a single plant but the arrangement does not convey a right to use the
asset. The purchaser does not have the right to control the use of the underlying asset. It does not have the
ability or right to operate the asset in a manner it determines (or to direct others to do so on its behalf), and it
does not control physical access. The arrangement does not contain a lease.
(b) Take-or-pay contract that does not depend on a specific asset (indefeasible right of use)
Taking the same facts as used in scenario (b) in Example 23.1 above, except that the agreement does not
specify which fibre strands will carry the traffic of Entity B’s customers. Entity A has the right and ability
(i.e. Entity A has multiple fibre strands available to transmit the data and it is feasible and practicable to use
those other assets) to use any of its fibre strands to carry Entity B’s customers’ traffic.
Although the agreement involves the use of PP&E, fulfilment of the agreement does not depend on specified
PP&E. Therefore, the arrangement does not contain a lease.
(c) The right to control the use of an underlying asset is not conveyed
A manufacturing company (the purchaser) enters into an arrangement with a third party (the supplier) to
supply a specific component part of its manufactured product for a specified period of time. The supplier
designs and constructs a plant next to the purchaser’s factory to produce the component part. The designed
capacity of the plant exceeds the purchaser’s current needs, and the supplier maintains ownership and control
over all significant aspects of operating the plant.
The supplier’s plant is explicitly identified in the arrangement, but the supplier has the right to fulfil the
arrangement by shipping the component parts from another plant owned by the supplier. However, to do so
for any extended period of time would be uneconomical. The supplier must stand ready to deliver a minimum
quantity. The purchaser is required to pay a fixed price per unit for the actual quantity taken. Even if the
purchaser’s needs are such that they do not need the stated minimum quantity, they still pay only for the
actual quantity taken.
The supplier has the right to sell the component parts to other customers and has a history of doing so by
selling in the replacement parts market, so it is expected that parties other than the purchaser will take more
than an insignificant amount of the component parts produced at the supplier’s plant.
The supplier is responsible for repairs, maintenance, and capital expenditures of the plant.
This arrangement does not contain a lease. An asset (the plant) is explicitly identified in the arrangement and
fulfilment of the arrangement is dependent on the facility. While the supplier has the right to supply
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component parts from other sources, the supplier would not have the ability to do so because it would be
uneconomical. However, the purchaser has not obtained the right to use the plant because it does not control
it, for the following reasons:
(a) the purchaser does not have the ability or right to operate or direct others to operate the plant or control
physical access to the plant;
(b) the likelihood that parties other than the purchaser will take more than an insignificant amount of the
component parts produced at the plant is more than remote, based on the facts presented; and
(c) the price paid by the purchaser is fixed per unit of output taken but see the following section where this
is discussed fur
ther.
2.1.4
Fixed or current market prices and control of the asset
The third control condition states that an arrangement will not contain a lease,
notwithstanding that a purchaser takes all but an insignificant amount of the output or
other utility if the price is contractually fixed per unit of output. We consider that by
this the Interpretation means absolutely fixed, with no variance per unit based on
underlying costs or volumes, whether discounts or stepped pricing.
In the manufacturing industry ‘lifetime’ agreements with step pricing between the
supplier and the purchaser are not uncommon. The parties to the agreement agree in
advance on progressive unit price reductions on achievement of specified production
volume levels, reflecting the supplier’s increasing efficiencies and economies of scale.
These types of contracts should be closely analysed, especially to see whether one of the
other two conditions, the ‘right to operate the asset’ or the ‘right to control the physical
access to the asset’, is met before concluding that the arrangement contains a lease.
‘Current market price per unit of output’ means that the cost is solely a market price for
the output of the asset without any other pricing factors. A ‘market price per KWH plus x
per cent change in the price of natural gas’ would not be the current market price per unit
of the output of the asset. Price increases based on a general index such as a retail and
price indices are unlikely to result in a current market price for the output in question.
Example 23.3: Fixed prices per unit
Purchaser P and supplier S enter into a parts supply agreement for the lifetime of the finished product
concerned. S uses tooling equipment that is specific to the needs of P. The tooling is explicitly identified in
the agreement and S could not use an alternative asset. The estimated capacity of the tooling equipment is
500,000 units which corresponds to the total production of the finished product units over its life cycle. P
takes substantially all of the output produced by S using the specific tooling.
Purchaser P and supplier S agree on the following unit price reductions in the parts supply agreement to
reflect S’s increasing efficiencies and economies of scale:
• from 0 to 100,000 units, price per unit €150;
• from 100,001 to 200,000, price per unit €140;
• from 200,001 to 300,000, price per unit €135;
• from 300,001 to 400,000, price per unit €132;
• above 400,000, price per unit €130.
The fulfilment of the arrangement depends on the use of a specific asset, the tooling. P has obtained the right
to use the tooling because, on the facts presented, the likelihood is remote that one or more parties other than
the P will take more than an insignificant amount of the tooling’s output. As the estimated capacity of the
tooling equipment corresponds to the total production of the finished product units produced by P, P takes
substantially all of the output produced using that tooling.
Leases (IAS 17) 1613
Stepped pricing does not mean a price ‘fixed per unit of output’ and, particularly as the stepped pricing is
agreed in advance, it is not equal to the current market price per unit as of the time of delivery of the output.
The arrangement contains a lease within the scope of IAS 17. The purchaser will have to determine whether
it is a finance or operating lease.
2.1.5
When to assess the arrangements
IFRIC 4 states that assessing whether an arrangement contains a lease should be made
at the inception of the arrangement, which is the earlier of the date of the arrangement
and the date of commitment by the parties to the principal terms of the arrangement,
on the basis of all the facts and circumstances. A reassessment of whether the
arrangement contains a lease should be made only if: [IFRIC 4.10]
(a) there is a change in the terms of the contract, except for a renewal or extension of
the arrangement;
(b) a renewal option is exercised or an extension is agreed to, unless the term of the
renewal or extension had been taken into account in the original assessment of the
lease term in accordance with IAS 17; [IAS 17.4]
(c) there is a change in whether or not the arrangement depends on specified item; or
(d) there is a substantial physical change to the specified assets.
Changes to estimates, for example of the amount of output that would be taken by the
purchaser, would not trigger a reassessment. [IFRIC 4.11].
If the arrangement is reassessed and found to contain a lease, or not to contain a lease,
lease accounting will be applied or discontinued as from the time that the arrangement
is reassessed. The same applies if a renewal option is exercised when this was not
previously anticipated, as described in (b) above. [IFRIC 4.11]. The exercise of renewal
options is discussed at 3.2.3 below.
2.1.6
Separation of leases from other payments within the arrangement
If an arrangement contains a lease within the scope of IAS 17 (see 3.1 below), both
parties to the arrangement are to apply IAS 17 to the lease element of the arrangement.
Other elements of the arrangement must be accounted for in accordance with the
appropriate standards. [IFRIC 4.12].
It must be stressed that this means that the lease element of the arrangement may be
classified as either an operating or finance lease. Therefore, having identified the lease
payments, the entity may still classify the arrangement as an operating lease if it does
not transfer substantially all the risks and rewards incidental to ownership of an asset
(see 3.2 below). [IAS 17.4, 8].
In order to apply IAS 17, the payments and other consideration under the arrangement
must be separated at inception or on reassessment between those for the lease of the
asset (that will meet the definition of minimum lease payments, see 3.4.3 below) and
those for other services and outputs. IFRIC 4 requires this to be done on the basis of
their relative fair values. [IFRIC 4.13]. This may require the purchaser to use estimation
techniques – this appears to be somewhat of an understatement as, unless the price to
be paid for both elements is clear and they have both been negotiated at market value,
it will always be necessary to use some form of estimation.
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The Interpretation suggests that it may be possible to estimate either the lease payments
(by comparison with similar leases that do not contain other elements) or the other
elements (using comparable arrangements) and then deduct the estimated amount from
the total under the arrangement. [IFRIC 4.14]. This is not a straightforward exercise and
the Interpretation does not go into any further detail as to how it would be carried out.
There may be no market-based evidence of fair value of the underlying assets because
of their specialised nature or because they are rarely sold, in which case it will be
necessary to use valuation techniques.
Discounted cash flow projections based on estimated future cash flows that will be
generated by specialised assets may be difficult to obtain, although it should be possible
to make some form of estimate, if need be with the assistance of valuation experts. The
be easy to identify comparable arrangements. The exercise will be complicated by the
fact that the fair value of a bundle of services is not necessarily the same as the
aggregation of their individual fair values and making such an assumption could lead to
an overstatement of the service element and consequent understatement of the fair
value of the lease element or vice versa.
The discount rates should reflect current market assessments of the uncertainty and
timing of the cash flows, i.e. the risk inherent in the separate elements of the
transaction. There are usually very different risk profiles for the provision of
services and for leasing assets. If, as suggested by the Interpretation, the entity
estimates one of the elements under the arrangement and derives the other by
deduction, i.e. it uses a residual method, it will always be necessary to carry out a
‘sense check’ on the derived payments.
IFRIC 4 suggests that only in rare cases will a purchaser conclude that it is impracticable
to separate the payments reliably. In the case of a finance lease, the entity should
recognise an asset at an amount equal to the fair value of the underlying asset that it has
identified as the subject of the lease, as described in 2.1.1 above. A liability should be set
up at the same amount as the asset. The entity would impute a finance charge based on
the purchaser’s incremental borrowing rate of interest (see 3.4.5 below) and, from this,
compute the reduction in the liability as payments are made. [IFRIC 4.15]. Presumably the
Interpretations Committee considers that the entity’s incremental borrowing rate
would have to be used because, if it were possible to determine the interest rate implicit
in the lease, the arrangement would not be one in which it was impracticable to separate
the payments reliably.
What this means is that an entity may be required to account for an asset held under a
finance lease when it is, in fact, unable to identify the lease payments. This will not often
happen in practice as obtaining control is likely to result in an entity being able to
identify the underlying payment streams.
If the lease is assessed as an operating lease, applying the Interpretation might affect the