Is it a lease? The IFRS 16 identification test

Many contracts that do not use the word lease contain one, and many called leases are really services. Data centre capacity, shipping charters, power purchase agreements and outsourcing deals all need the test. This guide sets it out with the examples that cause most debate.

By Mirza Fahad Baig, Chartered Accountant. Reviewed by Hamza Fida, Chartered Accountant. Checked against official sources on . 3 minute read.

Short answer

A contract contains a lease under IFRS 16 if it conveys the right to control the use of an identified asset for a period of time in exchange for consideration. That requires three things: an identified asset, which the supplier has no substantive right to substitute; the right to obtain substantially all the economic benefits from using it; and the right to direct how and for what purpose it is used.

At a glance

Test 1
An identified asset
Substitution right
Substantive only if practical and beneficial
Test 2
Substantially all economic benefits
Test 3
Right to direct the use
Capacity portions
Lease only if physically distinct
If no lease
Service contract
Is it a lease? The IFRS 16 identification testTest 1: An identified asset; Substitution right: Substantive only if practical and beneficial; Test 2: Substantially all economic benefits; Test 3: Right to direct the use; Capacity portions: Lease only if physically distinct; If no lease: Service contract.KEY FACTS AT A GLANCEIs it a lease? The IFRS 16 identification testTest 1An identified assetSubstitution rightSubstantive only ifpractical and beneficialTest 2Substantially alleconomic benefitsTest 3Right to direct the useCapacity portionsLease only if physicallydistinctIf no leaseService contractChecked against official sourcesTax BakersIs it a lease? The IFRS 16 identification testTest 1: An identified asset; Substitution right: Substantive only if practical and beneficial; Test 2: Substantially all economic benefits; Test 3: Right to direct the use; Capacity portions: Lease only if physically distinct; If no lease: Service contract.KEY FACTS AT A GLANCEIs it a lease? The IFRS 16identification testTest 1An identified assetSubstitution rightSubstantive only if practical and beneficialTest 2Substantially all economic benefitsTest 3Right to direct the useCapacity portionsLease only if physically distinctIf no leaseService contractChecked against official sourcesTax Bakers
Key facts at a glance, as set out in this guide.

What is the test?

Does the contract contain a lease?Does the contract contain a lease?Is there an identified asset, withno substantive substitution right?NoNot a lease:a serviceYesDoes the customer get substantiallyall the economic benefits?NoNot a lease:a serviceYesDoes the customer direct howand for what purpose it is used?NoNot a lease:a serviceYesThe contract contains a lease
All three conditions must hold throughout the period of use.

1. Is there an identified asset?

The asset is usually named in the contract, but it can be implied, for example when only one asset can meet the contract. A portion of an asset is an identified asset if it is physically distinct, such as a floor of a building, or if it represents substantially all of the asset's capacity. A share of capacity in a shared pipeline or fibre network that is not physically distinct is not an identified asset.

Even a named asset is not identified if the supplier has a substantive substitution right: it has the practical ability to swap the asset throughout the period, and it would benefit economically from doing so. A right to substitute only for repairs or on a future date is not substantive. If the customer cannot readily tell whether the supplier could substitute, it presumes the right is not substantive.

2. Does the customer get substantially all the economic benefits?

From using the asset throughout the period, within the defined scope of the contract: its output, by-products and other benefits. A customer that must pay the supplier a share of its sales from the asset still obtains the benefits; the payment is just part of the consideration.

3. Does the customer direct the use?

The customer directs the use if it can decide how and for what purpose the asset is used throughout the period, such as what it produces, when and how much. Where those decisions are predetermined in the contract, the customer still directs the use if it operates the asset, or if it designed the asset in a way that predetermines its use. Protective rights held by the supplier, such as limits on load or location, do not prevent the customer from directing use.

Worked examples: data centre capacity

ContractIdentified asset?Benefits and direction?Answer
Five years of exclusive use of three named server racks in a locked cage; the provider cannot move the customerYes: specified and physically distinctYes: the customer decides what runs on themLease
A guaranteed amount of storage on the provider's servers, which the provider allocates as it choosesNo: no specific serversNot relevantService
Named racks, but the provider can and regularly does move customers to equivalent racks to manage its estateNo: substantive substitution rightNot relevantService
Dedicated fibres in a cable, physically distinct, used as the customer choosesYesYesLease

What if a contract contains a lease and a service?

The lessee separates lease components from non-lease components, such as maintenance, and allocates the consideration on the basis of relative stand-alone prices. As a practical expedient, a lessee may choose, by class of asset, not to separate them and account for the whole contract as a lease, which increases the liability.

Why does it matter so much?

A lease puts an asset and a liability on the balance sheet and moves cost out of operating expenses into depreciation and interest. A service stays off the balance sheet and is expensed. The same contract can therefore change reported debt, EBITDA and gearing. See IFRS 16 explained and lessee accounting step by step.

Where to go next

Once a lease is identified, decide its term: see lease term and options. For reading the standard yourself, see how to read an accounting standard, which uses this very example.

Need help applying the standards?

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Questions people ask

What is the definition of a lease under IFRS 16?

A contract that conveys the right to control the use of an identified asset for a period of time in exchange for consideration.

When does a substitution right stop an asset from being identified?

When the supplier has the practical ability to substitute the asset throughout the period and would benefit economically from doing so.

Is a portion of capacity a lease?

Only if it is physically distinct or represents substantially all of the asset's capacity.

Must lease and non-lease components be separated?

Yes, unless the lessee chooses the practical expedient to treat them as a single lease component for that class of asset.

Sources

Every fee, date and rule on this page was taken from these official and primary sources.

  1. IFRS Foundation: IFRS 16 Leases

Rules and fees change. If you are reading this long after October 4, 2026, confirm the figures with the source before you rely on them.

IFRS 16IFRS 16 leases explainedIFRS 16IFRS 16 lessee accounting step by stepIFRS 16Lease term, extension and termination options under IFRS 16

More in IFRS 16

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This guide is general information. It is not tax or legal advice for your situation.