As the deadline for private and not-for-profit entities to adopt the Financial Accounting Standards Board (“FASB”) Accounting Standards Codification (“ASC”) Topic 842 (“Topic 842” or “the new standard”) quickly approaches, lessees need to think about identifying embedded leases. The concept of embedded leases is not new; however, it is receiving renewed attention as companies adopt the new standard.
This article investigates the definition of an embedded lease, the common types of agreements that contain embedded leases and best practices for identifying embedded leases within contracts when transitioning to Topic 842 and subsequent to the adoption date.
What is an embedded lease?
To identify embedded leases, it is important to remember the Topic 842 definition of a lease. ASC 842-10-15-3 defines a lease as a contract that 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. Additionally, under ASC 842-10-15-9, an asset is typically identified by being explicitly specified in a contract. However, an asset also can be identified by being implicitly specified at the time that the asset is made available for use by the customer. The two key elements to consider when identifying a lease include the identification of a tangible asset, either explicitly or implicitly and the right to control the asset as determined by the lessee
Simply put, an embedded lease is a lease within a larger contract or arrangement. Under previous guidance, operating leases and service contracts were expensed to the income statement, and there was no balance sheet recognition. Therefore, from a recognition standpoint, it was easy for embedded leases to hide in the income statement and continue to be accounted for as service contracts, particularly if those embedded leases would have otherwise been classified as operating leases. Under the new standard, companies are required to record right-of-use (“ROU”) assets and lease liabilities for all leases, including any identified embedded leases, and, therefore continuing to expense the cost of these assets without balance sheet recognition is not appropriate, provided that these assets are not short-term in nature.
Common Areas to Identify Embedded Leases
Transportation and Delivery Services (e.g., railcars, dedicated trucking fleets)
Complex Service and Information Technology Contracts (e.g., specified equipment, servers)
Warehousing Agreements (e.g., dedicated location within a warehouse)
Identification Process for Embedded Leases
The discovery phase for the search for embedded leases can be the most time-consuming. It is important to put together a strong project team to aid in the smooth implementation of the new standard. It is crucial to identify best practices for identifying embedded leases within contracts across operations of a business and ensure all team members are educated on Topic 842 and particularly on embedded leases
Take a close look at the business and operations. The project team should review operational areas with a greater likelihood of service agreements with potential embedded leases. Hold discussions with non-accounting departments to explain leases within the context of Topic 842 so that these individuals understand the broad concepts of the new standard. This may help individuals think through their day-to-day processes and identify arrangements that could potentially have embedded leases that are unknown to the accounting team
Review cash disbursement listing and recurring expense activity. Contracts that contain embedded leases will typically have a recurring payment attribute throughout the contract term. Reviewing general ledger transactions and cash disbursement listings can help in identifying lease-related payments that were not previously known.
Meet with the legal department. In-house legal counsel is very well versed in the common legal jargon that is included in contract language and service agreements. It is beneficial to meet with the legal team to see if there are any contracts that they are aware of that would be beneficial for the implementation team to review. Their expertise may also be helpful in answering the implementation team’s questions on specific contracts that have already been reviewed.
Perform a risk assessment. The implementation team should select high-risk contracts after discussion with various departments and evaluate the details of the agreement.
Overall, the steps above can aid in identifying embedded leases for the implementation of Topic 842. The identification steps above should continue until companies are reasonably certain that there are no longer any material-embedded leases that have not been identified. On a go-forward basis, lessees should work with management and the internal audit function, if present, to develop controls surrounding the identification of embedded leases for new and modified contracts.
Organizations need to find a suitable solution for calculating the FASB ASC Topic 842 right-of-use assets and lease liabilities at the transition date and the subsequent lease accounting. Generally, an Excel-based solution would be appropriate for a noncomplex portfolio of only a few leases. If the lease profile is more complex and voluminous, management is better served by a lease software solution. In addition to offering our clients simpLEASE (a lease solution software), Schneider Downs provides advisory services for the technical aspects of lease accounting.
1 In joint operating agreements, operators should determine which party or parties are counterparties to the contract and if a sublease exists. In most cases, a supplier enters into an agreement directly with the operator, but if it is entered into with multiple operators and/or non-operators where each party is proportionality liable, then the right of use asset and lease liability should be proportionately split between the parties.
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Material discussed is meant for informational purposes only, and it is not to be construed as investment, tax, or legal advice. Please note that individual situations can vary. Therefore, this information should be relied upon when coordinated with individual professional advice.