The IFRS Interpretations Committee (the “Committee”) is an interpretative body of the International Accounting Standards Board (the “IASB”) which works with the Board in supporting the application of IFRS Standards.

Agenda decisions are a way of making a statement about why a change of an IFRS Standard requirement or an interpretation of that requirement is unnecessary. They often include explanatory information that is intended to provide guidance for the consistent application of IFRS Standards. The Board expects entities to implement accounting policy changes in a timely manner if their policies are inconsistent with an agenda decision.

Definition of a Lease—Substitution Rights

(IFRS 16 Leases)

Published in April 2023

The Committee received a request on how to assess whether a contract contains a lease.

Fact Pattern

a) A customer enters into a 10-year contract with a supplier for the use of 100 similar new assets —batteries used in electric buses. The customer uses each battery together with other resources readily available to it (each battery is used in a bus that the customer owns or leases from a party unrelated to the supplier).

b) It is assumed that the supplier has the practical ability to substitute alternative assets throughout the contract term.

c) If a battery were to be substituted, the supplier would be required to compensate the customer for any revenue lost or costs incurred while the substitution takes place. Whether substitution is economically beneficial for the supplier at a point in time depends on both the amount of compensation payable to the customer and the condition of the battery.

d) At the inception of the contract, it is expected that the supplier would not benefit economically from substituting a battery that has been used for less than three years but could benefit economically from substituting a battery that has been used for three years or more.

The Question

The request asked about:

1.) the level at which to evaluate whether a contract contains a lease—by considering each asset separately or all assets together—when the contract is for the use of more than one similar asset; and

2) how to assess whether a contract contains a lease applying IFRS 16 when the supplier has particular substitution rights—ie the supplier:

I. has the practical ability to substitute alternative assets throughout the period of use; but

II. would not benefit economically from the exercise of its right to substitute the asset throughout the period of use.

Applying the requirements in IFRS 16 to the fact pattern described in the request

ad 1) The level at which to evaluate whether a contract contains a lease

In the fact pattern described in the request:

a) the customer is able to benefit from the use of each asset (a battery) together with other resources (a bus) available to it; and

b) each battery is neither highly dependent on, nor highly interrelated with, the other batteries in the contract.

Therefore, the Committee concluded that, in the fact pattern described in the request, applying paragraph B12 of IFRS 16 (which states that ‘an entity shall assess whether a contract contains a lease for each potential separate lease component’ and directs an entity to paragraph B32 of IFRS 16 for application guidance on separate lease components), the customer assesses whether the contract contains a lease— including evaluating whether the supplier’s substitution right is substantive—for each potential separate lease component, ie for each battery.

ad 2) Identified asset

In the fact pattern described in the request, each battery is specified. Even if not explicitly specified in the contract, a battery would be implicitly specified at the time it is made available for the customer’s use. Therefore, the Committee observed that, unless the supplier has the substantive right to substitute the battery throughout the period of use, each battery is an identified asset.

In the fact pattern described in the request, the condition in paragraph B14(a)—the supplier has the practical ability to substitute alternative assets throughout the period of use—is assumed to exist. The Committee observed, however, that because the supplier is not expected to benefit economically from exercising its right to substitute a battery for at least the first three years of the contract, the condition in paragraph B14(b) does not exist throughout the period of use. Therefore, the supplier does not have the substantive right to substitute a battery throughout the period of use. While determining whether a supplier’s substitution right is substantive throughout the period of use can require judgement, the Committee observed that the facts and circumstances in this fact pattern are such that it is clear that the supplier’s right is not substantive throughout that period.

The Committee’s conclusion

The Committee concluded that, in the fact pattern described in the request, each battery is an identified asset. To assess whether the contract contains a lease, the customer would then apply the requirements in paragraphs B21–B30 of IFRS 16 to assess whether, throughout the period of use, it has the right to obtain substantially all the economic benefits from use, and direct the use, of each battery. If the customer concludes that the contract contains a lease, it would apply the requirements in paragraphs 18–21 of IFRS 16 to determine the lease term.

The full text of this Agenda Decision can be found on the web of IFRS Foundation.

Source:   IFRIC Update March 2023