February 6, 2023
IFRS Interpretations Committee Re: Tentative Agenda Decision and comment letters: Definition of a Lease — Substitution Rights (IFRS 16)
Dear Board Members:
The Virginia Society of CPAs (VSCPA) Accounting & Auditing Advisory Committee has reviewed the tentative agenda decision regarding the definition of a lease and substitution rights in accordance with IFRS 16 (“the Request”), issued by the IFRS Interpretations Committee (“the Committee”).
The VSCPA is a leading professional association dedicated to enhancing the success of all CPAs and their profession by communicating information and vision, promoting professionalism, and advocating members’ interests. The VSCPA membership consists of more than 13,000 individual members who actively work in public accounting, private industry, government and education.
The VSCPA discusses its considerations and conclusions regarding the Request below.
Application of the requirements in IFRS 16 to the fact pattern described in the request
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. applying the requirements in paragraphs B14–B18, it is determined 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 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 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.
Tentative Agenda Decision
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.
b. how to assess whether a contract contains a lease applying IFRS 16 when the supplier has particular substitution rights — i.e. 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.
IFRS Interpretations Committee Response
In the fact pattern described in the request, the customer is able to benefit from use of each asset (a battery) together with other resources (a bus) available to it and 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.
In the fact pattern described in the request, each battery is specified. Even if not explicitly specified in the contract, a battery would be implicitly specified at the time it is made available for the customer’s use. Therefore, the Committee observed that, unless the supplier has the substantive right to substitute the battery throughout the period of use, each battery is an identified asset.
In the fact pattern described in the request, the condition in paragraph B14(a) — the supplier has the practical ability to substitute alternative assets throughout the period of use — is assumed to exist. The Committee observed, however, that the condition in paragraph B14(b) does not exist throughout the period of use 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. Those years are part of the period of use. Consequently, the supplier’s substitution right is not substantive throughout the period of use.
Therefore, the Committee concluded that, in the fact pattern described in the request, each battery is an identified asset. To assess whether the contract contains a lease, the customer would then apply the requirements in paragraphs B21–B30 of IFRS 16 to determine whether, throughout the period of use, it has the right to obtain substantially all the economic benefits from use, and direct the use, of each battery.
The Committee concluded that the principles and requirements in IFRS 16 provide an adequate basis for an entity 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.
VSCPA Response
The VSCPA understands there are two questions for consideration in this request.
- Is it appropriate to consider assets as a group or separately when considering whether a contract contains a lease?
- What constitutes a lessor substitution right with economic incentive? Asked another way, what is the bar for economic substance as it pertains to a lessor substitution right?
The VSCPA agrees with the Committee that a lessee should generally consider whether a contract contains a lease at the individual asset level. IFRS 16 considers the unit of account an individual leased asset, so it is most appropriate to consider each battery identified in the Committee’s fact pattern. The VSCPA recognizes that grouping assets together is reasonable if the outcome is not materially different than considering each asset individually, but this analysis must still be performed and considered at the asset level in order to conclude a portfolio approach is acceptable. In the fact pattern, it is clear that each physical battery would be identified when control transfers to the lessee.
The question about substitution rights is more nuanced. Paragraph B14 of IFRS 16 outlines the criteria necessary to conclude a substitution right has economic substance; however, both criteria are subjective and may result in differing conclusions among lessees and lessors. The VSCPA believes that this is intentional, as it’s very difficult to develop a bright-line threshold for economic substance. Looking at the fact pattern and the nature of the leased assets, we have the following assumptions:
- The batteries are presumed to be relatively small, easy to transport, and not requiring of any specially designed equipment to handle and transport.
- The batteries are available from other vendors in a competitive market
- The batteries would not cause any significant damage to the lessee’s assets or incur any significant depreciation in value if substituted.
Item c of the fact pattern concludes that there is no economic substance to the lessor’s substitution rights as they pertain to the batteries for the first three years of each battery’s use by the lessee. After three years, there is the possibility that the substitution rights may have economic substance.
If we assume that the lessor may exercise substitution rights after three years, each battery would still have a three-year lease life during which each battery meets the definition of a leased asset in accordance with IFRS 16. Therefore, the VSCPA believes that the lessee should estimate the probable date on which the lessor may substitute the assets (on an asset-by-asset basis unless the difference between that and on the full contract basis would not be materially different) and record a lease for the period during which the substitution right has no economic substance. For example, if the lessee believes that it is more likely than not that the lessor will substitute the batteries after 3 years, then the lessee should record three-year leases for all batteries to which this belief applies. The leases recorded would then need to be modified if circumstances change, as is otherwise required by IFRS 16. This is, in our opinion, the spirit of Paragraph B14 and of IFRS 16 as a whole.
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The VSCPA appreciates the opportunity to respond to this ED. Please direct any questions or concerns to VSCPA Vice President, Advocacy Emily Walker, CAE, at [email protected] or (804) 612- 9428.
Sincerely,
George Crowell, CPA
2022–2023 Chair
VSCPA Accounting & Auditing Advisory Committee
2022–23 VSCPA Accounting & Auditing Advisory Committee
George Crowell, CPA — Chair
Zach Borgerding, CPA — Vice Chair
Scott Davis, CPA
Tamara Greear, CPA
Josh Keene, CPA
Nick Kinsler, CPA
Daniel Martin, CPA
Michael Phillips, CPA
Chris Smith-Christian, CPA
Charles Valadez, CPA
Natalya Yashina, CPA