What are embedded leases?
Simply put, embedded leases are components within contracts that entail the use of a particular asset, where the user has control over that asset. You might be surprised at some of the types of contracts that often contain embedded leases, even though the contract may not contain the word “lease.”
Accounting for Embedded Leases represents one of the trickier aspects of implementing the new FASB and IASB lease accounting standards.
In this article, we’ll review the definition of embedded leases for ASC 842 and IFRS 16. Then we’ll go over guidelines for determining if an embedded lease exists, clarifying with an embedded lease example.
The impact of accounting for embedded leases under the new standards
For organizations with hundreds to thousands of leases, the need to be ready to comply with ASC 842 and/or IFRS 16 in just a year’s time has accounting teams scrambling. You need to gather all the necessary data about property and equipment leases, implement technology to do all the calculations and create journal entries, and decide how to amend your policies and procedures. That alone is a big task, but it gets even more difficult. Complicating the problem still further is the requirement to report on embedded leases that may be found in other types of contracts, especially those you have with service providers.
Although you may have done some embedded leases accounting in the past, it’s now a much bigger issue because the new standards bring operating leases and even some types of service contracts onto the balance sheet. That means embedded leases accounting has a much bigger impact on your income statement under the new rules.
In this article, we’ll review the definition of embedded leases for ASC 842 and IFRS 16, then go over guidelines for determining if an embedded lease exists and clarify with an embedded lease example.
Embedded leases accounting: 4 questions for identifying embedded leases
As you review the content of your existing contracts, ask these questions to decide if they contain embedded leases.
You’ll need to make these judgments on a case by case basis with the assistance of your advisory partners.
As you prepare to adopt the new lease accounting standards, you’ll need to review the content of all your existing contracts.
1. Does the agreement entail the use of one or more specific assets?
If no assets are specified, then no lease can exist within the contract. However, if an asset is explicitly or implicitly identified within an agreement, then a lease may exist.
Keep in mind that a lease may exist even if not specifically labeled as a lease within the contract. For example, power purchase agreements may include the use of a specified plant. Oil and gas drilling contracts may specify the use of equipment and pipelines.
2. Does the supplier have the practical ability to substitute a different asset?
If your agreement does specify the use of an asset, can the supplier easily substitute a different asset? And would the supplier benefit economically by doing so?
On the other hand, if the asset is an office copier, it’s not likely that the supplier can easily swap out one machine for another. And it’s also not likely that the supplier would benefit financially from doing that even if they could. In that case, a lease may be present.
Here’s another example related to real estate. Today’s corporate property portfolios often include the use of co-working space. If a co-working agreement doesn’t guarantee the use of a specific space within a building (such as hot desking) then the agreement may not be considered a lease.
3. Do you have control over use of the asset?
If you have physical control and decision making authority over the use of the asset, then a lease may be present.
Embedded leases accounting: next steps
Once you have determined which contracts do contain embedded leases according to the new lease accounting standards, what’s your next step? You’ll need to extract and get that data into a lease accounting software solution.
When you’re under the gun to get prepared to implement the new FASB and IFRS lease accounting standards, it’s easy overlook the ongoing maintenance of your lease data. To avoid an unexpected burden come Day 2, make sure your lease accounting software makes it easy to accommodate changes to existing leases and automatically update your accounting accordingly.
Questions? Let us show you how easy it is to manage your lease data and accounting in Visual Lease.