Definition of a Lease—Substitution Rights (IFRS 16 Leases)

The Committee received a request about how to assess whether a contract contains a lease. The request asked

about:

a. the level at which to evaluate whether a contract contains a lease—by considering each asset separately

or all assets together—when the contract is for the use of more than one similar asset; and

b. how to assess whether a contract contains a lease applying IFRS 16 when the supplier has particular

substitution rights—ie the supplier:

i. has the practical ability to substitute alternative assets throughout the period of use; but

ii. would not benefit economically from the exercise of its right to substitute the asset throughout

the period of use.

period of use; and

b. the right to direct the use of the identified asset throughout the period of use.

The period of use is ‘the total period of time that an asset is used to fulfil a contract with a customer (including

any non-consecutive periods of time)’ (Appendix A to IFRS 16).

Paragraph B12 of IFRS 16 states that ‘an entity shall assess whether a contract contains a lease for each potential

separate lease component’ and directs an entity to paragraph B32 of IFRS 16 for application guidance on separate

lease components. Paragraph B32 specifies that the right to use an underlying asset is a separate lease component

if both:

The first requirement for a contract to meet the definition of a lease is that a customer controls the use of an

identified asset. Paragraphs B13–B20 of IFRS 16 provide application guidance on an identified asset.

Paragraph B13 states that ‘an asset is typically identified by being explicitly specified in a contract. However, an

asset can also be identified by being implicitly specified at the time that the asset is made available for use by the

customer’.

But ‘even if an asset is specified, 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’ (paragraph B14). In that case, the

supplier—rather than the customer—controls the use of the asset. Consequently, there is no identified asset; the

and

b. the supplier would benefit economically from the exercise of its right to substitute the asset (ie the

economic benefits associated with substituting the asset are expected to exceed the costs associated with

substituting the asset).

Paragraph B16 states that ‘an entity’s evaluation of whether a supplier’s substitution right is substantive […]

shall exclude consideration of future events that, at inception of the contract, are not considered likely to occur’.

Paragraphs B15–B18 specify requirements that mean, in each of the following situations, a supplier’s substitution

right is not substantive (or the customer is not precluded from having the right to use an identified asset):

a. the supplier has a right or an obligation to substitute the asset only on or after either a particular date or

Paragraph B17 notes that the costs of substitution are more likely to exceed the associated benefits when the asset

is located at the customer’s premises or elsewhere.

Paragraphs BC112–BC115 of the Basis for Conclusions on IFRS 16 explain the IASB’s rationale in developing

the requirements on substitution rights. Paragraph BC113 states that ‘the IASB’s intention in including [these

requirements] is to differentiate between:

a. substitution rights that result in there being no identified asset because the supplier, rather than the

customer, controls the use of an asset; and

b. substitution rights that do not change the substance or character of the contract because it is not likely, or

practically or economically feasible, for the supplier to exercise those rights’.

customer cannot readily determine whether the supplier has a substantive substitution right. Paragraph BC115

notes:

a. the requirement in paragraph B19 responds to stakeholders concerns that ‘in some cases it would be

difficult, if not impossible, for a customer to determine whether a supplier’s substitution right is

substantive’.

b. ‘if substitution rights are substantive, then the IASB thinks that this would be relatively clear from the

facts and circumstances’.

Consequently, the Committee observed that the requirements in paragraphs B13–B19 set a high hurdle for a

customer to conclude that there is no identified asset when an asset is explicitly or implicitly specified.

In the fact pattern described in the request:

a. 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).

b. 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.

c. 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

The level at which to evaluate whether a contract contains a lease

In the fact pattern described in the request:

available to it; and

b. each battery is neither highly dependent on, nor highly interrelated with, the other batteries in the

contract.

Therefore, the Committee concluded that, in the fact pattern described in the request, applying paragraph B12,

the customer assesses whether the contract contains a lease—including evaluating whether the supplier’s

substitution right is substantive—for each potential separate lease component, ie for each battery.

Identified asset

ability to substitute alternative assets throughout the period of use—is assumed to exist. The Committee

observed, however, that because 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, the condition in paragraph B14(b) does not

exist throughout the period of use. Therefore, the supplier does not have the substantive right to substitute a

battery throughout the period of use. While determining whether a supplier’s substitution right is substantive

throughout the period of use can require judgement, the Committee observed that the facts and circumstances in

this fact pattern are such that it is clear that the supplier’s right is not substantive throughout that period.

The Committee concluded that, in the fact pattern described in the request, each battery is an identified asset. To

to evaluate the level at which to assess whether the contract contains a lease and whether there is an identified

asset in the fact pattern described in the request. Consequently, the Committee decided not to add a standard-

setting project to the work plan.