Updated March 2023

While we try not to be alarmists here at Embark, sometimes the fine people at the FASB (Financial Accounting Standards Board) force our hand. Case in point – public and private companies are both now knee-deep in the expansive new lease accounting standard in ASC 842, yet many are still scrambling to get their lease accounting house in order. And that’s no bueno.

That said, if you’re one of the many still trying to fully understand the countless ins-and-outs of ASC 842 – even with the effective dates now in the rearview mirror – we feel your pain. And that's precisely why we're taking a closer look at the new(ish) lease accounting guidance for you, with an emphasis on hunting down those pesky embedded leases. And while we’re at it, we’re also providing a handy template to help you both assess for and classify your leases. So on that note, let’s dive right in.

What Are Embedded Leases?

Although we'd typically hyperlink to the official definition of an embedded lease under the guidance, we're going to skip that step for a very good reason – it doesn't exist. In fact, while the guidance explicitly defines leases themselves, mum's the word on embedded leases under US GAAP.

Basically, the term embedded lease can refer to any contract that could potentially contain a lease component. And since it's not always apparent whether a contract actually contains such a component, accountants can sometimes feel as if they've entered a Where's Waldo scenario as they search for these embedded leases. Therefore, we're better off focusing on the definition of a lease as the footing for our discussion.

Definition of a Lease

As you probably remember from the old standard in ASC 840, a lease usually existed if there was any type of property, plant, or equipment (PPE), whether it was explicitly or implicitly identified. Further, the lessee had the right to use that specified PPE.

But under the new ASC 842 standard, the definition of a lease has shifted to more of a control model, one very similar to what we saw as companies transitioned to the new revenue recognition standard in ASC 606.

Obviously, the concept of control is becoming far more prevalent across the different standards as the FASB (Financial Accounting Standards Board) continues its updates. With ASC 842, you have a lease arrangement if the customer has the right to control an identified asset and obtain substantially all the benefits from using that asset throughout the period of use.

What Types of Contracts Might Contain Embedded Leases?

Now that we have a better idea of what an embedded lease is, let's narrow our focus to the most common types of contracts you might find them in. Of course, this will vary between industries and organizations but, to name a few:

• IT (information technology) arrangements with exclusive use-of-assets like data center arrangements or cloud computing services
• Contract manufacturing with exclusive use-of-space and/or equipment in a company's facilities
• Inventory management and warehousing services
• Logistics and transportation contracts
• Cable and satellite arrangements
• Billboard advertising contracts
• Healthcare and other industries with purchase contracts for consumables bundling free equipment

Changes and Impact Under the New ASC 842 Standards

At this point, you might be wondering why there's such a hullabaloo over the new lease accounting rules. Well, as discussed, there have been some changes to what constitutes a lease. However, what's really driving this intense focus, especially for lessees, is the fact that practically all operating leases now go on the balance sheet, with minimal exceptions.

Whereas before, under ASC 840, there was nothing really on the face of the financial statements to recognize leases other than the disclosures, this is a significant change with ASC 842. Now, if a company fails to identify all their leases, even those hiding in other contracts, the balance sheet will understate the right-of-use asset and the related lease liability.

Identifying Embedded Leases in Your Contracts

With the vast majority of leases heading to the balance sheet, lease identification is, of course, now a more material matter. In other words, it's imperative to get it right starting on day one and every day thereafter. So what's the best way to identify leases if some of them are so tricky to spot in contracts? We have some best practices to share with you.

Lease Portfolio Completeness

Completeness of your organization’s lease population is imperative. However, this can be more challenging in decentralized organizations or where lease records historically have not been well maintained.

Thus, the best place to start the exercise is often with your prior year’s minimum lease payment disclosure schedule and the population of leases used to compile that information. From there, we recommend two procedures:

1. Survey Different People in Different Departments

Between your IT, marketing, HR, legal, and procurement departments – to name just a few – there's a good chance several types of service contracts are floating around different corners of your operations. Thus, simply conducting brief surveys of company personnel can help you identify contracts that you might have otherwise missed. This is also a good time to educate these departments on what to look for in entering into future service contracts that could contain leases.

2. Review Recurring Vendor Payments  

Reviewing recurring vendor payments from your cash disbursement listing is a great way to identify potential lease contracts. Once you've spotted all of those vendor payments, it's then just a matter of reviewing the underlying contracts for leasing activities or components.

As an additional bonus, knocking out these lease portfolio completeness procedures will also put a smile on your auditor’s face since they’d inevitably be asking for them anyway.

Consult Your Company's Capitalization Policy

In many companies, embedded leases can be material or immaterial. Thus, you should always look to your company's capitalization policy for guidance on accounting for any given lease contract.

For example, if your capitalization policy is $5,000, anything less than that amount will go straight to your P&L as an expense. Therefore, you would exclude any lease component with total lease payments less than that amount as it would simply be expensed under the policy.  

Evaluating Embedded Leases

There's no special framework for embedded leases since they're nothing more or less than just a standard lease under the guidance. Therefore, evaluating for embedded leases still comes down to the definition of a lease under ASC 842:

• Is there an identified asset within the contract?
• Does the customer have control of a leased asset throughout the period of use, including:
• the right to substantially all economic benefit from the asset, and
• the right to direct the use of an identified asset?

When you check off all of these criteria, you have a lease on your hands. However, it can be a little bit trickier depending on the facts and circumstances. So on that note, let's look at these important bullet points a bit closer.

Determining if There's an Identified Asset

We're going to start by figuring out if there's an identified asset in the potential lease agreement according to a couple of factors:

1. Asset Specification and Substitution Rights

In most cases, the assets subject to leases are listed and easy to identify, maybe a vehicle, a parcel of land, or a piece of equipment with a serial number. For instance, let's say you have a service agreement with a supplier that only has one asset to provide that service. Naturally, that would be an identified asset. 

However, other assets can be implicitly included in the contract simply to fulfill the service agreement. As an example, suppose a supplier has multiple assets that can provide the service and you don’t know which specific asset you will get. In that case, whether or not you have an identified asset depends on whether the supplier has a substantive right to substitute alternative assets throughout the period of use to fulfill the contract.  

Zooming further in on substitution rights, you have to evaluate if those rights are substantive or not. If the supplier has the right to substitute an asset and redeploy it somewhere else, they are really the ones with control of the asset. For a better sense of direction, the standard lists a couple of things to meet for a substitution right to be substantive:

• The supplier must have the practical ability to actually exercise the substitution rights, where there is an alternative asset they could replace the original with
• Once again, there must be an economic benefit to the supplier for exercising the substitution right that exceeds the costs of the substitution

Further, when assessing the economic benefit of a substitution, lessees should like at factors like:

• Relocation costs: The supplier has alternative assets but they're located off-premise, requiring significant time and money to ship them
• Business interruptions: A supplier has a substitute available but swapping it out would create an interruption to operations for the supplier, customer, or both
• Asset modifications: The customer is currently using a modified asset, meaning a substitute would require additional time and money to modify

Although these types of examples can serve as a helpful barometer, there's usually a good amount of judgment still involved. 

Now, if you're a lessee, we know what you're saying – how are we supposed to be privy to everything happening on the lessor side of the fence? Because, yes, it's often challenging to determine if they meet these criteria for the substitution right. However, the standard explicitly states that if you can't come to the answer or don't have enough information, you have to presume the substitution right is not substantive.

Also, if the substitution right isn't substantive throughout the entire period of use, then it's not a substantive substitution right – and, yes, that’s a mouthful. For example, if a supplier only has such rights for the first six months of a two-year contract, the guidance doesn't consider it substantive. Similarly, swapping out an asset due to a defect is also not a substantive right.

2. Physically Distinct Specified Assets

Most of the time, an asset will be complete and, thus, easy to identify. However, a capacity portion of an asset can also be an identified asset as long as it's physically distinct. Under such circumstances, the customer has the right to receive substantially all of the capacity of the asset identified.

For example, if your lease contract provides you with one floor of a business building, it would be an identified asset because that floor is a physically distinct part of the building. The same premise holds for a lease providing use of substantially all the data capacity of a fiber-optic cable or a satellite giving access to a specific frequency. In all these cases, the asset could very well be physically distinct and, therefore, identified for lease accounting purposes.

Assessing Control of the Asset

Just when you thought there couldn't be any more criteria and checklists, the FASB throws another set your way. This time, you're assessing if a company has the right to control the identified asset throughout the period of use by determining whether two factors exist:

1. The Right to Obtain Substantially All of the Economic Benefits

Determining whether a lessee has the right to obtain substantially all of the economic benefits from use of the identified asset will be obvious since, in many situations, the lessee in a lease has exclusive use of the asset. 

However, some contracts allow parties other than the customer to use the asset in minor amounts. This could occur when an asset is not on the lessee's property. In this case, a customer would not control an asset if another party has the right to more than an insignificant amount of its potential economic benefit.

2. The Ability to Direct the Use of the Asset

Assessing the ability to direct an asset's use comes down to analysis that sounds straight out of journalism class – who, what, where, when, why, and how. In other words, you need to determine if a customer can change:

• What outputs the asset produces
• When the asset produces the output
• Where the asset produces the output 
• How much output the asset produces

To use common terminology, you need to determine who has the decision-making rights most relevant to the economic benefits obtained from the use of the asset. Another way to think about the most relevant decision-making rights is asking who determines “how and for what purpose” the identified asset is used.

Sometimes, those rights are predetermined within the contract. In other words, neither the customer nor the supplier controls those decisions about how and for what purpose an identified asset will be used throughout the specified period of time.  For example, if the lessee leases a vehicle from a provider, the contract will most likely contain language limiting what the customer can do with that vehicle. So a demolition derby is probably verboten.

In these instances, a customer can still have the right to direct the use of the asset. For proof, the customer must either:

1. Have the right to operate the asset or direct others to operate it in a manner it determines throughout the period of use with the ability for the supplier to change it, or
2. have designed the asset in a way that predetermines how and for what purpose the asset will be used throughout the period of use.

Ultimately, if the contract provides substantially all of the economic benefits as well as the ability to direct the use of the identified asset, then the contract is a lease under ASC 842.

Next Steps in Your Lease Accounting

Let's assume you've passed the seemingly countless checklists thus far and can now safely say your contract contains an embedded lease. As much as we'd like to tell you all of the heavy lifting is behind you, there's still a fair amount to do.

Like it or not, we've reached the point where ASC 842 and 606 concepts begin to converge. Specifically, the lease guidance requires you to measure the lease total consideration, then allocating it between the lease and non-lease components. With embedded leases, since they're usually part of a service agreement, you will typically have multiple components – a  non-lease, service piece, and a lease piece.

For lessees, you allocate the contract consideration among the different components based on the relative standalone prices. This is where things can get tricky, though, since you determine those prices through either observable inputs or estimates from management. As you probably already know, service providers usually don't want to make the cost of each contract piece too obvious.

Remember, the observable standalone cost is the price a lessor charges or, in some instances, the price similar suppliers charge for similar lease or non-lease components. When estimating standalone prices, US GAAP requires lessees to maximize the use of observable input information when available. However, many lessees will likely have to form estimates of the standalone selling prices of leased assets. And, yes, this process can entail an absolute mountain of time-consuming, arduous, painstaking work.

For lessors, you allocate contract consideration among the lease and non-lease components following the transaction price allocation guidance under ASC 606. This is generally done on a relative standalone selling price basis.  

The Good News: There are Practical Expedients

Thankfully, the FASB provides a practical expedient that allows lessees to not separate lease and non-lease components in a contract, but rather combine the components as a single lease component. This election is made by the class of the underlying asset. 

Lessors also have a non-separation expedient for lease and non-lease components they can elect by the class of the underlying asset. However, unlike the lessees, there are some rules around its eligibility. 

For example, in order to apply the expedient for lessors, the lease and non-lease components must have the same timing and pattern of transfer and the lease component must qualify as an operating lease if it were separately evaluated. If they meet the criteria to elect the expedient, the single combined component is then either accounted for as a single lease component under ASC 842 or a single non-lease component under ASC 606. This determination will depend on which component is more predominant in the contract.  

Also, while it's definitely easier to combine your lease and non-lease components, it can involve some unforeseen outcomes. For example, combining components for lessees could significantly gross up your balance sheet by a much larger ROU asset and lease liability balance since all payments in the contract will go towards the lease. Therefore, depending on which internal metrics are most important to you, your bank, or your investors, not electing the expedient may be more appropriate, even for just certain asset classes.  

Another expedient provides a short-term lease accounting policy election, letting you omit leases with contract terms of 12 months or less from your balance sheet. While this is undoubtedly beneficial, don’t forget you still need to consider renewal options on those short-term leases and whether a renewal is reasonably certain.

We understand that much of what we just discussed might seem overwhelming. And we’ll be the first to admit that ASC 842 is neither simple nor straightforward, despite the FASB's recent attempts to simplify codification. However, take solace in the fact that you're certainly not alone and, even better, we designed the accompanying lease template to walk preparers and finance leaders through the paces, streamlining both the assessment and classification processes. And as always, the lease accounting gurus here at Embark are ready to swoop in and save the day whenever you need us.