When is an asset identified is an important question in accounting for IFRS 16 Leases.
Even if an asset is specified, a customer does not have the right to use an identified asset if, at inception of the contract, a supplier has the substantive right to substitute the asset throughout the period of use (i.e., the total period of time that an asset is used to fulfil a contract with a customer, including the sum of any non-consecutive periods of time). When is an asset identified?
A substitution right is substantive if the supplier has the practical ability to substitute alternative assets throughout the period of use and the supplier would benefit economically from exercising its right to substitute the asset. When is an asset identified?
In many cases, it will be clear that the supplier will not benefit from the exercise of a substitution right because of the costs associated with substituting an asset. The physical location of the asset may affect the costs associated with substituting an asset. For example, if an asset is located at the customer’s premises, the cost associated with substituting it is generally higher than the cost of substituting a similar asset located at the supplier’s premises. However, simply because a supplier concludes that the cost of substitution is not significant does not automatically mean that it would economically benefit from the right of substitution. When is an asset identified?
Substantive supplier’s substitution right
IFRS 16 further clarifies that a customer should presume that a supplier’s substitution right is not substantive when the customer cannot readily determine whether the supplier has a substantive substitution right.
Contract terms that allow or require a supplier to substitute alternative assets only when the underlying asset is not operating properly (e.g., a normal warranty provision) or when a technical upgrade becomes available do not create a substantive substitution right. When is an asset identified?
Specific substitution rights
A supplier’s right or obligation to substitute alternative assets only on or after a particular date or the occurrence of a specified event also does not create a substantive substitution right because the supplier does not have the practical ability to substitute alternative assets throughout the period of use. When is an asset identified?
Variety of supply arrangements
Consumer products entities and retailers enter into a variety of supply arrangements that will need to be evaluated to determine whether they involve the use of an identified asset. For example, some contract manufacturing arrangements require the use of an explicitly or implicitly specified asset (e.g., an entire facility) or involve the use of a portion of a larger asset (e.g., a production line within a facility). In other situations, logistics service providers store goods for customers and the location of the warehouse is not explicitly specified in the arrangement. When is an asset identified?
This is because the customer is only concerned with the specific service level (e.g., delivery time) provided by the logistics service provider and not where the goods are physically stored. However, once a particular warehouse is used (i.e., the asset is identified), it may not be practicable for the logistics service provider to move the customer’s goods to another warehouse and simultaneously retain the agreed performance level (e.g., delivery time).
Even if the arrangement specifies an asset, consumer products and retail entities will also need to carefully evaluate whether the supplier has substantive substitution rights (i.e., whether, throughout the period of use, it can practically use another production line to make the product or it can move the customer’s goods to another location and economically benefit from doing so) to determine if there is an identified asset subject to lease accounting.
See also: The IFRS Foundation