Definition of a Lease: Substitution Rights (IFRS 16)

Date recorded:


In its November 2022 meeting, the IFRS IC discussed a submission about how to assess whether a contract contains a lease applying IFRS 16 when the supplier has particular substitution rights. In the fact pattern, a customer enters into a 10-year contract with a supplier for the use of 100 similar assets (batteries in electric buses). The supplier has the practical ability to substitute alternative assets throughout the 10-year contract term. If an asset were to be substituted, the supplier would be required to indemnify the customer for any revenue lost or costs incurred while the substitution takes place. For this reason, it is expected that the supplier could benefit economically from substituting an asset only when the buses are in the workshop for maintenance or other reasons. At inception of the contract, that event is not considered likely to occur in the first three years of the contract.

The submission asked:

  • What the implications are if the supplier:
    • Has the practical ability to substitute alternative assets throughout the period of use but
    • Is expected to benefit economically from the exercise of its right to substitute the asset only on the occurrence of events or circumstances that are not considered likely to occur until some time into the contract term
  • If a contract is for the use of multiple similar assets, at what level an entity evaluates whether the supplier’s substitution right is substantive—by considering each asset separately or all assets together

15 comment letters were received. Almost all respondents agreed with the IFRS IC’s analysis of level at which to evaluate whether a contract contains a lease. Most respondents agreed (or did not necessarily disagree) with the conclusion that, there is an identified asset in the fact pattern described but they raised comments on the analysis in the tentative agenda decision.

Staff analysis

Most of the respondents agreed with the staff conclusion that the supplier’s substitution right is not substantive but suggested that the IFRS IC should explain the judgement applied in determining that the condition in IFRS 16:B14(b) does not exist throughout the period of use. Moreover, the wording of the IFRS IC’s analysis could inappropriately imply that the economic benefit to the supplier must exist ‘continuously throughout the period of use’ or ‘at all points in time over the contract term’. They also raised concerns on the applicability on other fact patterns and this agenda decision may result in far fewer substitution rights being judged to be as substantive.

The staff explained that the first paragraph of IFRS 16:B14 explicitly requires assessment of whether a substantive substitution right exists "throughout the period of use". Conditions in IFRS 16:B14(a)-(b) merely help to make such assessment and therefore both conditions have to exist "throughout the period of use". The staff agreed that judgement is required to make such assessment. The example in IFRS 16:B14(a) illustrates that the supplier can have the practical ability to substitute alternative assets throughout the period of use even if it could source alternative asset only within a reasonable period of time. It could explain such right does not have to be at "all points" throughout that period but it ought to be "a reasonable period of time". Accordingly, in order to make it clear that the agenda decision does not imply that the substitution right must exist at all points throughout the period of use, the staff will include the reference to the example of IFRS 16:B14(a) and explain further the IFRS IC’s conclusions in the agenda decision.

One respondent suggested that, if "throughout the period of use" applies to both conditions in IFRS 16:B14(a)-(b), such phrase (which already exists in condition (d)) should be added to condition (b) as an Annual Improvement. The staff considered it not necessary because the requirements in paragraphs B13-B19 provide an adequate basis for an entity to assess whether substitution rights are substantive and the explanatory material in this agenda decision would be helpful in explaining this. Some respondents suggested the resulting outcome of the agenda decision does not reflect economic reality and suggested that IFRS 16:B14 should be reviewed. The staff said that the IASB intentionally set a high hurdle for a customer to conclude that there is no identified asset by setting the requirements in paragraphs B13-B19 and the review of IFRS 16:B14 is therefore not necessary.

Staff recommendation

The staff recommended finalising the agenda decision with some amendments to explain clearer the conclusions on the questions asked.

IFRS IC discussion

All IFRS IC members agreed with the conclusion in the draft agenda decision and they commented that suggested amendments to the agenda decision addressing the concerns/comments raised by the respondents make the analysis better and clearer to reach the conclusion now.

IFRS IC members spent extensive time commenting on whether IFRS 16:B14(b) should be amended by adding the phrase "throughout the period of use". Since IFRS 16:B14(a) contains such phrasing while IFRS 16:B14(b) does not, some IFRS IC members considered it would be clearer to add whether both conditions have to be met throughout the period of use. These members believed that if there is no such phrase in condition IFRS 16:B14(b), it would bring confusion or give room to apply judgement whether it is required for condition in IFRS 16:B14(b). However, other IFRS IC members were of the view that such amendment is not necessary because it is very clear from the first sentence of IFRS 16:14, which is the overarching principle, that both conditions have to exist throughout the period of use. The conditions in IFRS 16:B14(a)-(b) merely help to evaluate whether such right is substantive. Another IFRS IC member, on the other hand, suggested to take out such phrasing in IFRS 16:B14(a) for consistency.

Another concern shared by several IFRS IC members was over the phrase "every minute of every day" being used to  to explain "throughout the period of use" They considered such phrase is too strong and suggested and the staff agreed to change that phrase to "all the time".

A few IFRS IC members commented that there was not sufficient analysis on why the supplier is considered to have practical ability to substitute the assets (the condition in IFRS 16:B14(a)). The staff responded that such analysis would involve the consideration of more fact and circumstances, which is not the focus of this agenda decision, so it is assumed that the supplier has such practical ability in the agenda decision.

One IFRS IC member agreed with the conclusion of the agenda decision but commented that the analysis is too technical but not focusing on the substance of the arrangement. The commercial substance of the arrangement is that the lessor grants the right to use assets to the lessee and the lessee needs such assets for its operation. The lessor has an obligation rather than a right to substitute the assets to ensure the smooth operation of the lessees. It would be unintuitive not to apply lease accounting due to the different terms of the contract and merely analysing whether the right is substantive. The IFRS IC member would rather use this analysis to arrive at the conclusion that there is a lease.

IFRS IC decision

The IFRS IC decided, by a vote of all, to finalise the agenda decision with some suggested amendments to the text.

Related Topics

Correction list for hyphenation

These words serve as exceptions. Once entered, they are only hyphenated at the specified hyphenation points. Each word should be on a separate line.