The existence of substitution rights may result in the determination that a specific asset has not been identified. If an asset is implicitly specified because the supplier does not have any alternative assets available to fulfill the contract, substitution rights do not exist. If, however, an asset is explicitly specified in a contract, but the supplier has a contractual right to substitute that asset, the entities would need to evaluate the criteria in
ASC 842-10-15-10 to determine if the substitution rights are substantive.
ASC 842-10-15-10
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. A supplier’s right to substitute an asset is substantive only if both of the following conditions exist:
a. The supplier has the practical ability to substitute alternative assets throughout the period of use (for example, the customer cannot prevent the supplier from substituting an asset, and alternative assets are readily available to the supplier or could be sourced by the supplier within a reasonable period of time).
b. The supplier would benefit economically from the exercise of its right to substitute the asset (that is, the economic benefits associated with substituting the asset are expected to exceed the costs associated with substituting the asset).
When both of these criteria are met, the asset is not an identified asset irrespective of whether it is specified in the underlying contract.
Provisions that permit an alternative means for fulfilling a contract under certain circumstances may indicate that the customer does not have the right to use an identified asset. For example, a large manufacturing entity may enter into an agreement with a customer that specifies a particular model of equipment to be used to fulfill the contact. Although the model number is specified, if the manufacturer has several interchangeable pieces of equipment and can use any one of them to satisfy its obligations under the contract, the arrangement may not include an identified asset. Similarly, a contract that permits a supplier to outsource its obligation to deliver a product or service may not meet the identified asset criterion.
As discussed in
ASC 842-10-15-14, a supplier's right to replace a specified asset during the term of an arrangement if it is not working properly or becomes defective is not considered a substantive substitution right (i.e., an identified asset would still exist) and would not by itself preclude the arrangement from being considered a lease. Likewise, a provision that contractually permits or requires a supplier to substitute other assets on or after a specified date does not preclude the arrangement from being considered a lease prior to the substitution date.
Question LG 2-1 discusses how customer approval affects substitution rights.
Question LG 2-1
Is a substitution right that requires customer approval considered substantive?
PwC response
No. A substitution right in a contract that allows substitution only with customer approval is not considered substantive.
Supplier has practical ability to substitute the asset
In addition to having a substitution right, a supplier must have a replacement asset that can perform the functions required under the arrangement. Contractual language is not sufficient alone; the parties to the contract should also consider the practical ability of the supplier to substitute the asset and to execute the substitution within a reasonable amount of time. This evaluation should be performed based on information available at contract inception and should exclude consideration of future events that are not considered likely to occur.
To evaluate whether the supplier has the practical ability to substitute the asset, all relevant factors, such as those discussed below, should be considered together.
- Whether similar assets that can be used to satisfy the arrangement are readily available
- Whether any obstacles to substitution, such as cost or physical feasibility exist (e.g., if the asset is located on the customer’s premises)
Supplier can benefit from exercising substitution right
In addition to having the practical ability to substitute one asset for another, the supplier must also benefit economically from the substitution (e.g., the benefit must exceed the cost of substitution) for it to be considered substantive. A supplier may be able to articulate the benefits of substitution and related costs, and it may even have a history of when substitutions have occurred to help guide its analysis. The customer, on the other hand, is likely to find this assessment more challenging.
For a customer, this analysis is similar to how it might consider the economic factors when evaluating whether purchase and renewal options are reasonably certain. See
LG 3.3.3.1 for information on that analysis. In the case of substitution rights, the analysis primarily considers factors from the supplier’s perspective. Examples of factors to consider include:
- Transportation costs of relocating one asset to a location where it can be used to satisfy the arrangement or to move the output from the production location to the customer
- Foregone production resulting from down time necessary to switch assets and other disruptions to the supplier’s and/or customer’s business
- Costs to convert an asset that may not have produced identical output
- Reduced production costs or increased production volume resulting from a more efficient version of an asset
There is no specific measurement threshold to be met; judgment is required to determine how significant the supplier’s economic benefits should be for the substitution right to be substantive, thereby precluding lease accounting.
Generally, a supplier will be in a better position to determine whether it can benefit from exercising a substitution right, but it may be obvious to a customer that the substitution right benefits the supplier when there is a clear economic incentive and the barriers to substitution are minimal. When the customer does not have adequate transparency to the practicality or economics of supplier substitution rights, it should assume that the substitution right is not substantive and that the arrangement contains an identified asset. When an asset resides on a customer’s premises, a supplier generally does not have a substantive substitution right because the costs and potential disruption would be significant.
Additionally, the assessment as to whether a substitution right is substantive should be based on facts and circumstances that exist at the inception of the contract. Any circumstances that are not likely to occur during the period of use would be disregarded in the analysis. While a supplier may use substitution rights to manage its assets, and historically substitutes assets across its portfolio, the parties should consider whether it is likely that a specific asset will be substituted while in use by a customer. For example, a car rental company that frequently substitutes cars while they are under contract to customers may be unable to support an assertion that substitution of a particular car under rental is likely to occur, because a typical car rental period is short. Thus, it may be difficult to apply an entity-wide assertion that substitution rights are substantive.
Consideration should also be given to whether the future events that might occur are within the supplier’s ability to influence.
ASC 842-10-15-11 discusses future events that, at inception, are not considered likely to occur during the period of use. An example is a provision in a contract that allows the supplier to substitute the asset for new technology when it is available, but the technology is not substantially developed at inception of the contract. This would not be considered a substantive substitution right. Similarly, rights to substitute the asset predicated on government approval, changes in regulations, or expected changes in customers’ usage may not be substantive substitution rights. The analysis is performed at the inception of the arrangement and does not consider hypothetical or contingent changes. Rights that allow for the replacement of certain parts, or the asset as a whole, as a result of loss or wear and tear are not considered substantive substitution rights.
Example LG 2-3 illustrates a substitution rights that is substantive.
EXAMPLE LG 2-3
Supplier with substantive substitution rights
Warehousing Corp owns a large warehouse that can be subdivided into numerous subsections by inserting removable walls. It leases out different portions of storage space to its customers based on their respective needs.
Manufacturing Corp contracts with Warehousing Corp to reserve 1,000 square feet of space to store its excess inventory for a three-year period. The contract states that Manufacturing Corp’s inventory will be stored in a specified location in the warehouse. However, Warehousing Corp has the right to shift Manufacturing Corp’s inventory to another location within its warehouse at its discretion, subject to the requirement to provide 1,000 square feet for the three-year period.
Warehousing Corp frequently reorganizes its space to meet the needs of new contracts. The cost of reallocating space is low compared to the benefits of being able to accommodate as many customers as possible in the warehouse.
Does the contract contain an identified asset?
Analysis
No. While the contract explicitly specifies the location where Manufacturing Corp’s inventory will be stored, the asset is not identified because Warehousing Corp has a substantive substitution right. Warehousing Corp has agreed to provide a specific amount of storage space within its warehouse at a specific location. However, Warehousing Corp has the unilateral right to relocate Manufacturing Corp’s inventory. It would benefit by relocating the customer’s inventory and can do so without significant cost. As such, Warehousing Corp’s substitution rights are considered substantive, and there is not an identified asset.
Example LG 2-4 illustrates a substitution right that is not substantive.
EXAMPLE LG 2-4
Supplier without substantive substitution rights
Warehousing Corp owns a large warehouse that can be subdivided into numerous subsections by inserting removable walls. It leases out different portions of storage space to its customers based on their respective needs.
Manufacturing Corp contracts with Warehousing Corp to reserve 1,000 square feet of space to store its excess inventory for a three-year period. Warehousing Corp has the right to shift Manufacturing Corp’s inventory to another location within its warehouse at its discretion, subject to the requirement to provide 1,000 square feet for the three-year period. However, Manufacturing Corp specified in its contract that its materials must be stored at a specific temperature.
Warehousing Corp frequently reorganizes its space to meet the needs of new contracts; however, Warehousing Corp only has one location in its warehouse with a cooling system capable of maintaining the required temperatures based on the layout of its HVAC system.
Does the contract contain an identified asset?
Analysis
Yes. The asset is identified because Warehousing Corp does not have a substantive substitution right. Warehousing Corp has agreed to provide a specific level of capacity within its warehouse at a specific location within the warehouse and does not have the unilateral right to relocate Manufacturing Corp’s inventory without significant cost of installing additional cooling systems or modifying its HVAC system.
Supplier with a substitute right after a particular date
A supplier’s substitution right is not substantive (and, thus, there could be an identified asset) when a substitution right exists for only a portion of the contract term.
ASC 842-10-15-13 provides guidance on this situation.
ASC 842-10-15-13
If the supplier has a right or an obligation to substitute the asset only on or after either a particular date or the occurrence of a specified event, the supplier does not have the practical ability to substitute alternative assets throughout the period of use.
Example LG 2-5 analyzes a substantive substitution right only after a particular date.
EXAMPLE LG 2-5
Supplier with substitution right after a particular date
Warehousing Corp owns a large warehouse that can be subdivided into numerous subsections by inserting removable walls. It leases different portions of storage space to its customers based on their respective needs.
Manufacturing Corp contracts with Warehousing Corp to reserve 1,000 square feet of space to store its excess inventory for a three-year period. The contract states that Manufacturing Corp’s inventory will be stored in a specified location in the warehouse. Within the first year of the arrangement, Warehousing Corp has the right to move Manufacturing Corp’s inventory to a different 1,000 square foot location within its warehouse at its discretion.
Does Warehousing Corp have a substantive substitution right?
Analysis
The substantive substitution right does not exist throughout the period of use. As such, Manufacturing Corp could have a lease of the warehouse space beginning in year two of the agreement, provided the other criteria are met.
Arrangement term that exceeds the economic life of the identified asset
The term of an arrangement may exceed the economic life of the identified asset. The accounting term of a lease cannot exceed the economic life of the underlying asset subject to the lease. When an arrangement is longer than the economic life of the identified asset, the supplier may be required to use a comparable asset at a future date that may be specified in the arrangement, or at the end of the economic life of the original asset. Such arrangements could include a lease of the first identified asset as well as a forward starting lease of a second asset when the first asset is replaced.