Getting lease accounting right starts with a simple but critical question:
👉 Is this contract a lease?
Under IFRS 16, the answer to that question can have a significant impact on your balance sheet, profit and loss, and even loan covenants. Misclassify a contract, and your balance sheet might tell the wrong story raising unwanted audit questions.
The tricky part is that many contracts don’t actually use the word “lease.” Some appear to be service agreements but are actually leases in disguise. Others seem like leases but turn out to be something else entirely.
In this article, we’ll walk through how to identify a lease under IFRS 16, why it matters, and what to watch out for in those borderline situations that trip up even experienced finance teams.
Why It Matters
Under IFRS 16, if a contract contains a lease, the lessee has to recognize:
- a right-of-use asset, and
- a lease liability on the balance sheet
(Unless the contract qualifies for short-term or low-value exemptions.)
If you miss this step or get it wrong, the numbers in your financial statements can be off — and not by a little. That’s why CFOs, accountants, and auditors need to ask the right questions from day one.
A good starting point is:
“Does this contract give us control over the use of a specific asset in exchange for payment?”
If the answer is yes, there’s a good chance IFRS 16 applies.
The Two Key Tests
IFRS 16 says a contract is or contains a lease if two things are true:
Test 1: Is there an identified asset?
Test 2: Does the customer has the right to control its use during the contract term.
Let’s break these down.
Step 1: Check for an Identified Asset
First, look at whether the contract involves a specific asset. This could be a building, a floor, a particular machine, or even part of a larger item — like one fiber-optic cable in a network.
There are two ways this can happen:
Explicit identification — The contract names the asset.
Example: “Warehouse Unit 7B at the Logistics Park, with exclusive access via Bay Door 12.”
This level of specificity is common in real estate and distribution contracts, and it clearly identifies a distinct asset.
Implicit identification — Even if not named, the supplier can only deliver the service using one specific asset.
Example: A cloud hosting agreement where the provider guarantees your data resides on a single physical server in their Frankfurt facility, and migration requires your written consent.
Even though the server isn’t named by serial number, the practical and contractual constraints mean only one specific asset can fulfill the contract.
But here’s the catch: if the supplier has the substantive right to substitute the asset during the contract period, it’s not actually “identified.”
✅ Lease Example: Substantive Substitution Restricted
A manufacturing company contracts for a specific industrial press machine, serial number XYZ-4401. The supplier can only substitute if the machine breaks down and a comparable replacement is immediately available.
Why it’s a lease: Substitution is limited to rare, reactive circumstances. The customer has effective use of one identified asset.
❌ Service Contract Example: Substantive Substitution Rights
A logistics company uses a fleet pool arrangement where the supplier provides “10 delivery vans” but can swap any vehicle for maintenance, fuel efficiency, or route optimization at their discretion.
Why it’s not a lease: The supplier retains practical ability and economic incentive to substitute. No single van is “identified.”
Step 2: Assess the Right to Control
Even if there’s an identified asset, the customer must also have the right to control how it’s used.
This boils down to two questions:
- Does the customer get substantially all the economic benefits from using the asset?
- Does the customer decide how and for what purpose the asset is used?
If both answers are “yes,” then the contract likely contains a lease.
✅ Lease Example: Customer Controls Use
A retailer leases refrigeration units for their stores. They decide what products to stock, temperature settings, operating hours, and can relocate units between stores. The lessor only provides quarterly maintenance.
Why it’s a lease: The retailer directs how the units are used and obtains all the economic benefits (storage capacity for their inventory). Maintenance services are incidental.
❌ Service Contract Example: Supplier Controls Use
A company contracts with a third-party logistics provider to store inventory in a shared warehouse. The provider decides bin locations, handling equipment, and can move inventory to optimize space across multiple clients.
Why it’s not a lease: The supplier controls how the warehouse space and equipment are used. The customer only specifies what to store and when to retrieve it — they don’t direct the use of the underlying asset.
Insurance Industry Example 1: Claims Processing Center
An insurance company enters a 10-year agreement for exclusive use of Floor 8 in a shared office building to house its claims processing operations. The insurer determines office layout, IT infrastructure, working hours, and staffing. The landlord provides building maintenance and security.
Assessment: This is a lease. The insurance company has the right to control a physically distinct portion of the building (Floor 8) and derives substantially all economic benefits from using that space for its operations.
Borderline Situations and Common Pitfalls
Some contracts live in the grey zone. These are the ones that usually spark debates between finance, legal, and auditors. Here are a few areas to watch carefully:
🔄 Substitution Rights
If the supplier can freely replace the asset whenever they want, there’s no identified asset. But if substitution is only allowed in rare cases (like repairs), the asset may still count as identified.
The key test: Does the supplier have both the practical ability and an economic incentive to substitute?
Portions of Assets
Leasing a physically distinct part of an asset (e.g., one floor of a building) usually qualifies.
But leasing a non-distinct portion (e.g., 20% of a pipeline’s capacity) doesn’t — unless it represents substantially all of the asset’s capacity.
Example: A telecommunications company leases 15 of 96 fiber strands in an undersea cable (16% of capacity). This is not a lease because the strands aren’t physically distinct and don’t represent substantially all the cable’s capacity. However, if they leased 90 of 96 strands (94% of capacity), it would likely qualify as they’re obtaining substantially all the economic benefits.
Contractual Restrictions
Sometimes usage is limited by contract (e.g., a vehicle can only operate within a specific territory, or equipment can only be used during certain hours). That’s fine — as long as the customer gets the economic benefits within that scope, control usually still exists.
These are often “protective rights” that protect the lessor’s interest, not substantive limitations on the customer’s control.
Predetermined Decisions
If key operating decisions are pre-set, control can still lie with the customer — especially if they designed the asset or have exclusive operating rights.
Example: A pharmaceutical company enters a 10-year contract for a manufacturing line built to their exact specifications. While the contract stipulates the production process (to ensure regulatory compliance and quality standards), the pharma company has exclusive rights to the output and determines production schedules.
Assessment: Despite the operational restrictions, this is a lease because the customer designed the asset for their specific purpose and has exclusive rights to direct its use within the predetermined parameters. The restrictions are protective, not indicative of supplier control.
Separating Lease and Non-Lease Components
Many contracts combine lease elements with services. Common examples include:
- Office leases with cleaning or security services
- Equipment leases with maintenance
- IT infrastructure with support services
Under IFRS 16, you should separate the lease components (which go on the balance sheet) from the non-lease components (which remain expenses).
Embedded Lease Example: IT Outsourcing
An IT outsourcing agreement states the vendor will provide “dedicated infrastructure for ERP hosting.” Upon review, this includes two physical servers exclusively assigned to your company for five years, located in a specific rack. This embedded lease component must be separated from the software support services.
Why it matters: The dedicated servers meet the lease definition (identified asset + control), while software licenses and support are service components. Missing this creates an audit adjustment.
Practical Shortcut: As a practical expedient, companies can elect not to separate and treat everything as a lease. This can simplify accounting, but it can also increase reported liabilities, making it a strategic choice worth discussing with your auditors.
A Practical Checklist for Finance Teams
Here’s a simple framework you can apply when reviewing contracts:
- Read the contract carefully — Don’t rely on labels. “Service agreement” might still hide a lease.
- Identify the asset — Explicitly or implicitly.
- Check substitution rights — Can the supplier swap it at will? Do they have both practical ability and economic incentive?
- Assess control — Who decides how and when the asset is used? Who benefits?
- Look for embedded leases — Especially in IT, logistics, and outsourcing agreements.
- Separate components — Lease vs non-lease elements.
- Document your conclusion — Maintain a clear audit trail of your lease identification assessment.
Why CFOs and Auditors Should Care
This isn’t just about ticking compliance boxes. Getting lease identification right affects:
- Balance sheet strength — Leases increase assets and liabilities, affecting leverage ratios.
- Profit and loss — Lease costs move from straight-line rent to depreciation and interest.
- Debt covenants — Some loan agreements use ratios impacted by IFRS 16.
- Transparency — Investors and regulators pay close attention to lease obligations.
Final Thoughts
Identifying a lease under IFRS 16 is all about understanding control and economic benefits, not just spotting the word “lease” in a contract.
By taking a structured, thoughtful approach, CFOs and finance teams can confidently classify contracts, ensure clean financial statements, and avoid painful restatements later.
The examples in this guide span multiple industries because lease identification challenges appear everywhere — from manufacturing floors to data centers to insurance operations. The principles remain consistent: look for the identified asset, assess who controls its use, and don’t let contract labels mislead you.
Ready to Master IFRS 16?
Explore our upcoming course on Lease Accounting and learn how to apply IFRS 16 from identification to reporting — designed for CFOs, auditors, and accounting teams.
Download our free Lease Identification Checklist to use in your next contract review and ensure you’re capturing all lease obligations accurately.
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