IFRS IC agenda decision on definition of a lease: level of evaluation and substitution rights

Keywords: Mazars, Thailand, IFRS, IC, IASB, Interpretations Committee, IFRIC, Lease 

9 June 2023

The decision was ratified by the IASB (International Accounting Standards Board) in April and published in an addendum to the March 2023 IFRIC Update (available here). 

The question related to: 

• the level at which to evaluate whether a contract contains a lease when the contract covers the use of several similar assets (i.e. should each asset be considered separately or all assets together?); and 
• how to assess whether a contract contains a lease when the supplier has particular substitution rights, particularly when it: 
  • has the practical ability to substitute the underlying asset throughout the period of use; but 
  • would not benefit economically from exercising its substitution right throughout the period of use.

In the fact pattern submitted to the IFRS IC:  

• a customer enters into a 10-year contract with a supplier for the use of 100 similar batteries to be used in electric buses. The customer uses each battery with other readily available resources (each battery is used in a bus that the customer owns or leases from a party unrelated to the supplier); 
• the supplier has the practical ability to substitute the batteries throughout the contract term; 
• if a battery had to be substituted, the supplier would be required to compensate the customer for any loss of income or cost incurred during the substitution; 
• at inception of the contract, the expectation is that the supplier would not benefit economically from substituting a battery that had been used for less than three years, but could benefit economically from substituting a battery that had been used for three years or more. 

In the preamble to its decision, the Committee noted that: 

• the requirements in paragraphs B13 to B19 of IFRS 16 set a high hurdle for a customer to   conclude that there is no identified asset when an asset is explicitly or implicitly specified;  
• the use of judgement is required to determine whether a supplier’s substitution right is substantive throughout the period of use;  
• paragraph B14(a) specifies that a supplier has the practical ability to substitute the underlying asset throughout the period of use even if it does not already have alternative assets but could source those assets within a reasonable period of time. This illustrates the fact that “throughout the period of use” does not mean “at any given moment throughout this period”. 

At what level should the contract be evaluated to determine whether it contains a lease? 

In response to this question, the IFRS IC concluded that the evaluation should be carried out for each potential separate lease component, or in this specific case, for each battery. This includes the evaluation of whether the supplier’s substitution right is substantive. 

This is because, in the fact pattern, (i) the customer can benefit from the use of each battery, and (ii) each battery is neither highly dependent on nor highly interrelated to the other batteries in the contract. 

Is there an identified asset? 

In response to this question, the IFRS IC first observed that each battery is specified (i.e. even if it is not explicitly specified in the contract, a battery is implicitly specified when it is made available to the customer) and that, unless the supplier has a substantive substitution right throughout the period of use, each battery is an identified asset. 

Next – although the condition relating to the supplier’s practical ability to substitute the battery throughout the period of use (IFRS 16 B14a) is assumed to be met – the IFRS IC noted that the use of judgement is required to determine whether the supplier’s substitution right is substantive. In this specific case, the facts and circumstances clearly show that the supplier does not have a substantive substitution right throughout the period of use.  

The IFRS IC’s conclusion 

The IFRS IC concluded that, in the fact pattern submitted, each battery is an identified asset and the customer must apply IFRS 16 to determine whether the contract contains a lease (which requires it to determine whether, throughout the period of use, it has the right to obtain substantially all the economic benefits from the use of each battery and to direct the use of each battery) and, if the contract does contain a lease, to determine the lease term.