Not every contract that includes a lease is purely a lease. Many agreements bundle the right to use an asset together with other services, such as maintenance, insurance, or utilities. Under IFRS 16, businesses are required to separate, or “unbundle,” these components, and getting this wrong can significantly distort your lease liability and right of use asset figures.
This step is often rushed or overlooked entirely, especially in contracts where the lease and service elements are not clearly itemized. Here is how to approach it correctly.
Why Unbundling Matters
If a contract combines a lease component with non-lease components and a business fails to separate them, the entire payment amount may end up being treated as part of the lease liability. This overstates both the lease liability and the right of use asset, since service related payments should not be capitalized in the same way as lease payments.
Getting this separation right keeps your balance sheet accurate and ensures that operating costs like maintenance are expensed appropriately rather than inflating your lease obligations.
What Counts as a Lease Component
A lease component exists when a customer has the right to control the use of an identified asset for a period of time in exchange for consideration. This is the core right being leased, such as the right to occupy a specific floor of a building or use a particular piece of equipment.
What Counts as a Non-Lease Component
Non-lease components are the other elements bundled into the contract that are not directly related to the right to use the asset. Common examples include maintenance services, cleaning services, security services, or administrative fees charged alongside the lease.
For example, a lease of office space that also includes building maintenance and reception services as part of the same monthly payment includes both a lease component and non-lease components that need to be accounted for separately.
How to Separate the Components
IFRS 16 requires businesses to allocate the contract consideration between lease and non-lease components based on their relative standalone prices. This means identifying what each component would cost if purchased separately, then using that ratio to split the total contract payment.
If standalone prices are not directly observable, businesses need to estimate them using the best available information, such as pricing for similar services offered separately in the market, or cost plus a reasonable margin where market pricing is not available.
The Practical Expedient Option
Recognizing that this separation process can be time consuming, IFRS 16 offers a practical expedient that allows lessees to elect, by class of underlying asset, not to separate non-lease components from lease components. Instead, the entire contract can be accounted for as a single lease component.
This expedient can simplify accounting significantly, but it comes with a tradeoff. Choosing not to separate components means the entire payment, including the non-lease service elements, gets capitalized as part of the lease liability and right of use asset. For contracts with substantial service components, this can meaningfully inflate the reported lease liability.
Weighing the Practical Expedient Against Accuracy
Businesses need to think carefully about whether using this expedient makes sense for their specific circumstances. For a lease with a small, relatively insignificant service component, the expedient might be a reasonable simplification. But for a lease where maintenance or service costs make up a substantial portion of the payment, separating the components properly likely gives a more accurate financial picture, even though it requires more effort.
It is also worth noting that this election is made by class of underlying asset, which means a business can apply the expedient consistently to certain categories of leases, such as vehicles, while still separating components for others, such as property leases with significant service elements.
Common Challenges in Practice
One of the biggest challenges businesses face is that lease agreements do not always clearly itemize the cost of each component. A single monthly invoice might combine rent, maintenance, and utility charges without breaking down what portion relates to each. In these situations, businesses need to work with available market information or negotiate more detailed pricing breakdowns with lessors where possible.
Another common challenge is inconsistency across similar contracts. If one property lease separates components while a very similar lease does not, this can create confusion during audit review and make it harder to compare lease costs across the business.
Building a Consistent Approach
To avoid these issues, it helps to establish a clear internal policy on how lease and non-lease components will be handled, including which asset classes will use the practical expedient and which will require formal separation. Documenting the standalone price estimation method used for separated contracts also creates a defensible record for audit purposes.
Frequently Asked Questions
FAQ 1. What happens if a business does not separate lease and non-lease components?
Unless the practical expedient is elected, failing to separate these components can result in an overstated lease liability and right of use asset, since non-lease service costs would be incorrectly included in the lease measurement.
FAQ 2. What is the practical expedient for non-lease components under IFRS 16?
It allows lessees to elect, by class of underlying asset, to account for lease and non-lease components together as a single lease component, simplifying the accounting but potentially inflating the reported lease liability.
FAQ 3. How should standalone prices be estimated if they are not directly observable?
Businesses can use pricing for similar services offered separately in the market, or estimate a reasonable price using a cost plus margin approach when market pricing is not readily available.
Final Thoughts
Unbundling lease and non-lease components is a detail that is easy to overlook, but it has a real impact on how accurately your lease liabilities reflect your actual obligations. Whether you choose to separate components or apply the practical expedient, having a clear, consistent, and well documented approach will keep your lease accounting accurate and easier to defend during an audit.
