Introduction
Under ASC 842 and IFRS 16, correctly identifying whether a contract contains a lease is essential because both standards require recognition of right‑of‑use assets and lease liabilities. Misidentification can lead to compliance issues, misstated financials, and audit findings.
Organizations should evaluate contracts at inception and reassess them only when required by the applicable accounting standards.
Why Proper Lease Identification Matters Under ASC 842 and IFRS 16
- Prevents misclassification between lease and service contracts
- Ensures accurate recognition of right‑of‑use assets
- Reduces audit risk and financial reporting errors
- Supports compliance for dual reporters (IFRS + US GAAP)
Definition of a Lease
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.
Three key elements must generally exist:
- An identified asset.
- The customer obtains substantially all of the economic benefits from using the asset.
- The customer has the right to direct how and for what purpose the asset is used during the period of use.
If any of these elements is absent, the arrangement may represent a service contract rather than a lease.
Step 1 – Is There an Identified Asset?
The asset must be explicitly or implicitly specified in the contract.
Examples include:
- Building Suite 210
- MRI Machine #MRI-102
- Truck VIN 1HGCM82633A123456
If the supplier has a substantive right to substitute the asset throughout the contract and would benefit economically from doing so, the arrangement generally does not contain an identified asset.
Example
A logistics company agrees to transport products using any vehicle from its fleet.
Because the supplier may substitute vehicles at any time without customer approval, there is generally no identified asset.
Result:
This is likely a service contract rather than a lease.
Step 2 – Who Receives the Economic Benefits?
The customer must obtain substantially all economic benefits from using the identified asset.
Economic benefits include:
- Primary output
- By-products
- Other commercial benefits derived from use
Example
A hospital leases an MRI machine exclusively for five years.
The hospital receives all benefits generated by operating the equipment.
This criterion is satisfied.
Step 3 – Who Directs the Use?
The customer must determine:
- How the asset is used.
- When it is used.
- For what purpose it is used.
If the supplier controls these decisions throughout the contract, the arrangement is generally considered a service agreement.
Example
A manufacturer leases a specialized production machine and decides operating schedules, production volume, and products manufactured.
The customer directs the use of the asset.
The contract likely contains a lease.
Embedded Leases
One of the most common implementation challenges is identifying embedded leases within broader service contracts.
Examples include:
- Outsourced warehouse agreements
- Data center hosting arrangements
- Transportation contracts
- Energy supply contracts
- Medical equipment management agreements
Organizations should review procurement and legal contracts carefully to identify lease components that may require separate accounting.
Healthcare Example
A hospital signs a seven-year agreement with a medical imaging company.
The agreement specifies one CT scanner located in the hospital. The hospital determines patient scheduling and operating hours, while the supplier performs maintenance.
Analysis:
- Identified asset? Yes.
- Economic benefits? Yes.
- Right to direct use? Yes.
Conclusion:
The contract contains a lease.
Common Mistakes
Organizations frequently:
- Assume all rental agreements are leases.
- Ignore embedded leases.
- Fail to document management’s conclusions.
- Overlook substitution rights.
- Misclassify service contracts as leases.
Developing a standardized contract review process can significantly reduce these risks.
Practical Checklist
Before concluding that a contract contains a lease, ask:
- Is there an identified asset?
- Does the customer receive substantially all economic benefits?
- Does the customer direct how and for what purpose the asset is used?
- Does the supplier have substantive substitution rights?
- Is consideration exchanged for the right to use the asset?
If the answer supports each of the first three questions and no substantive substitution right exists, the contract likely contains a lease.
| Criterion | ASC 842 | IFRS 16 |
|---|---|---|
| Identified asset | Required | Required |
| Control of use | Customer must direct use | Customer must direct use |
| Substitution rights | Must evaluate substantive rights | Same evaluation |
| Embedded leases | Common in service contracts | Common in service contracts |
Conclusion
Proper lease accounting begins with accurately identifying whether a contract contains a lease. A disciplined review of contractual terms helps ensure compliance with ASC 842 and IFRS 16, reduces audit findings, and improves the quality of financial reporting. Organizations that establish formal review procedures are better positioned to recognize lease obligations accurately and consistently.
References
- FASB Accounting Standards Codification Topic 842, Leases.
- IASB, IFRS 16 Leases.
- Deloitte, Roadmap—Leases.
- EY, Applying IFRS: A Closer Look at IFRS 16.
- PwC, Lease Accounting Guide.