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Scope

Question 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

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