Agenda Paper 2

Background

The Committee received 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

Staff analysis

From the outreach performed on the first question, most respondents said that the submitted fact pattern is not common in their jurisdictions. Some respondents said supplier substitution rights—different from those described in the submitted fact pattern—are generally common in practice. The two respondents who observed fact patterns similar to the one submitted said they there is diversity in how customers account for such contracts.

For the second question, some respondents said they were aware of different views regarding the level at which to assess whether supplier substitution rights are substantive. Portfolio application, portions of assets and separate lease components approach set out in paragraphs B1, B20 and B32 of IFRS 16 respectively are applied by different entities.

IFRS 16:B13-B19 provide guidance to assess whether the substitution right is substantial to respond to the first question. The staff views this guidance as a high threshold for a customer to conclude that there is no identified asset when an asset is explicitly or implicitly specified. The staff state that a customer must demonstrate that a supplier’s substitution right is substantive—in particular, when the asset is located at the customer’s premises. The staff considered that both conditions in IFRS 16.B14(a)-(b) have to exist throughout the period of use in order to demonstrate the substitution right is substantial.

Some people may hold an alternative view in reading IFRS 16:B13-B19 and considered that the supplier must have the practical ability to substitute alternative assets throughout the period of use (as required in IFRS 16:B14(a)) but only needs to be able to benefit economically from exercising its substitution right at some point during the period of use. Therefore, the substitution right in the fact pattern is substantial and there is no identified asset. However, the staff disagrees with this view because the substitution right is not substantive throughout the period of use given the supplier would not benefit economically from exercising its right in the first three years of the contract. They were of the view that IFRS 16:B14 requires such a right to be in existence throughout the period of use, which is not the case in the fact pattern. Furthermore, IFRS 16:BC112 reiterates that the supplier controls the use of an asset if it can substitute the asset throughout the period of use. It would be inappropriate to imply that there is no lease if the supplier has the substantive right to substitute the asset for any part of the contract term. In view of these considerations, the staff concluded that there is an identified asset in the fact pattern submitted because the asset is specified and the supplier’s substitution right is not substantive throughout the period of use.

IFRS 16:B12 requires an entity to assess whether a contract contains a lease for each potential “separate lease component” and IFRS 16:B32 provides guidance on the identification of separate lease components. Applying these to the second question, the contract in the fact pattern is for the use of 100 similar assets (i.e. batteries used in electric buses). The customer is able to benefit from use of each battery together with other resources (i.e. a bus) available to it and each battery is neither highly dependent on, nor highly interrelated with, the other batteries in the contract. The staff thus concluded that, the customer assesses whether the contract contains a lease—including evaluating whether the supplier’s substitution right is substantive—for each asset.

Staff recommendation

The staff recommended that the Committee do not add a standard-setting project to its agenda and instead publish a tentative agenda decision that outlines the applicable requirements in IFRS 16 and how a customer applies those requirements in the submitted fact pattern.

IFRS IC discussion

There was a lively debate and Committee members contributed meaningful suggestions on how the agenda decision should be drafted to articulate the principle or objective in IFRS 16 for assessing whether there is a substantive substitution right and deliver educational guidance. Committee members generally agreed with the conclusion that the contract contains a lease in the fact pattern submitted but had various comments on the analysis in the agenda decision to get to that conclusion.

Some of the Committee members were not convinced that both of the criteria in IFRS 16:B14(a)-(b) have to exist “throughout the period of use” because such phrase only appears in (a) but not in (b) of IFRS 16:B14. There was no much guidance as to whether the condition in (b) of IFRS 16:B14 is met if the economic benefit exists at some points in time. A number of Committee members agreed with this and added that it was the analysis of the factors in IFRS 16:B15-B19 that helps to conclude or support in assessing whether the supplier has control over the assets. For example, if the batteries are kept on the premises of the customer and there is a practicability issue in replacing them as indicated by IFRS 16:B17. In that case, the replacement is maintenance which does not preclude the customer from having the right of use as indicated in IFRS 16:B18 and the substitution right is not obvious as indicated in IFRS 16:B19. It follows that there is a substantive substitution right applying IFRS 16:B14. Committee members commented that instead of singling out IFRS 16:B14, the staff should have laid out the thought process and taken into consideration the factors in IFRS 16:B15-B19 collectively in order to arrive at its conclusion in the agenda decision.

Most of the Committee members said that the agenda decision may result in a misunderstanding that the condition in IFRS 16:B14(b) has to exist during every single moment of the period of use. Some Committee members said it would be useful to use the example in IFRS 16:BC115 to illustrate a scenario in which the economic benefit only exists during a period that is too short (in the example, 6 months out of 15 years of lease). One Committee member said that if the economic benefit exists during the majority of the lease term, the conclusion may be different. Therefore, these Committee members said that judgement is required to determine whether the benefit exits “throughout the period of use” instead of the benefit having to exist at every single moment. They suggested to explain this in the agenda decision.

One Committee member pointed out that the first sentence of IFRS 16:B16 states that “… a customer does  not have the right to use an identified asset if the supplier has the substantive right to substitute the asset throughout the period of use.” He believes that this should be read as both conditions in IFRS 16:B14(a)-(b) need to exist “throughout the period of use” because the conditions help determining whether the right is substantive.

Some Committee members, on the other hand, doubted whether the condition in IFRS 16:B14(a) is met given the batteries are kept on the customer’s premises and it is the customer who control where the buses go. It looks like the supplier may not have the practical ability to substitute when the customer controls where the batteries are.

The staff clarified that when the IASB developed IFRS 16, it intentionally set a high hurdle for “substantive” substitution rights to be met. The first paragraph of IFRS 16:B14 fits the objective of the IASB by saying that the right has to be “throughout the period of use” and IFRS 16:B19 says that if the right is not obviously substantive, the entity should assume that it is not. It is not surprising that the conclusion is that the substitution right is not substantial in the fact pattern submitted given the right is not obviously substantive. Having said that, staff agreed with the Committee members’ comments on the analysis, and will amend the drafting of the agenda decision to walk through the thought process with consideration of the factors in IFRS 16:B15-19 instead of focusing on IFRS 16:B14 only. 

Only a few Committee members commented on the unit of account. They generally agreed with the conclusion and the analysis in the agenda paper that the unit of account is a single battery. Only one Committee member said she believes the unit of account should be the entire contract. The staff explained that the unit of account does not depend on how the entity manages or runs its business.

IFRS IC decision

10 out of 14 Committee members agreed with the conclusion that the contract contains a lease and all Committee members agreed that the unit of account is the single battery. The staff will amend the drafting of the tentative agenda decision before it is published.