Is Parking area a lease or a non-lease component as per Ind AS 116?

Background:

Ind AS 116 has been effective for the financial period beginning from 1 April 2019 onwards. There are many challenges that entities are facing while implementing and transiting to such new leases accounting standards.

One issue that is constantly faced by every lessee is doing accounting for parking charges paid by the lessee to the lessor for the premise of the lease.

This article aims to explain the principle guidance for accounting of such parking charges’ paid by the lessee, with the help of the below example:

Facts of the Case: 

The Company has entered into a lease agreement with a lessor for a premise (specified measured area on 4th, 5th, and 6th floor of building-2 of the commercial complex) for the purpose of office use. Such agreement is entered on the lease commencement date i.e 15 July 20XX.  Key terms of the agreement are as follows:

• The total term of the lease is 9 years (from July 15, 20XX to July 14, 20XX) and the lock-in period is 3 years. Post lock-in period, the lessee can terminate the lease by serving 3 months’ notice period or by paying rent in lieu of thereof.
• The monthly rent for the premises during the first three years is fixed and has to be paid in advance by the 7th day of each month. Further, the contract states that lease rent shall be escalated by 12% every 3 years.
• Office floors area and spaces are identified in the agreement, agreement states the measured area and floors of the building.
• The above-specified rent payable is for leased premises as well as for 118 car parking spaces on an exclusive use basis.

Issue:

The parking area is a lease or a non-lease component within the meaning of Ind AS 116?

Technical Guidance: 

A contract contains a lease only if it relates to an identified asset. An asset can either be explicitly specified in a contract or implicitly specified at the time it is made available for use by the customer.

An asset is typically identified by being explicitly specified in a contract. However, an asset can also be identified by being implicitly specified at the time that the asset is made available for use by the customer. 

Substantive substitution rights

Even if an asset is specified, a customer does not have the right to use an identified asset if the supplier has the substantive right to substitute the asset throughout the period of use. A supplier’s right to substitute an asset is substantive only if both of the following conditions exist:

• The supplier has the practical ability to substitute alternative assets throughout the period of use (for example, the customer cannot prevent the supplier from substituting the asset and alternative assets are readily available to the supplier or could be sourced by the supplier within a reasonable period of time); and
• The supplier would benefit economically from the exercise of its right to substitute the asset (ie the economic benefits associated with substituting the asset are expected to exceed the costs associated with substituting the asset).

If the supplier has a right or an obligation to substitute the asset on or after either a particular date or the occurrence of a specified event, the supplier’s substitution right is not substantive because the supplier does not have the practical ability to substitute alternative assets throughout the period of use.

An entity’s evaluation of whether a supplier’s substitution right is substantive is based on facts and circumstances at the inception of the contract and shall exclude consideration of future events that, at the inception of the contract, are not considered likely to occur.

If the customer cannot readily determine whether the supplier has a substantive substitution right, the customer shall presume that any substitution right is not substantive.

A capacity portion of an asset is an identified asset if it is physically distinct (for example, a floor of a building). A capacity or other portion of an asset that is not physically distinct (for example, a capacity portion of a fiber optic cable) is not an identified asset unless it represents substantially all of the capacity of the asset and thereby provides the customer with the right to obtain substantially all of the economic benefits from the use of the asset.

The supplier would benefit economically from the exercise of its right to substitute the asset:

To control the use of an identified asset, a customer is required to have the right to obtain substantially all of the economic benefits from the use of the asset throughout the period of use (for example, by having exclusive use of the asset throughout that period). A customer can obtain economic benefits from the use of an asset directly or indirectly in many ways, such as by using, holding, or sub-leasing the asset. The economic benefits from the use of an asset include its primary output and by-products (including potential cash flows derived from these items), and other economic benefits from using the asset that could be realized from a commercial transaction with a third party.

When assessing the right to obtain substantially all of the economic benefits from the use of an asset, an entity shall consider the economic benefits that result from the use of the asset within the defined scope of a customer’s right to use the asset.

Analysis and Discussion:

Evaluation of the Condition -1 “Practical ability to substitute the asset with the lessor”

• Since the assets are given in the case – Office premises and parking spots - are physically distinct and can be used independently of each other, therefore, these shall be evaluated separately.
• Whilst the office floor spaces are identified, the spot for parking are not identified in the agreement. However, the lessor has designated the exclusive parking space for use of lessee upon the start of the lease period.
• We have been explained that the lessee’s number of parking is 118, and the lessor has a space capacity of more than 1000 parking in the same building premise. Therefore, the lessee’s parking space does not represent the substantial capacity portion of the total parking space capacity of the lessor.
• Considering the above, the lessor has readily available parking space available for substitution purposes. Further, if the lessor changes the parking space anytime during the agreement period, in that case, the lessee does not have the right to prevent the lessor from doing so.  Therefore, the lessor has the practical ability to substitute the parking space throughout the agreement period.
• Basis discussion with the lessee, the lessor reserves the right to change such exclusive parking space given to the lessee anytime during the agreement period.

Considering the above, the lessor has the practical ability to substitute the parking space throughout the agreement period.

Evaluation of the Condition -2 "Economic benefits from substitution are with lessors"

We have been given an understanding that the lessor sells the parking spaces for use for a shorter period as and when customers require, and lessors keep the discretion of deciding the parking space prices to be rented out to the different customers.

 Therefore, benefits arising from the substitution of the parking spaces will continue to be with the lessor considering the discretion of the lessors for substituting parking space and determination of its prices lies with the lessor.

Conclusion:

In line with the above explanations, the lessor has substantive substitution right with respect to the change in the exclusive parking space for use of the lessee, and therefore, the exclusive parking space is not an identified asset within the meaning of Ind AS 116.