IFRS 16 Supplier Substitution Rights

The IFRS Interpretations Committee recently addressed this matter and included it in their most recent compilation of Agenda decisions.

The example they considered was looking at the level of a lease where individual assets are leased as a group and not individually noted, and the supplier has certain substitution rights.

The scenario provided or, is as follows:

• 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).
• It is assumed that the supplier has the practical ability to substitute alternative assets throughout the contract term such that the condition in paragraph B14(a) exists.
• 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.
• 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 IFRIC indicated that the customer is both able to benefit from a single battery independent from the other batteries as it will be used in a bus and each battery is neither highly dependent on, nor highly interrelated with, the other batteries in the contract [IFRS 16.B12]. Consequently, the assessment must be done for each potential separate lease component, the battery.

In order for the substitution rights to be substantive, the supplier must have the practical ability to substitute alternative assets throughout the period of use and must benefit economically from substituting the asset [IFRS 16.B14].

A total of 100 batteries were specified in the contract, and although each one might not have been explicitly specified, it would be implicitly specified at the time that it is made available for the customer’s use. Therefore, supplier substitution rights should be considered, as follows:

• It is assumed that the supplier has the practical ability to substitute the batteries at any point in time.
• 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, therefore, the substitution rights do not exist throughout the period of use.

The IFRIC concluded that the supplier does not have the substantive right to substitute a battery throughout the period of use. A lease would therefore exist in this scenario.

Authors:

Justine Combrink, IFRS Partner and Frans Smith, IFRS Manager

19 July 2023