You might have heard the term “embedded lease” appearing increasingly often, especially in relation to ASC 842. While you won’t find the term mentioned explicitly in these accounting standards, the concept is extremely relevant and highly important – and can make a huge difference to your bottom line, quite literally.
What is an embedded lease?
An embedded lease is a specialized type of lease agreement found within a larger contract. In accounting, this refers to a contract that grants the right to control a specific asset over a defined period, typically in exchange for compensation. Understanding the concept of embedded leases is crucial for compliance with ASC 842 and proper financial reporting.
For example, a contract might have the elements of a lease in place: an asset to be used, payments to be made over an agreed timeframe, and so on – but might not actually call this a “lease” or mention the word lease anywhere in the contract. According to ASC 842, this agreement is nevertheless a lease and it needs to be accounted for under the provisions of the relevant lease standard.
This would be an example of an embedded lease.
So what are the specific criteria that need to be met in order for an agreement to be a lease?
Criteria for an embedded lease
ASC 842 defines a lease as follows: “a contract is or contains a lease if the contract conveys the right to control the use of identified property, plant, or equipment (an identified asset) for a period of time in exchange for consideration.”
A period of time may be described in terms of the amount of use of an identified asset (for example, the number of production units to produce).
When performing the analysis to determine if an arrangement contains an embedded lease, multiple arrangements may be considered to be a single transaction. If two or more arrangements are entered into at the same time with the same counterparty (or related parties), a reporting entity should consider whether the analysis should be performed on each contract or the combination of contracts.
This definition is going to be crucial in understanding where a contract contains an embedded lease. Let’s look at this definition in more detail:
The right to control
In order to test whether an entity has the right to control an asset, the following two questions must be answered:
- Does the party in question have the right to obtain substantially all of the economic benefits from the use of the asset?
- Does the party in question have the right to direct the use of the identified asset?
Both of these questions have to be answered in the affirmative in order for the right to control to be in place.
Additionally, the customer (and potentially lessee) must
- Have the right to obtain the economic benefits from the use of the identified asset
- Have the right to direct the use of the identified asset
The identified asset
ASC 842 directs that the identified asset in question can be explicitly or implicitly identified that is physically distinct. This is an area that has a significant impact for embedded leases, as sometimes the identified asset isn’t explicitly mentioned and so it could be assumed that no lease can exist – however noting that this asset can be implicitly identified opens up many more contracts to the possibility of an embedded lease.
What’s an example of an explicitly or implicitly identified asset? An explicitly identified asset might have a unique identifying number or name. An implicitly identified asset might be the delivery of an asset to a specific location. The name of the asset is not specified, but it’s clear that the asset in question is implicitly identified. When a supplier must use an asset to fulfill the obligations in the contract, then there might be an implicitly specified asset (subject to determining whether there are substantive substitution rights).
An identified asset must be physically distinct. A physically distinct asset may be an entire asset or a portion of an asset (one floor of a building, one shop in a shopping mall).
No substitution
Qualifying the identified asset test above is the “No asset substitution” principle. This means that the asset is not considered “identified” – whether explicitly or implicitly – if the asset can be easily substituted for another by the provider of that asset, (the provider of the asset has a substantive right to substitute the asset).
A provider’s right to substitute an asset is substantive if both: (1) the provider has the practical ability to substitute alternatives, (2) the provider would benefit economically from the exercise of its right to substitute the asset. A provider’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 and would not by itself preclude the arrangement from being considered a lease.
Examples of an embedded lease
We’ll look at two examples of an embedded lease to better understand the process involved:
Example 1
Worldwide Medical is a healthcare provider that runs regional hospitals. The company works with Hands On IT to manage their IT needs, which includes storing information in the cloud. In order to comply with patient privacy requirements however, certain Worldwide Medical information is stored on their own dedicated server. Worldwide medical issues instructions on usage of the server, which is actioned by Hands On IT.
This agreement contains an embedded lease. There is the right to control and an identifiable asset (the dedicated server) and therefore even though the contract might not specify a “lease” per se, an embedded lease is indeed in place.
Example 2
Acme Inc manufactures specialized equipment for use in space programs. The equipment requires a specialized fire-proof widget that is manufactured for the firm by Manufacturer A , on a 5-year deal. In order to provide the specialized part, Acme insists on Manufacturer A setting aside a specific dedicated production line for their widgets. Based on Acme’s needs, they instruct Manufacturer A when and how much to produce.
Again, an embedded lease is in place. There is control of the asset – Acme Inc dictates when and how it is used; and there is an identifiable asset, in this case the production line.
What’s excluded from being classified as an embedded lease?
Like any other lease per ASC 842, the following are excluded from being classified as an embedded lease per the Topic:
- Leases of intangible assets (assets that lack physical substance)
- Leases to explore for or use nonregenerative resources such as minerals, oil, and natural gas
- Leases of biological assets, such as timber
- Leases of inventory
- Leases of assets under construction
Who is impacted by embedded leases?
As we’ve seen before, almost every single company is impacted by the changes of ASC 842 – similarly, almost every U.S. company needs to be aware of the possibility of embedded leases existing within their organization in order to comply with the new standard, which is applicable imminently.
What action should you take?
Now that you understand the importance of embedded leases, and the dangers associated with not recognizing them, the question is: what to do next? Deloitte suggests 5 steps to take to begin your journey of compliance with ASC 842 from an embedded lease perspective.
- Look at all operations: meet with different departments and stakeholders to explain the concept of embedded leases and enlist their assistance with identifying such leases within contracts
- Assess areas of risk: some areas will be riskier than others, and this is where your search should begin; often it’s areas around dedicated or specialized equipment that hide embedded leases
- Review expense activity: go through expense accounts in the GL to identify amounts that may point to the existence of an embedded lease
- Perform a physical inspection: tour production facilities or similar areas for evidence of assets that might give rise to an embedded lease
- Examine contracts: go through all contracts – not just obvious leases – for evidence of embedded leases in place
Obviously some of these steps are not practical at scale. And that’s where automated lease accounting packages come in.
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