The new lease accounting standards, also known as FASB 842, IFRS 16, and GASB 87, are effective for public companies and are soon to be effective for private companies as well as governmental entities. One of the more challenging aspects of these guidelines is the identification of embedded leases.
What is an embedded lease?
Simply put, an embedded lease is a lease agreement that exists within a contract. Such a lease exists in a contract if the contract has an identified asset and “control” of that asset is passed to the lessee. In these scenarios, it is fairly common for the lessee to be completely unaware of the lease agreement.
Many organizations fail to recognize that service contracts often contain embedded leases. However, properly identifying them can be like a scavenger hunt. 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 find embedded leases and what you need to do to properly address them.
Which organizations are typically impacted?
Companies in the banking, manufacturing, energy, oil and gas, healthcare, retail, restaurant and logistics/transportation industries will have a significant number of service contracts with embedded leases. Government entities are likely to have embedded leases as well.
How the new guidelines impact embedded leases
Under current lease accounting guidance, service contracts that contain embedded leases are treated the same as service contracts that don’t – they are amortized straight-line over the contract term. Under the new lease accounting rules, you have to bifurcate the contract into the lease and non-lease components and record those embedded leases to avoid material misstatements.
What are the common misconceptions?
The new rules around embedded leases are among the trickiest components of the new lease guidance. While the FASB included practical expedients that dictate that companies don’t need to re-evaluate expired or existing contracts, there is a very big caveat: Errors are not grandfathered. Essentially, you do not need to reevaluate contracts as long as there are no errors and the embedded leases are properly identified to begin with. The issue is how do you know there are no errors, without reviewing all your service contracts?
So those practical expedients are based on the premise that companies don’t have errors in the first place. Since embedded leases have historically been given lax treatment, companies 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.
To identify embedded leases, the first thing you need to do is determine if there is an identified asset in the contract. Identification can be explicit or implicit. Explicit identification is when the 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. Please note that if the contract grants the supplier the right to substitute one asset for another, then there is no identification and therefore no embedded lease.
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 1 truck. In order to satisfy its obligations under the contract, the supplier must use that truck. As a result, the truck is implicitly identified.
The second way to determine if you have an embedded lease is to evaluate if the lessee has the right to control the asset and obtain substantially all its economic benefits.
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?
Most embedded leases are contained in service contracts. Reach out to your supply chain, procurement and/or requisition departments, because they are the ones who typically sign the services contracts. You can also partner up with your accounts payable team to find out all the payments being made to all service contracts. 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 vehicle 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. When it comes to embedded leases, you’ll need to properly allocate consideration to the lease and non-lease components of the contract. This is a practice that many companies may think they can skip, but it’s critical to compliance.
Don’t go it alone
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. Check out these tools to make your transition smoother: