Lease Accounting: What is an Embedded Lease?

Lease accounting rules are soon to change for private companies with the adoption of the provisions of ASC 842, Leases. As privately held entities prepare to implement the rules, there has been talk about the new emphasis on embedded leases. So, what exactly are embedded leases?

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What are embedded leases?

ASC 842 indicates that an entity should evaluate new contracts to assess whether they are leases, or contain leases within them, to determine if the entity needs to apply lease accounting rules. When a contract not traditionally thought of as a lease contains terms that meet the description of a lease, this gives rise to what is commonly referred to as an embedded lease. Thus, the word “lease” does not even have to appear in an agreement for it to possibly be considered a lease for accounting purposes. Lease accounting rules under ASC 842 apply just as much to embedded leases as they do to traditional lease contracts. 

What are the implications of embedded leases?

As a result of this new definition and scope for arrangements accounted for as leases, there is a new emphasis on embedded leases. Certain contracts that were not commonly thought of as leases in the past will begin receiving lease accounting treatment in the future. 

What are the new criteria of a lease to be accounted for pursuant to ASC 842?

According to ASC 842, an arrangement is (or contains) a lease if it provides the right to control an identified asset for a period of time in exchange for consideration. Based on this description of arrangements in the scope of ASC 842, entities will assess four primary attributes to identify leases, including leases within other host contracts: 

1. Control by the customer (including the ability to direct the use of, and benefit economically from the asset),
2. Identification of an asset that generally cannot be substituted,
3. Indication of a period of time (or term), and
4. Exchange of consideration.  

There are intricacies involved in fully assessing these criteria, and financial statement preparers should consult the guidance in ASC 842 when evaluating whether contracts are in the scope of the new lease accounting rules.    

What types of agreements are likely to contain embedded leases?

Companies adopting the provisions of ASC 842 will need to evaluate new contracts to identify potential embedded leases. Some common types of contracts that may contain embedded leases include agreements for:

• Contract manufacturing arrangements that grant exclusive use of equipment or space in a manufacturer’s facility,
• Information technology arrangements that provide exclusive use of assets (data management and cloud services),
• Transportation,
• Inventory management and warehousing,
• Cable and satellite,
• Advertising (billboards),
• Sale of consumables with “free” equipment,
• Arrangements that bundle a service with a device, and
• Other contracts for which assets are used to provide items or services.

What are some examples of embedded leases?

One example of an arrangement with a potential embedded lease is a contract for data center services with the following terms and conditions:

1. The customer’s data is stored on a dedicated piece of equipment, and the customer is able to direct the use of the equipment.
   • Therefore, the customer has “control” of the asset.
2. The equipment to be used by the service provider is specified by the customer and cannot generally be substituted.
   • “Identification of the asset” is present.
3. A five-year data center term is contractually agreed upon.
   • Hence, the “period of time” is known.
4. The agreement specifies a monthly fee the customer will pay the supplier.
   • There is “exchange of consideration.”

Another example of an arrangement with a potential embedded lease is a contract manufacturing agreement with the following terms and conditions:

1. The customer specifies that due to the proprietary and highly customized nature of products to be manufactured, a dedicated production line must be used by the supplier. The manufacturer uses its employees to produce the units. The customer controls the periods that the production equipment is idle or operational.
   • The customer has “control” of the asset.
2. The customer specifies which production line is used by the manufacturer. The manufacturer is not able to change production to another line.
   • Thus, “identification of the asset” is present.
3. A three-year contract manufacturing term is agreed upon.
   • The “period of time” is known.
4. The agreement specifies payments to the supplier.
   • There is “exchange of consideration.”

For each of the above examples, all four of the lease identification criteria are met, and as such, a lease would be considered to be contained within the host agreements (the data center and contract manufacturing agreements). Therefore, the right-of-use (ROU) asset and lease liability are recorded for the contract.

Key takeaways

Financial statement preparers should proactively identify embedded leases as part of paving the way for adopting the new lease accounting rules. Contact our team to learn more about how Sikich can help you identify embedded leases and prepare to implement the new lease accounting model.

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