Substance v legal Form - An Explanation using IFRS 16

1. Financial statements provide information about a company’s rights and obligations. Rights and obligations are created by the company entering into contracts (for example a lease) with another party (for example a lessor). The legal form of a lease contract contains the specific terms between parties. These terms create the legal rights and obligations under the contract. The problem that directors face is how to measure and present these terms in a fair and unbiased manner. Financial reporting standards (for example IFRS 16) are the method by which the contractual terms are communicated in a fair and unbiased manner. 
2. In assessing whether an item meets the definition of an asset, liability or equity, attention needs to be given to its underlying substance and economic reality and not merely its legal form. This does not mean one ignores or disregards the contractual terms which set out the legal form. The legal form simply describes the terms and conditions of the contract and one then apply the substance and economic reality principle to determine the accounting treatment of the legal form. 
3. In a lease contract there is very little debate as to the legal form. The legal form consists of a lessee being permitted to use an item which legally is not owned for a period of time; for a certain consideration.  The question that has been argued for more than a decade; is what epitomises the substance and economic reality of the legal form contained in a lease contract?
4. While the legal form of a lease agreement is that the lessee may acquire no legal title to the leased asset, IFRS 16 makes the case that the substance and economic reality of lease contract are that the lessee acquires the economic benefits of the use of the leased asset. IFRS 16 argues that if these economic benefits are not reflected in the lessee's balance sheet, the economic resources and the level of obligations of an entity are understated, thereby distorting financial ratios. This no different from the manner in which IFRS 16’s predecessor IAS 17 accounted for a “finance lease”. 
5. A lease was classified as a finance lease if it transfers substantially all the risks and rewards incident to ownership. The assessment of whether a lease contract transferred substantially all the risks and rewards incident to ownership to the lessee was dependent on whether the lessee acquired the economic benefits of the use of the leased asset for the major part of its useful life in return for entering into an obligation to pay for that right an amount approximating to the fair value of the asset and the related finance charge. Any lease that did not transfer substantially all the risks and rewards incident to ownership to the lessee was determined to be an operating lease. What was considered to be an operating lease did not seem to tie in with the principle that the lessee acquired the economic benefits of the use of the leased asset and therefore could be not be recognised on the balance sheet. It is self-evident that even under an operating lease economic benefits are acquired by the lessee especially where the asset leased represents the main income producing asset of an entity. 
6. For example most leases in the airline industry are currently classified as operating. The aircraft leased by an airline represent is main income producing asset which does not appear on the balance sheet. 
7. As a result of this mismatch IFRS 16 shifts from the risk and reward model of IAS 17 as being the determinants of the lease contracts underlying substance and economic reality to a control model. IFRS 16 aims to distinguish a lease based on whether a lessee is able to control the asset being leased. Control represents the major component of the definition of an asset. Control is conveyed where the lessee has both the right to direct the identified asset’s use and to obtain substantially all the economic benefits from that use. Even in an operating lease under IAS 17 the lessee has control by the mere fact that the lessee has the right of use of the leased asset. 
8. Therefore the underlying substance and economic reality of a lease contract that best fairly presents the contracts legal form is the control model. The control model has the main impact that almost all leases go on balance sheet.