What Embedded Leases Mean in the New Lease Standard

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.

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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:

1. an asset identified to be used in the contract
2. control of the asset by the entity because the entity directs the use of the asset and it is dedicated to (or dedicated substantially to) only the use of the entity

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:

• The available use of an asset may be either explicitly stated in the contract or implicitly stated in the contract. Explicitly stated assets are easier to identify as there are specific identifiers such as a serial number, address, model number, etc. These are the most common embedded leases. Implicitly stated assets are based on a set of requirements for the assets to be used in the contract and then identified at the commencement of the contract. Both explicitly and implicitly stated assets result in the contract containing a lease.
• The supplier may have a substitution right to use one of many assets available to them and could substitute the assets without significant cost. This may lead to the asset not being specified in the contract and would mean the contract does not contain a lease.
• A warehouse location could supply services to hold inventory. Depending on the terms of the contract, there could be a specific portion of the warehouse that is dedicated to the contract, which could signify a lease. In contrast, however, if the square footage of space could be anywhere within the facility, it would not signify a lease.

Once an asset has been identified, an entity needs to consider whether they control the asset. Here are some things to consider:

• An entity may direct the assets by providing how and when the assets will be used in the contract. For example, an entity may have a contract with a delivery service company that uses a specific truck to transport products for the entity and it is only used to service this contract. The entity may determine when and where the products will be delivered, and this may be an indication of a lease in the contract.
• An entity may not direct the use of an asset in a situation where the supplier will make decisions about how the asset will be used. For example, an IT management service contract for storing data where the service provider makes decisions about where the servers will be located and how they will be used. In this example, the service provider may provide a certain amount of storage space and the entity will determine the information loaded to the servers, but the provider may make the decisions about how to provide the storage space to the entity and the overall use of the network. Therefore, this may lead to the contract not being a lease.

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.