While the effective date of the new lease standards for domestic public companies, international companies, and governmental organizations has already passed, private companies are still in the weeds of the lease accounting transition. Given the timing of year-end, many governmental entities may also still be tackling implementation of the new lease standard, GASB 87. Each standard has its own set of challenges, but there’s one aspect of all of the guidelines that is especially challenging — the identification of embedded leases.
What is an embedded lease?
An embedded lease is a lease agreement that exists within a contract. A lease is defined as a contract that conveys the right to control the identified asset for a period of time in exchange for consideration. For evaluation purposes, two of the most important elements of that definition to consider are if the contract contains an identified asset and, if the right to “control” that asset is determined by the lessee. Because the lease is embedded in another contract, it is fairly common that these arrangements have historically not been accounted for as leases, especially if the management of the contract has been handled within a department/AP versus review by the Accounting department. Properly identifying the embedded lease agreements can be like a scavenger hunt, and many organizations fail to recognize that service contracts often contain embedded leases.
Unfortunately, it’s not as simple as doing a “CTRL+F” search on all of your contracts for the words “lease” or “rent.” We’ll walk you through how to identify embedded lease agreements and what you need to do to properly address them.
Which organizations are typically impacted?
Organizations that typically have service contracts often have embedded leases. In today’s environment, this means that most companies or organizations are impacted.
How the new guidelines impact embedded leases
Under legacy lease accounting guidance, service contracts that contained embedded leases were often treated the same as service contracts without an embedded lease. This is because there often was not a P&L impact difference, and so companies did not identify and separately account for service contracts and operating leases separately.
To avoid material misstatements under the new lease accounting rules, it is important for organizations to identify whether service contracts contain a lease. If so, they must bifurcate the contract into lease and non-lease components. This could have a significant impact on the balance sheet now that organizations are required to capture an ROU asset and corresponding lease liability. The organization would then recognize the lease component of the embedded lease.
What are the common misconceptions?
The FASB included a practical expedient within ASC 842 that if selected, allows organizations the opportunity to not re-address its determination of a lease contract. This allows organizations the opportunity to not re-evaluate its population of identified leases contracts. However, there is a very big caveat — errors are not grandfathered. Essentially, if your organization selects this practical expedient, you do not need to re-evaluate your identified lease agreements under the definition of ASC 842, as long as the identification of a lease under ASC 840 was complete and there are no errors. This means that the embedded leases should have been properly identified and accounted for under ASC 840. The issue is how do you know there are no errors without reviewing all your service contracts?
As we mentioned above, given the similarity in the P&L treatment for operating leases and service contracts, embedded lease identification has historically been lax at many organizations. Therefore, organizations must do a comprehensive review of their service contracts to ensure they have a complete record of their embedded leases. The risks of failing to properly record them are too high.
How to identify embedded leases
To identify embedded leases, the first thing your organization should do is determine if there is an identified asset within the contract. Identification can be explicit or implicit.
Explicit identification is when the underlying asset is actually identified in the service contract. For instance, a transportation service contract may require the supplier of the service to use Truck # 3340 to deliver the customer’s goods.
On the other hand, an asset is implicitly identified when the only way the supplier can satisfy their obligations under the contract is to utilize that asset. For instance, a transportation service contract may require the supplier of the service to move the customer’s goods, however, the supplier has only one truck. In order to satisfy its obligations under the contract, the supplier must use that truck. As a result, the truck is implicitly identified.
When evaluating if there is an identified asset, governmental organizations should consider that GASB 87 indicates that lease agreements can have interruptions in usage. An organization only has to obtain the present service capacity during the period of use, not uninterrupted control of the asset. For example, if your organization rented a piece of equipment for only two days a week, with another organization renting it for the other five, under GAAP, it is not a lease because you are only obtaining 40% of the lease’s service capacity. Under GASB, however, the lessee can have a lease component in which they only utilize the assets for certain portions of a time. Under GASB, this arrangement represents a lease of the equipment for two days a week over the term of the arrangement.
GASB 87 allows substitution of an asset and the contract will remain a lease. Within GASB 87, the premise is that the right to control the asset relates to the service capacity of the underlying asset, and therefore substitution of an identical asset maintains the lease arrangement. In contrast, U.S. GAAP and IFRS 16 require more analysis to determine the impact of substitution rights on the definition of the lease. If the contract grants the supplier the right to substitute one asset for another, it is practical for the supplier to substitute and the supplier would benefit economically from doing so, then the substantive substitution right means that there is not an identified lease
After an organization has determined that the contract contains an identified asset, the organization must then determine if the customer has both the right to obtain substantially all of the economic benefits throughout the lease term and the right to direct the use of the identified asset.
If there is identification, control, and the organization obtains substantially all the economic benefits, then you have a lease.
Where can you find embedded leases?
Reach out to your supply chain, procurement and/or requisition and IT departments, for an understanding of the inventory of their service contracts to determine if these agreements contain an embedded lease. To validate the completeness of this inventory, you can partner up with your accounts payable team and obtain a listing of all the payments being made on service contracts and determine if there are any additional contracts that should be evaluated.
Logistics, transportation, warehousing, and data center service contracts are among the most common places to look for embedded leases. For banks, ATM service contracts could be another source of embedded leases. Since those contracts often don’t contain the word “lease,” you’ll need to look for language that says “exclusive use,” “solely,” “Identification Number,” etc.
Let’s take a look at a transportation contract, for example. If, for the duration of the contract term, only a specific railcar can be used to transport your organization’s goods, you could potentially have an embedded lease in the transportation contract.
Here’s another example. Let’s say your organization utilizes a data center. Is a certain space within the data center allocated to be used exclusively by your organization? If so, there may be an embedded lease in your contract.
LeaseQuery’s Embedded Lease Test is a tool that simplifies this decision-making process. It walks you through step-by-step to help you determine whether your contracts contain embedded leases:
Remember to properly bifurcate the lease
There are numerous pitfalls to avoid when transitioning to the new standards. In terms of accounting for embedded leases, after the agreements are identified, your organization will need to identify and allocate consideration to the lease and non-lease components of the contract. Allocating consideration is a step that is often overlooked within the lease accounting process, but it’s critical to compliance.
The new rules around embedded leases underscore the importance of taking a holistic view of all your leases – not just real estate. Navigating and complying with the new standards depends on it.