The new lease standard, ASC Topic 842, has been delayed for many entities. However, the effective date is right around the corner. Entities that use the delay wisely will be better prepared to implement the new standard when the time comes.
What is an Embedded Lease?
When thinking about the new lease standard, most people think about leases such as land, buildings, vehicles and equipment that are used in operations. These types of leases will need to be evaluated when implementing the new lease standard; however, there may be other contracts that are not commonly thought about. One such instance is the embedded lease, which may be found within service contracts paid on a monthly or other recurring basis.
Under the new ASC 842 lease standard, a lease is a contract with an identified asset controlled by the lessee over the term of the contract. This means that service contracts, such as IT service contracts, supply, contracts, delivery contracts and many other operating agreements, could contain a lease if there is an asset in control of the lessee that the service provider needs to provide the service.
Here’s how to start implementing the new lease standard now.
How to Identify an Embedded Lease: Where do I Start in Identifying Contracts that Could be Leases?
Identifying these contracts starts by reviewing expense details for recurring payments—not only the lease or rent expenses, but all the expense accounts. For each recurring payment, obtain the applicable contract and review it to determine if your entity has an embedded lease in a service contract. Obtaining these contracts could be a challenge, so start looking for them now.
After implementation, consider updating the process for reviewing new contracts to include determining whether service contracts contain an embedded lease. This will allow the accounting staff to identify leases on the front-end, instead of discovering them when closing the financial books (or when your entity’s auditor starts asking questions).
What Should You Consider When Reviewing a Contract To Determine If It Contains An Embedded Lease?
Careful consideration should be given to the terms of the contract to determine if it contains a lease. For there to be a lease, a contract must have both of the following:
Directing the use of the asset happens when the entity provides information to the service provider about how and when the asset will be used.
Here are some embedded lease examples of situations to consider when determining whether an asset is identified in a service contract:
Once an asset has been identified, an entity needs to consider whether they control the asset. Here are some things to consider:
Continue to Plan for The New Lease Standard
Implementation of the new lease standard has many elements to consider, and the impact of embedded leases should not be overlooked. Proper planning and preparation in advance of the adoption date will help both private and public companies alleviate challenges in the transition.