How IFRS 15, IFRS 16 and IAS 12 Interact:…

How IFRS 15, IFRS 16 and IAS 12 Interact: Revenue, Leases and Tax Together

By Sai Manikanta Pedamallu (ACCA, CMA US, CSCA US, CGMA, ACMA, Dip IFRS, M.Com, MBA, MA)

Lead Instructor, Global Fin X | www.globalfinx.in/manikanta

An Indian equipment manufacturer signs a five-year contract with a customer. It supplies a machine, installs it, maintains it, and charges a fixed monthly fee plus a per-unit charge based on output.

That single contract engages three standards, and the order in which they are applied determines the answer. Apply them in the wrong sequence and every subsequent number is wrong, including the tax.

The standards have been covered individually: IFRS 15 in Posts 11 through 14, IFRS 16 in Posts 27 through 32, and IAS 12 in Posts 62 through 64 and 68. This post covers what happens where they meet.

The Sequence Is Not Optional

Step one: determine whether the contract contains a lease. IFRS 16's scope test runs first.

Step two: separate lease components from non-lease components.

Step three: allocate the consideration between them.

Step four: apply IFRS 16 to the lease components and IFRS 15 to the non-lease components.

Step five: apply IAS 12 to whatever the first four steps have recognised.

The sequence follows from how the standards define their own scope. IFRS 16 applies to contracts that are, or contain, leases. IFRS 15 applies to contracts with customers other than those within the scope of other standards, including IFRS 16. Tax has no independent view; deferred tax attaches to assets and liabilities that already exist, and those exist only after the first four steps are complete.

An entity that begins by asking "what is our revenue on this contract" has started at step four and will have skipped the question that determines whether part of the arrangement is revenue at all.

Step One: Is There 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.

The three elements established in Post 27 apply: an identified asset, the right to obtain substantially all the economic benefits from its use, and the right to direct its use.

The distinction that matters most in practice is between a lease and a service.

A customer that has the right to direct how and for what purpose a specific machine is used, throughout the period, has a lease. A customer that receives output from equipment the supplier operates, controls, and can substitute has a service.

The consequences diverge completely.

If it is a lease, the supplier is a lessor. It applies the lessor accounting in Post 29, classifying the lease as finance or operating, and recognising either a net investment or lease income. The customer recognises a right-of-use asset and a lease liability.

If it is a service, the supplier applies IFRS 15 and recognises revenue as the performance obligation is satisfied. The customer recognises an expense as the service is received. Neither party recognises a lease.

Getting this wrong is not a presentational difference. It changes whether an asset and a liability appear on the customer's balance sheet at all, and it changes whether the supplier reports revenue or finance income.

Step Two: Separating Components

Where a contract contains both a lease and something else, the components are identified separately.

The right to use an underlying asset is a separate lease component where the lessee can benefit from use of that asset either on its own or together with other readily available resources, and the underlying asset is neither highly dependent on nor highly interrelated with the other underlying assets in the contract.

Activities that do not transfer a good or service are not separate components. Administrative tasks to set up a contract, and reimbursements of the lessor's costs, are not separate components even though they attract consideration. They form part of the total consideration allocated across the actual components.

Common non-lease components in practice include maintenance, cleaning, security, and consumables supplied alongside the leased asset.

Step Three: Allocating the Consideration

The allocation differs depending on which side of the contract the entity sits, and the difference is worth being precise about.

A lessee allocates the consideration on the basis of relative stand-alone prices. Where an observable stand-alone price is not readily available, the lessee maximises the use of observable information.

A lessee may elect a practical expedient, by class of underlying asset, not to separate non-lease components from lease components and instead to account for the whole as a single lease component.

That expedient is a genuine simplification with a genuine cost. Combining a maintenance element into the lease increases the lease liability and the right-of-use asset, because the maintenance consideration is discounted into the liability. An entity electing it reports higher lease liabilities and higher depreciation and interest, and lower operating expenses, than one that separates.

A lessor allocates the consideration by applying IFRS 15. The lessor has no equivalent practical expedient. It applies the transaction price allocation requirements from Post 12, allocating on the basis of relative stand-alone selling prices.

This asymmetry is deliberate and it means the two parties to the same contract may split it differently.

Step Four: Measuring Each Component

The lease component follows IFRS 16. For the lessee, a right-of-use asset and a lease liability measured as covered in Post 28. For the lessor, classification as finance or operating and the corresponding measurement from Post 29.

The non-lease components follow IFRS 15. Identify performance obligations, determine the transaction price, allocate it, and recognise revenue as each obligation is satisfied.

Two interaction points arise here.

Variable payments. A usage-based charge may be a variable lease payment or variable consideration under IFRS 15, depending on which component it relates to. Variable lease payments not based on an index or rate are excluded from the lease liability and recognised in profit or loss as incurred, as covered in Post 27. Variable consideration under IFRS 15 is estimated and included in the transaction price subject to the constraint, as covered in Post 13. The same cash flow receives different treatment depending on which component it attaches to.

Financing. A lease liability is discounted by definition. A non-lease component with an extended payment period may contain a significant financing component under IFRS 15, requiring separation of revenue from interest. Both produce interest, and both need identifying.

Step Five: The Tax Layer

Deferred tax is applied to the assets and liabilities that steps one to four have produced, using the framework in Post 62: compare each carrying amount to its tax base and recognise deferred tax on the difference.

Three specific interactions matter.

Leases: The 2021 Amendment

Before the May 2021 amendment, entities took different views on whether the initial recognition exemption applied to leases. The amendment settled it: the exemption does not apply to transactions that give rise to equal taxable and deductible temporary differences.

A lease at inception produces exactly that. The right-of-use asset and the lease liability are broadly equal. Where the tax deduction follows the lease payments rather than the accounting depreciation and interest, both have a nil tax base.

The result is a taxable temporary difference on the right-of-use asset and a deductible temporary difference on the lease liability, equal and offsetting at inception, with deferred tax recognised on both.

They do not stay equal. The right-of-use asset depreciates on a straight-line basis while the lease liability unwinds on an effective interest basis, which front-loads the interest and slows the reduction in the liability. The liability therefore exceeds the asset through most of the lease term, producing a net deductible temporary difference and a net deferred tax asset that builds and then unwinds.

For Indian entities with the substantial lease portfolios described in Post 32, this is a material and recurring deferred tax movement that did not exist before the amendment.

Contract Assets and Contract Liabilities

IFRS 15 recognises revenue as performance obligations are satisfied, which frequently differs from when invoices are raised or cash is received. Indian tax law generally follows the invoicing or completion position rather than the accounting recognition pattern.

A contract asset arises where the entity has performed but has no unconditional right to consideration. Where the related revenue has not yet been taxed, the asset has a nil tax base and a taxable temporary difference arises.

A contract liability arises where consideration has been received in advance of performance. Where the amount has already been taxed on receipt, the liability's tax base is reduced accordingly and a deductible temporary difference arises.

For Indian IT services companies with substantial unbilled revenue balances, and for real estate developers recognising revenue over time while tax follows completion, these differences are among the largest on the balance sheet.

Variable Consideration and the Constraint

Where variable consideration is constrained under IFRS 15, accounting revenue is lower than the amount that may eventually be taxed. Where it is included but not yet taxed, the reverse applies. Either way, a temporary difference arises and must be identified.

Worked Example: The Three Standards Together

An Indian equipment manufacturer enters a five-year contract with a customer on 1 April 2026.

The contract provides: a specified machine installed at the customer's plant, which the customer directs the use of throughout the term; installation services at inception; maintenance for five years; a fixed annual charge of Rs. 60 lakh; and a variable charge of Rs. 20 per unit produced.

Stand-alone prices: machine lease, Rs. 45 lakh per year; installation, Rs. 25 lakh; maintenance, Rs. 15 lakh per year.

Step One: Is There a Lease?

The machine is specified in the contract, the supplier cannot substitute it without the customer's consent, the customer obtains substantially all the output, and the customer directs how and for what purpose it is used.

The contract contains a lease.

Step Two: Components

Three components: the lease of the machine, the installation service, and the maintenance service. Installation and maintenance are distinct from the lease, since the customer benefits from the machine independently and the services are separately available in the market.

Step Three: Allocation

From the customer's perspective, assuming it does not elect the practical expedient, the fixed consideration of Rs. 60 lakh per year, plus the installation charge, is allocated on relative stand-alone prices between the lease and the two service components.

From the supplier's perspective, the same allocation is performed applying IFRS 15's transaction price allocation requirements.

The variable charge of Rs. 20 per unit relates to use of the machine. It is a variable lease payment not based on an index or rate, excluded from the lease liability and recognised by the customer in profit or loss as units are produced, and by the supplier as lease income as it accrues.

Step Four: Measurement

The supplier classifies the lease as finance or operating under Post 29's criteria. Assuming the lease term covers a major part of the machine's economic life and the present value of lease payments approaches its fair value, this is a finance lease: the supplier derecognises the machine, recognises a net investment in the lease, and recognises finance income over the term.

Installation revenue is recognised when the installation performance obligation is satisfied. Maintenance revenue is recognised over the five years as the service is provided.

The customer recognises a right-of-use asset and a lease liability for the lease component, depreciating the asset over the lease term and unwinding the liability at the incremental borrowing rate. Installation is expensed or capitalised depending on whether it forms part of the cost of the right-of-use asset. Maintenance is expensed as the service is received.

Step Five: Deferred Tax

The customer. The right-of-use asset and lease liability each have a nil tax base, assuming the tax deduction follows the lease payments. Deferred tax is recognised on both, gross, and the net position moves through the lease term as the liability unwinds more slowly than the asset depreciates.

The supplier. The net investment in the lease has a carrying amount determined under IFRS 16 and a tax base determined by the tax treatment of the transaction, which in India commonly follows the lease rentals received. Any difference produces a temporary difference. Contract assets or liabilities arising on installation and maintenance are assessed separately against their tax bases.

The single contract has produced, for the customer, a right-of-use asset, a lease liability, and deferred tax on both, and for the supplier, a lease receivable, revenue on two service obligations, finance income, and deferred tax on the differences between each accounting carrying amount and its tax base.

Sale and Leaseback: All Three at Once

The sale and leaseback transaction covered in Post 30 is the clearest case where the three standards operate in sequence within one transaction.

IFRS 15 determines whether a sale has occurred, by reference to whether the buyer obtains control of the asset. This is the threshold question and it is answered by the revenue standard, not the lease standard.

If a sale has occurred, IFRS 16 governs the leaseback: the seller-lessee recognises a right-of-use asset at the proportion of the previous carrying amount relating to the right retained, and recognises only the gain relating to the rights transferred.

If a sale has not occurred, there is no leaseback. The transaction is a financing arrangement: the seller retains the asset and recognises a financial liability under IFRS 9.

IAS 12 then applies to the outcome, which differs completely between the two cases. A sale produces a partial gain, a right-of-use asset, and a lease liability, each with its own tax base. A failed sale produces a retained asset and a financial liability, with entirely different temporary differences.

A single control assessment under IFRS 15 therefore determines the entire lease and tax outcome.

Where the Interactions Break Down

Five failure modes recur.

Starting with revenue. An entity that identifies performance obligations before testing for a lease will allocate consideration to components that should have been lease components, and will report revenue where it should report lease income or finance income.

Treating a lease as a service to avoid balance sheet recognition. The IFRS 16 identified asset and control tests are not elective. A customer with the right to direct the use of a specified asset has a lease regardless of what the contract is called.

Applying the lessee practical expedient without considering its effect. Combining non-lease components into the lease is permitted but it increases the lease liability, the right-of-use asset, depreciation, and interest. Entities elect it for administrative convenience without modelling the reported consequence.

Assuming lessor and lessee split the contract identically. The lessee may elect not to separate; the lessor has no such election. The two parties may account for the same contract differently, and neither is wrong.

Applying the initial recognition exemption to leases. The 2021 amendment removed leases from its scope. Entities continuing the pre-amendment treatment carry an understated deferred tax position on both the right-of-use asset and the lease liability.

What Big 4 Auditors Focus On

The lease identification assessment for service-like contracts. Auditors test outsourcing, logistics, data centre, power purchase, and equipment supply arrangements against the identified asset and control criteria, since these are the contracts most likely to contain unidentified leases.

Component separation and allocation. Auditors test whether non-lease components have been identified and whether the allocation uses stand-alone prices, and where a lessee has elected the practical expedient, whether the election has been applied consistently by class of underlying asset.

Variable payment classification. Auditors test whether usage-based charges have been correctly classified as variable lease payments, excluded from the liability, or as variable consideration under IFRS 15, estimated and constrained.

Deferred tax on leases post-amendment. Auditors specifically test whether deferred tax has been recognised gross on both the right-of-use asset and the lease liability, and whether the net position has been tracked as the two diverge over the lease term.

Contract asset and liability tax bases. For entities with material unbilled revenue or advance receipts, auditors test whether the tax base has been correctly determined by reference to when the amount is taxed, rather than assuming it equals the carrying amount.

Sale and leaseback control assessment. Auditors test the IFRS 15 control conclusion first, since the entire lease and tax treatment depends on it, and examine repurchase options and put arrangements that may prevent control transferring.

Dip IFRS Exam Angle

Integrated questions spanning multiple standards are common at the higher end of the Dip IFRS paper.

Most tested areas:

Identifying whether a contract contains a lease before applying any revenue analysis.

Separating lease and non-lease components and allocating consideration.

Recognising that a lessee may elect not to separate while a lessor must apply IFRS 15 allocation.

Applying the correct treatment to variable payments depending on the component they relate to.

Recognising deferred tax on both the right-of-use asset and the lease liability following the 2021 amendment.

Applying the IFRS 15 control test to determine whether a sale and leaseback contains a sale.

Common traps:

Applying IFRS 15 to a contract that contains a lease without performing the IFRS 16 scope test.

Including variable lease payments not based on an index or rate in the lease liability.

Assuming the lessee and lessor must allocate the contract identically.

Applying the initial recognition exemption to a lease and recognising no deferred tax.

Recognising the full gain on a sale and leaseback rather than only the gain on rights transferred.

Treating a failed sale and leaseback as producing a right-of-use asset. It produces a retained asset and a financial liability.

FAQ

Why must the lease test come before the revenue analysis?

Because IFRS 15 applies to contracts with customers other than those within the scope of other standards, including IFRS 16. Until the lease question is answered, the entity does not know which parts of the contract are within IFRS 15's scope at all.

Can the same contract be a lease for the customer and a service for the supplier?

No. The lease definition is applied to the contract, and both parties should reach the same conclusion on whether a lease exists. What can differ is the allocation of consideration, since the lessee may elect not to separate non-lease components while the lessor must apply IFRS 15 allocation.

Does electing the lessee practical expedient reduce work without consequence?

It reduces work but not without consequence. Combining non-lease components into the lease increases the lease liability and right-of-use asset, shifts operating expense into depreciation and interest, and changes EBITDA. The election should be made with that effect understood.

Why does deferred tax on a lease not net to nil throughout the lease term?

Because the right-of-use asset depreciates on a straight-line basis while the lease liability unwinds on an effective interest basis. The liability reduces more slowly in the early years, so the two diverge after inception even though they were broadly equal at the start.

How does a contract asset create a temporary difference?

Where revenue has been recognised for accounting purposes but the amount has not yet been brought into taxable profit, the contract asset has a nil or reduced tax base, producing a taxable temporary difference and a deferred tax liability.

Which standard decides whether a sale and leaseback contains a sale?

IFRS 15. The question is whether the buyer obtains control of the asset, and that is answered by the revenue standard. IFRS 16 then governs the leaseback only if a sale has occurred.

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This is Post 92 of the Global Fin X IFRS Series. Previous: IFRIC 12 PPP Accounting in Indian Infrastructure. Next: Post 93: IFRS in Big 4 Audit Practice: What Associates and Senior Associates Actually Do.

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