IFRIC agenda decision – Substitution rights in a lease

IFRS Interpretations Committee (the Committee) agenda decisions are those issues that the Committee decided not to take onto its agenda. Although not authoritative guidance, these decisions are regarded as being highly persuasive in practice. All entities reporting under IFRS should be aware of these decisions, as they could impact the way particular transactions and balances are accounted for.

In the addendum to the update from its March 2023 meeting, the IFRS Interpretations Committee (Committee) issued a final agenda decision dealing with lease substitution rights.

Fact pattern

  • A customer enters into a 10-year contract with a supplier to use 100 similar new batteries for its fleet of electric buses
  • The customer uses each battery together with its other resources (i.e. the electric buses) which it either owns or leases from third parties that are not related to the supplier
  • The supplier has the practical ability to substitute alternative batteries throughout the 10-year contract term
  • If the supplier substitutes batteries during the contract term, it must compensate the customer for any revenue lost or costs incurred while substitution takes place
  • Whether substitution is economically beneficial to the supplier at a point in time depends on the amount of compensation payable to the customer and the condition of the battery
  • At inception, it is expected that the supplier:
    • Would not benefit economically from substituting a battery that has been used for less than three years
    • Could benefit economically from substituting a battery that has been used for three years or more.

IFRS 16 background

IFRS 16 Leases requires lessees to capitalise a right-of-use asset and a lease liability in their balance sheet for all lease contracts. 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. Entities must assess whether a contract contains a lease for each potential separate lease component.

In order for an entity to control the use of an identified asset, it must have the right to:

  • Obtain substantially all of the economic benefits from using the identified asset
  • Direct the use of the identified asset.

In addition, the supplier must not have a substantive right to substitute the asset throughout the period of use.

What is a substantive substitution right?

A supplier’s right to substitute an asset is substantive if both of the following apply:
  • The supplier has the practical ability to substitute alternative assets throughout the period of use
  • The supplier would benefit economically from exercising its right to substitute the asset.

Questions

Two questions were put to the Committee:

Rationale for agenda decision – Is each battery an identified asset?

Entities must assess whether a contract contains a lease for each potential separate lease component. The right to use an underlying asset is a separate lease component if both of the following apply:

  • The lessee can benefit from using the underlying asset either on its own, or together with other resources that are readily available to the entity
  • The underlying asset is neither highly dependent on, nor highly interrelated with, other underlying assets in the contract.

The Committee concluded that in this fact pattern, each battery is a separate lease component because the customer uses each battery together with its own resources, and each battery is not highly dependent on, nor interrelated with other batteries specified in the contract. That is, each battery is installed in a separate bus. The customer must therefore assess whether the contract contains a lease for each battery.

Rationale for agenda decision – Does the supplier have a substantive right to substitute each battery throughout the period of use?

As each battery is a separate identified asset, the customer must assess whether the supplier has a substantive right to substitute each battery throughout the period of use.

The supplier has the practical ability to substitute batteries throughout the period of use. However, 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. As the first three years of each battery’s life form part of the period of use, the supplier does not have a substantive right to substitute batteries throughout the period of use (the 10-year contract).

Conclusion

In the fact pattern described, the Committee concluded that each battery is an identified asset, and the supplier’s right to substitute batteries is not substantive throughout the period of use.

The Committee further concluded that the principles and requirements in IFRS 16 provide an adequate basis for the customer to evaluate the level at which to assess whether the contract contains a lease, and whether there is an identified asset. It therefore decided not to add a standard-setting project to its work plan.

More information

Refer to our FAQ for a more in-depth analysis of the agenda decision.

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