Identified asset – 2 Complete with comprehensive examples

Identified asset

a term from IFRS 16 Leases. Let’s see what it is all about….

A lease is a contract, or part of a contract, that conveys the right to use an asset (the underlying asset) for a period of time in exchange for consideration.

The key factors to consider when applying the lease definition are as follows.

Identified asset

1. Specified asset

An asset can be either explicitly specified in a contract (e.g. by a serial number or a specified floor of a building) or implicitly specified at the time it is made available for use by the customer. (IFRS 16.B13, IFRS 16.BC111)

Food for thought – What does ‘implicitly specified’ mean?

An asset is implicitly specified if the facts and circumstances indicate that the supplier can fulfil its obligations only by using a specific asset. This may be the case if the supplier has only one asset that can fulfil the contract. For example, a power plant may be an implicitly specified asset in a power purchase contract if the customer’s facility is in a remote location with no access to the grid, such that the supplier cannot buy the required energy in the market or generate it from an alternative power plant.

In other cases, an asset may be implicitly specified if the supplier owns a number of assets with the required functionality, but only one of those assets can realistically be supplied to the customer within the contracted time-frame – i.e. the supplier does not have a substantive right to substitute an alternative asset to fulfil the contract – see 3.3. For example, a supplier may own a fleet of vessels but only one vessel that is in the required geographic area and not already being used by other customers.

1.1 Capacity portions

A capacity portion of an asset can be an identified asset if: (IFRS 16.B20)

  • it is physically distinct (e.g. a floor of a building, a specified strand of a fibre-optic cable or a distinct segment of a pipeline); or
  • it is not physically distinct, but the customer has the right to receive substantially all of the capacity of the asset (e.g. a capacity portion of a fibre-optic cable that is not physically distinct but represents substantially all of the capacity of the cable).

Case – Identified asset: Capacity portion is not an identified asset

Customer D enters into an arrangement with Supplier E for the right to store its gas in E’s specified storage tank. The storage tank has no separate compartments. At inception of the contract, D has the right to use up to 60% of the capacity of the storage tank throughout the term of the contract. E can use the other 40% of the storage tank as it sees fit.

E has no substitution rights. However, the arrangement allows E to store gas from other customers in the same storage tank.

Identified asset

In this scenario, there is no identified asset. This is because D only has rights to 60% of the storage tank’s capacity and that capacity portion is not physically distinct – i.e. is not physically separated – from the remainder of the tank, and does not represent substantially all of the capacity of the storage tank.

Case – Identified asset: Capacity portion is an identified asset

Customer C enters into an arrangement with Supplier S for the right to store its products in a specified storage warehouse. Within this storage warehouse, rooms V, W and X are contractually allocated to C for its exclusive use. S has no substitution rights. Rooms V, W and X represent 60% of the warehouse’s total storage capacity.

Identified asset

In this example, there is an identified asset. This is because:

  • the rooms are explicitly specified in the contract;
  • the rooms are physically distinct from the other storage locations within the warehouse; and
  • S has no (substantive) substitution rights.

Food for thought – Does ‘substantially all’ of the capacity of an asset mean 90 percent?

Not necessarily. IFRS 16 does not define what is meant by ‘substantially all’ in the context of the definition of a lease.

IFRS 16 uses the same phrase in one of the criteria used by the lessor to determine lease classification: whether the present value of the lease payments (including the residual value guaranteed by the lessee or a third party) equals or exceeds substantially all of the fair value of the asset.

US GAAP allows but does not require the use of a threshold of 90 percent for ‘substantially all’ when a lessor is determining classification. In our view, although the 90 percent threshold may provide a useful reference point, it does not represent a bright-line or automatic cut-off point under IFRS Standards.

For the purpose of applying the lease definition, a company should develop an interpretation of ‘substantially all’ and apply it on a consistent basis.

1.2 Substantive supplier substitution rights

Even if an asset is specified in a contract, a customer does not control the use of an identified asset if the supplier has a substantive right to substitute the asset for an alternative asset. Such a right exists if the supplier: (IFRS 16.B14)

  • has the practical ability to substitute the asset throughout the period of use; and
  • would benefit economically from exercising its right to substitute the asset.

A supplier’s right or obligation to substitute the asset for repairs and maintenance, because the asset is not working properly – i.e. a ‘warranty-type’ obligation – or because a technical upgrade becomes available, is not a substantive substitution right. (IFRS 16.B18)

A supplier has the practical ability to substitute alternative assets when the customer cannot prevent it from substituting the asset and the supplier has alternative assets either readily available or available within a reasonable period of time. (IFRS 16.B14(a))

However, there is no practical ability to substitute the asset throughout the period of use (and therefore there is no substantive substitution right) if the substitution right applies, for example, only: (IFRS 16.B15)

  • to a part of the period of use or at or after a specific date; or
  • on the occurrence of a particular event.

The ‘period of use’ (IFRS 16 Definition) 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).

A supplier would benefit economically from the exercise of its right to substitute the asset when the economic benefits associated with substituting the asset are expected to exceed the related costs. (IFRS 16.B14(b))

The costs associated with substitution are generally higher if the asset is not located at the supplier’s premises – i.e. when it is at the customer’s premises or elsewhere. In this situation, the costs are more likely to exceed the benefits associated with substituting the asset. (IFRS 16.B17)

Case – Identified asset: Substantive substitution right

Customer L enters into a five-year contract with Freight Carrier M for the use of rail cars from M to transport a specified quantity of goods. M uses rail cars of a particular specification, and has a large pool of similar rail cars that can be used to fulfil the requirements of the contract.

The rail cars and engines are stored at M’s premises when they are not being used to transport goods. The costs associated with substituting the rail cars are minimal for M.

Relevant experience demonstrates that:

  • M benefits economically from being able to deploy alternative assets as necessary to fulfil its contracts with customers; and
  • the conditions that make substitution economically beneficial are likely to continue throughout the period of use.

In this case, because the rail cars are stored at M’s premises, it has a large pool of similar rail cars and substitution costs are minimal, M has the practical ability to substitute the assets – i.e. the rail cars are not implicitly specified. In addition, the substitution is economically beneficial to M throughout the period of use. Therefore, M’s substitution rights are substantive and the arrangement does not contain a lease.

Case – Identified asset: No substantive substitution right

Customer L enters into an eight-year contract with Supplier K that requires K to install and maintain specific lighting equipment at L’s stores. The equipment is designed and selected by K, subject to L’s approval. K has an option to upgrade the equipment for future technological advancements and an obligation to replace any damaged or defective equipment.

However, the equipment is large and costly to transport and install. Therefore, it is not economically feasible or practicable for K to substitute alternative assets once the equipment is installed – i.e. the costs of substitution would exceed the benefits.

Therefore, the substitution rights are not substantive and so fulfilment of the arrangement is dependent on the use of identified assets.

Case – Supplier’s substitution right does not apply throughout the period of use

(IFRS 16.B14–B15)

Scenario 1

Customer S enters into a contract with Supplier T for the right to use a motor vehicle for five years. T has the right to substitute the asset at any time after three years from the commencement of the contract (i.e. no substitution right for the first three years).

Because the supplier’s substitution right does not apply throughout the period of use, it is not substantive.

Scenario 2

The contract is the same as above except that it gives T the right to substitute the identified asset on a single date, three years into the lease, but not at any other time.

The substitution right is not substantive because it does not apply throughout the period of use.

Scenario 3

The contract is as above but T has a right to substitute on the occurrence of a particular event.

The substitution right is not substantive because it does not apply throughout the period of use but only on the occurrence of a particular event.

Food for thought – How do you evaluate whether the supplier would benefit economically from exercising its substitution rights and what should a customer do if it cannot assess whether a substitution right is substantive?

Judgement will be required to evaluate when the economic benefits associated with substituting the asset are expected to exceed the costs associated with doing so.

Examples of factors to consider include:

  • the availability of other assets to fulfil the contract;
  • the alternative use of the asset and additional benefits for the supplier;
  • the costs that would be incurred to substitute the asset (e.g. costs of relocation, disruption of activity during a period of time); and
  • the feasibility of substituting the asset (because of size, remote location etc).

Because the analysis is performed from the supplier’s perspective, it is more difficult for the customer to determine whether the supplier’s substitution right is substantive.

Many of the factors that influence whether a substitution right is substantive are specific to the supplier – e.g. whether the supplier has access to alternative assets, the costs involved in substitution etc. The customer may not have access to this information. (IFRS 16.B19, IFRS 16.BC115)

If a customer cannot readily determine whether a supplier has a substantive substitution right, then the customer should presume that any substitution right is not substantive.

Food for thought – When and how does a company assess whether substitution rights are substantive?

A company assesses whether substitution rights are substantive at inception of the contract. At that time, the company considers all of the facts and circumstances, but not future events that are not likely to occur. For example, it excludes the following future events: (IFRS 16.B16)

  • an agreement by a future customer to pay an above-market rate for use of the asset;
  • the introduction of new technology that is not substantially developed at inception of the contract;
  • a substantial difference between the customer’s use of the asset, or the performance of the asset, and the use or performance considered likely at inception of the contract; or
  • a substantial difference between the market price of the asset during the period of use and the market price considered likely at inception of the contract.

2. Economic benefits from using the asset

To determine whether a contract conveys the right to control the use of an identified asset, a company assesses whether the customer has the rights to: (IFRS 16.B9)

  • obtain substantially all of the economic benefits from use of the identified asset throughout the period of use; and
  • direct the use of the identified asset throughout the period of use (see Section 4.4).

The economic benefits from using an asset include its primary output, by-products and other economic benefits from using the asset that could be realised from a commercial transaction with a third party (e.g. sub-leasing the asset). The benefits derived from ownership of the asset (e.g. income tax credits) are excluded from the analysis. (IFRS 16.B21, IFRS 16.BC118)

A company considers the economic benefits that are in the defined scope of the right to use the asset – e.g. if a contract limits the use of a vehicle to only one particular territory during the period of use, then the company considers only the economic benefits from use of the vehicle within that territory, and not beyond. (IFRS 16.B22)

Case – Economic benefits: Primary products and by-products

Utility Company C enters into a 20-year contract with Power Company D to purchase all of the electricity produced by a new solar farm. D owns the solar farm and will receive tax credits relating to the construction and ownership of the solar farm, and C will receive renewable energy credits that accrue from use of the solar farm. (IFRS 16.IE2, Ex9)

C has the right to obtain substantially all of the economic benefits from use of the solar farm over the 20-year period because it obtains:

  • the electricity produced by the farm over the lease term: i.e. the primary product from use of the asset; and
  • the renewable energy credits: i.e. the by-product from use of the asset.

Although D receives economic benefits from the solar farm in the form of tax credits, these economic benefits relate to the ownership of the solar farm. The tax credits do not relate to the use of the solar farm and therefore are not considered in this assessment.

Case – Sub-letting

Customer C enters into a contract to use an office. Because C does not need all of the space covered by the contract, it sub-lets 25%. C receives substantially all of the economic benefits through its own use and sub-letting (other benefits). (IFRS 16.B21)

Case – Sharing the economic benefits

Customer G enters into a two-year contract to use a business jet. G shares access and use of the business jet with another party. Both parties have the right to use the jet at any point in time, subject to a certain number of hours per month and the other party not using it at the same time. G does not receive substantially all of the economic benefits because it shares the use of the asset with another party. (IFRS 16.B22)

Food for thought – How does a company evaluate whether a customer has the right to substantially all of the economic benefits from use of an asset?

Evaluating whether a customer has the right to obtain substantially all of the economic benefits from use of an asset throughout the period of use is straightforward in many situations, generally because the customer in a lease frequently has exclusive use of the asset.

However, in some situations a contract may provide a party other than the customer the right to more than a minor amount of the economic benefits from use of the same asset. In evaluating whether the customer has the right to obtain substantially all of the economic benefits from use of an asset, a company considers the complete population of economic benefits that can be derived from the asset in the scope of the customer’s right to use.

Food for thought – Are tax credits and similar items ‘economic benefits’ for the purpose of applying the lease definition?

It depends on whether the benefits arise from ownership or use of the asset. (IFRS 16.BC118)

A lease conveys a right to use the underlying asset. Accordingly, the benefits derived from ownership of the asset (e.g. income tax credits) are excluded when considering whether a customer has the right to obtain substantially all of the economic benefits from use of the identified asset throughout the period of use.

Conversely, benefits such as renewable energy credits received from use of the asset are more akin to a by-product and so will be included in the analysis of economic benefits.

IFRS 16 includes specific guidance in this area and has the potential to bring consistency in assessing whether an arrangement contains a lease. However, given the variety of arrangements seen in practice, and the complex structures sometimes used to allocate specific forms of benefits to different parties, judgemental issues still remain in practice.

Food for thought – Can a customer obtain substantially all of the benefits from use even if lease payments are variable?

Yes. The existence of variable lease payments derived from the use of an asset – e.g. a percentage of sales from use of a retail space – does not prevent a customer from having the right to obtain substantially all of the economic benefits from use of the asset. In these cases, although the customer passes on certain benefits to the supplier, the customer receives the cash flows arising from use of the asset. (IFRS 16.B23)

For example, Customer D enters into a contract to use a retail store. The rent payments include a fixed amount per month plus 20 percent of the retail revenue generated from the store. D receives substantially all of the economic benefits: the gross proceeds accrue to D. Sharing a part of the revenues generated from the store (or, generally, usage-based rentals) does not prevent a contract from being a lease.

3. Right to direct the use

A customer has the right to direct the use of an identified asset in either of the following situations: (IFRS 16.B24)

  • the customer has the right to direct how and for what purpose the asset is used throughout the period of use (see 3.2); or
  • the relevant decisions about how and for what purpose the asset is used are predetermined and either:
  • the customer has the right to operate the asset (or to direct others to operate the asset in a manner that it determines) throughout the period of use, without the supplier having the right to change those operating instructions; or
  • the customer designed the asset (or specific aspects of the asset) in a way that predetermines how and for what purpose the asset will be used throughout the period of use (see 3.3).

The following diagram summarises the assessment of the right to direct the use (last part of the first diagram on this page).

Identified asset* if other criteria are met (see 3.1 below)

Food for thought – How are decision-making rights evaluated?

IFRS 16 effectively requires a threefold classification of decision-making rights into the following categories, which feature in the analysis in different ways.

  • How and for what purpose’ (or relevant) decisions: Unless they are predetermined, these determine whether the arrangement contains a lease (see 3.1–2).
  • Operating decisions: These are ignored, unless the ‘how and for what purpose’ decisions are predetermined, in which case there is a lease if the customer makes the operating decisions and the other criteria for a lease are met (see 3.3).
  • Protective rights: These typically define the scope of the customer’s right to use an asset but do not, in isolation, preclude a conclusion that there is a lease. However, when protective rights are too restrictive for the customer to have any substantive decision-making authority over the use of the asset, this could indicate that the how and for what purpose decisions are predetermined (see 3.4).

Assessing the categories into which decisions fall is a key area of judgement in practice.

3.1 How and for what purpose decisions

In assessing who has the right to direct how and for what purpose the asset is used, a company considers the decision-making rights that are most relevant to changing how and for what purpose the asset is used. Decision-making rights are ‘relevant’ when they affect the economic benefits derived from use. (IFRS 16.B25)

Examples of relevant decisions that, depending on the circumstances, grant the right to change how and for what purpose the asset is used include the following. (IFRS 16.B26)

  • What: rights to change the type of output that is produced by the asset – e.g. deciding whether to use a shipping container to transport goods or for storage.
  • When: rights to change when the output is produced – e.g. deciding when a power plant will generate power.
  • Where: rights to change where the output is produced – e.g. deciding on the destination of a truck or a ship.
  • Whether and how much: rights to change whether the output is produced, and the quantity of that output – e.g. deciding whether to produce energy from a power plant and how much energy.

Examples of decision-making rights that do not grant the right to change how and for what purpose the asset is used include: rights to operate an asset, rights to maintain an asset or rights to take output that has already been produced.

However, rights to operate an asset drive the analysis if the relevant decisions about how and for what purpose the asset is used are predetermined (see 3.3). (IFRS 16.B27, IFRS 16.B29)

Case – Right to direct the use: Decision to take output

Customer M enters into a 20-year contract with Supplier S, a solar developer, to install, operate and maintain a solar plant on M’s facility. The solar plant has been designed by S to fulfil M’s energy demand. M has the right to purchase any energy produced and S has the obligation to sell the energy to M whenever M wants to purchase it. Energy that is not purchased by M is sold into the grid – i.e. M has no obligation to purchase energy.

In this example, M’s decision about whether to purchase the electricity from the solar plant affects only to whom the existing output is directed (to M or the grid). It does not affect when, where, whether or how much energy is produced.

Therefore, it is not a how and for what purpose decision.

3.2 Determining who makes the how and for what purpose decisions

A company has the right to direct how and for what purpose the asset is used if, in the scope of its rights of use defined in the contract, it can change how and for what purpose the asset is used throughout the period of use (see 3.1). (IFRS 16.B25)

In assessing whether a company has the right to direct the use of an asset, only the rights to make decisions about the asset’s use during the period of use are considered. Decisions that are predetermined before the period of use – i.e. commencement date – are not considered. (IFRS 16.B29)

Case – Right to direct the use: How and for what purpose decisions

Customer T enters into a five-year contract with Supplier U, a ship owner, for the use of an identified ship. T decides whether and what cargo will be transported, and when and to which ports the ship will sail throughout the period of use, subject to restrictions specified in the contract.

These restrictions prevent T from sailing the ship into waters at a high risk of piracy or carrying explosive materials as cargo. U operates and maintains the ship, and is responsible for safe passage. (IFRS 16.IE2.Ex6B)

T has the right to direct the use of the ship. The contractual restrictions are protective rights that protect U’s investment in the ship and its personnel (see 3.4).

In the scope of its right of use, T determines how and for what purpose the ship is used throughout the five-year period because it decides whether, where and when the ship sails, as well as deciding the cargo that it will transport.

T has the right to change these decisions throughout the period of use. Therefore, in this example the contract contains a lease.

Food for thought – How is an arrangement analysed when the customer and the supplier each make some of the how and for what purpose decisions?

A company does not have to take all of the how and for what purpose decisions in order to have the right to direct the use of the asset – the decisions can be allocated between the parties. Judgement is required to assess the individual significance of the different how and for what purpose decisions – i.e. their impact on the economic benefits.

If some decisions have greater significance than others, then the party that makes the more significant decisions generally directs the right to use the asset.

For example, Retailer T enters into a contract with Landlord L to use a specific retail unit for a five-year period. The unit is part of a larger retail space with many retail units. The contract requires T to use the unit to operate its well-known store brand to sell its goods during the hours when the larger retail space is open.

L can make reasonable changes to the opening hours of the larger retail space. T decides on the mix of goods sold from the unit, their pricing and the quantity of inventory held. (IFRS 16.IE2.Ex4)

In this example, there are a number of how and for what purpose decisions that are not predetermined. L can make reasonable changes to the opening hours.

However, by deciding the mix of goods, their pricing and available quantities, T makes the decisions that will have a more significant impact on the economic benefits derived from the unit. Therefore, it is T that directs the right to use the unit.

3.3 How and for what purpose decisions are predetermined

The decisions about how and for what purpose the asset is used can be predetermined in a number of different ways.

They could, for example, be agreed between the customer and the supplier in negotiating the contract, with neither party being able to change them after the commencement date, or they could, in effect, be predetermined by the design of the asset. However, situations in which all how and for what purpose decisions are predetermined are likely to be rare. (IFRS 16.B24, IFRS 16.BC121)

As mentioned in Right to direct the use above, when the relevant decisions about how and for what purpose the asset is used are predetermined, the customer has the right to control the use of an identified asset when either:

  • the customer has the right to operate the asset; or
  • the customer designed the asset.

Case – Right to direct the use: Predetermined decisions

Customer R enters into a contract with Supplier S, a ship owner, for the transport of cargo from A Coruña to Hartlepool on an identified ship. The contract details the cargo to be transported on the ship and the dates of pick-up and delivery.

The cargo will occupy substantially all of the capacity of the ship. S operates and maintains the ship and is responsible for the safe passage of the cargo on board the ship. R is prohibited from hiring another operator for the ship during the term of the contract or operating the ship itself. (IFRS 16.IE2, Ex6A)

R does not have the right to control the use of the ship because it does not have the right to direct its use. R does not have the right to direct how and for what purpose the ship is used; these decisions are predetermined in the contract – i.e. the journey from A Coruña to Hartlepool transporting specified cargo within a specified time frame.

R does not have the right to operate the ship and did not design the ship in a way that predetermined how and for what purpose it would be used. R has the same rights over the use of the ship as if it were only one of many customers transporting cargo on the ship. Therefore, the contract does not contain a lease.

Case – Right to direct the use: Predetermined decisions: Customer designed the asset

Customer C enters into a 20-year contract with Energy Supplier E to install, operate and maintain a solar plant for C’s energy supply. C designed the solar plant before it was constructed – C hired experts in solar energy to help in determining the location of the plant and the engineering of the equipment to be used. C has the exclusive right to receive and the obligation to take all energy produced. (IFRS 16.IE2.Ex9A)

In this example, the nature of the solar plant is such that all of the decisions about how and for what purpose the asset is used are predetermined because:

  • the type of output (i.e. energy) and the production location are predetermined in the agreement; and
  • when, whether and how much energy is produced is influenced by the sunlight and the design of the solar plant.

Because C designed the solar plant and thereby programmed into it any decisions about how and for what purpose it is used, C is considered to have the right to direct the use. Although regular maintenance of the solar plant may increase the efficiency of the solar panels, it does not give E the right to direct how and for what purpose the solar plant is used.

Food for thought – What happens if only some of the how and for what purpose decisions are predetermined?

In some cases, many, but not all, of the decisions about how and for what purpose an asset is used are predetermined in the contract. However, the customer has the right to make the remaining relevant decisions. In these cases, a question arises over whether the customer has the right to direct how and for what purpose the asset is used throughout the period of use. (IFRS 16.B24(a), IFRS 16.B29)

The IFRS Interpretations Committee discussed this question in the context of a shipping contract and observed that because not all of the relevant decisions about how and for what purpose the ship is used are predetermined, the customer applies IFRS 16.B24(a) and assesses whether it has the right to direct how and for what purpose the asset is used. That is, when some but not all of the relevant decisions are predetermined, the assessment of whether the customer has the right to direct the use of the ship focuses on the relevant decisions that are not predetermined.

3.4 Supplier’s protective rights

A contract may include certain terms and conditions designed to protect the supplier’s interest in the identified asset or other assets, to protect its personnel or to ensure the supplier’s compliance with laws or regulations. These protective rights typically define the scope of the right to use an asset but do not, in isolation, prevent the customer from having the right to direct the use of the asset within that scope. (IFRS 16.B30)

For example, a contract may: (IFRS 16.B30)

  • specify the maximum amount of use of an asset or where or when the customer can use the asset;
  • require a customer to follow particular operating practices; or
  • require a customer to inform the supplier of changes in how an asset will be used.

Case – Protective rights: Scope of right of use

Customer L enters into a two-year contract with Supplier M, an aircraft owner, for the use of an identified aircraft. The contract details the interior and exterior specifications for the aircraft. It also contains contractual and legal restrictions on where the aircraft can fly.

Subject to these restrictions, L determines where and when the aircraft will fly, and which passengers and cargo will be transported on it. M is responsible for operating the aircraft, using its own crew. (IFRS 16.IE2.Ex7)

The restrictions on where the aircraft can fly define the scope of L’s right to use the aircraft. In the scope of its right of use, L determines how and for what purpose the aircraft is used throughout the two-year period of use because it decides whether, where and when the aircraft travels, as well as deciding the passengers and cargo that it will transport. L has the right to change these decisions throughout the period of use.

The contractual and legal restrictions on where the aircraft can fly are protective rights and do not prevent L from having the right to direct the use of the aircraft.

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