The Interpretations Committee IFRS considered an interesting question regarding the classification of a contract as a lease, taking into account two aspects — the presence of more than one underlying asset in the contract and the existence of a specific right of replacement, which means that the supplier has the practical ability to exercise the right of replacement during the term of use but does not directly derive economic benefits from exercising that right.

The issue was examined using a practical case study, in which a company enters into a 10-year contract for the use of 100 identical batteries used in electric buses. The company uses each battery in conjunction with other resources at its disposal (electric buses owned by the company). The supplier may replace these batteries during the term of the contract. At the same time, the supplier must compensate the company for lost revenue or expenses incurred during the replacement. Whether the replacement will be economically beneficial for the supplier is unknown, as it depends both on the amount of compensation payable to the company and on the condition of the battery. However, preliminary calculations indicate that if the battery lasts less than three years, there will be no economic benefits; if it lasts more than three years, economic benefits are possible.

Our readers likely have their own professional opinions on this situation, but we invite you to review the Interpretation Committee’s perspective.

The Committee carefully analyzed both IAS IFRS. 16 “Leases” itself and the guidance on its application, as well as the basis for the conclusions, as a result of which it emphasized that high barriers have been established for the customer to conclude that an identified asset does not exist when the asset is explicitly or implicitly defined. In addition, the Committee emphasized that determining whether the supplier’s right of replacement is significant over the useful life requires the exercise of professional judgment. Citing paragraph B14(a), the Committee notes that “during the useful life” does not mean “every minute of every day during that period.” The Committee considers these conclusions to be fundamental to resolving the issue at hand.

To provide a complete picture, here is an excerpt from IFRS 16, “Lease,” that pertains to our question

B14 Even if an asset is specified, the customer does not have the right to use the identified asset if the supplier has a significant right to replace the asset during the period of use. The supplier’s right to replace the asset is significant if both of the following conditions are met:

(a) the supplier is practically able to replace the asset with alternative assets during its useful life (for example, the customer cannot prevent the supplier from replacing the asset, and the supplier has alternative assets available for replacement or can obtain them within a reasonable time); and

(b) the supplier will derive economic benefits from exercising its right to replace the asset (i.e., the economic benefits associated with replacing the asset are expected to exceed the costs associated with replacing the asset).

On the substance of the matter, the Committee ruled that each battery is an identifiable asset. Even if this is not explicitly stated in the contract, the battery will be implicitly identified at the moment it becomes available for use by the company. Therefore, the company must make a judgment regarding the identification of a lease for each individual battery, including assessing the materiality of the right to replace it as one of the conditions for identifying a lease. This conclusion was based on the fact that the company can derive benefits from each battery separately, along with other available resources, and that each battery is neither highly dependent on nor highly interdependent with the other batteries in the contract.

Regarding the second part of the question, the supplier does, in fact, have the practical ability to replace the batteries throughout the entire period of use. However, the Committee noted that the condition in paragraph B14(b) is not met throughout the entire period of use, since the supplier is not expected to derive economic benefits from exercising its right to replace the battery at least during the first three-year period of use. Although determining the materiality of the supplier’s right to replacement during the period of use requires professional judgment, in the specific situation at hand, it is clear that the supplier’s right to replacement is not material throughout the entire period of use.

Let’s add our own commentary. In other words, the useful life consists of two parts—the first three years (when replacement would not yield economic benefits) and the subsequent years (when replacement may yield economic benefits). And according to the standard, the expected economic benefits associated with the replacement of an asset, which exceed the costs associated with the replacement of the asset, must exist throughout the entire useful life, not just during a portion of it.

Therefore, the Committee concluded that, in the situation under consideration, each battery is an identifiable asset. If the agreement is classified as a lease, the company must, based on the requirements of paragraphs 18–21 of IFRS 16 “Leases,” determine the lease term.

The committee doesn't say so explicitly, but it seems that the reference to the lease term is, to some extent, a hint that this right of replacement might somehow affect the lease term. But, as usual, that’s a whole other story. And it, too, may hold many interesting details ))

Relevant webinars on the topic of the publication:

• IFRS 16 “Lease” for Landlords: Undeservedly Forgotten and Overlooked Innovations
• IFRS 16 “Rent” and COVID-19: Accounting for Concessions with Examples
• Changes to Lease Agreements: Examples—Tracking Modifications at IFRS

© Olena Kharlamova