IFRIC 4 is an accounting standard issued by the International Financial Reporting Interpretations Committee (IFRIC) that provides guidance on how to determine whether an arrangement contains a lease or not. In this standard, a lease is defined as a contract that conveys the right to use an asset for a period of time in exchange for consideration.
There are two types of leases: finance leases and operating leases. A finance lease is a lease that transfers substantially all the risks and rewards incidental to ownership of an asset to the lessee. An operating lease is a lease other than a finance lease.
Determining whether an arrangement contains a lease requires an assessment of whether the arrangement conveys the right to use an asset and whether the arrangement is for a period of time. The right to use an asset is conveyed when the customer has the ability to direct the use of and obtain substantially all the economic benefits from the use of the asset. The period of time is the period for which the customer has the right to use the asset, including any renewal options.
Examples of arrangements that contain a lease include:
A contract to lease a warehouse for five years in exchange for monthly rent payments.
A contract to lease a company car for three years in exchange for monthly lease payments.
A contract to lease a photocopier for two years in exchange for monthly lease payments.
A contract to lease an airplane for ten years in exchange for monthly lease payments.
Cases studies:
Case 1:
Company A leases a warehouse from Company B for a period of five years in exchange for monthly rent payments. Company A has the ability to direct the use of and obtain substantially all the economic benefits from the use of the warehouse. The arrangement is for a period of time. Therefore, this arrangement contains a lease.
Case 2:
Company C enters into a contract with Company D to use a piece of equipment for a period of two years. Company C has the ability to direct the use of and obtain substantially all the economic benefits from the use of the equipment. The arrangement is for a period of time. Therefore, this arrangement contains a lease.
Case 3:
Company E enters into a contract with Company F to use a piece of equipment for a period of one year. Company E has the ability to direct the use of and obtain substantially all the economic benefits from the use of the equipment. However, the arrangement is not for a period of time that is significant relative to the economic life of the equipment. Therefore, this arrangement does not contain a lease.
In summary, IFRIC 4 provides guidance on how to determine whether an arrangement contains a lease or not. It is important for companies to correctly identify whether an arrangement contains a lease, as this will impact the accounting treatment of the arrangement. If an arrangement contains a lease, the lessee will need to recognize a right-of-use asset and lease liability on its balance sheet. If an arrangement does not contain a lease, it will be accounted for as a service contract