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Embedded lease identification and accounting
Impacts on balance sheet reporting under ASC 842
When it comes to ASC 842 compliance, you might have to do a little detective work. Identifying contracts that contain embedded leases may call for a closer look.
- Complying with the new lease standard
- Watch the videos
- Take note: Not every lease has the word “lease” in it
- Identifying embedded leases
- Uncovering the embedded lease: Real-world examples
Complying with the new lease standard
The definition of a lease under the updated standard isn't much different than under ASC 840. And the requirement to search for embedded leases isn't new. But the financial statement impact of failing to appropriately identify a lease under ASC 842 can be more significant.
Under ASC 840, operating leases and service contracts that may have contained leases were expensed in a similar fashion. As a result, companies may not have been rigorous about identifying embedded leases. That leads us to where we are today.
The Financial Accounting Standards Board's (FASB's) new lease standard requires many leases to be recorded on the balance sheet, which represents a big change in financial reporting. The rules are expected to have an impact on companies in many industries. From manufacturing to telecommunications and financial services to pharmaceuticals, nearly all organizations enter into lease arrangements. The FASB's new lease accounting rules went into effect for public business entities for fiscal years beginning after December 15, 2018 (i.e., January 1, 2019 for calendar year-end companies) and will go into effect for all other entitles for fiscal years beginning after December 15. 2021 (i.e., January 1, 2022 for calendar year-end entities).
Where could your leases be hiding?
Common areas for embedded leases:
Information technology contracts
Cable and satellite services
Transportation and delivery services
Contract manufacturing arrangements
Power purchase arrangements
Complex service contracts
Take note: Not every lease has the word “lease” in it
Identifying and collecting the contracts that may contain embedded leases can be tricky. That's because all contracts that meet the accounting definition of a lease may not be labeled as a lease. A contract is, or contains, a lease if it conveys the right to control the use of a specified asset (e.g., plant, property, and equipment) over a period in exchange for consideration. It's not uncommon for service contracts to convey to the customer the right to use a specified asset during the contract term.
For example, a company enters into a contract to advertise on a billboard. Although this contract could be written as an advertising service contract, the right to use the billboard may meet the definition of a lease. Or a company could enter into an arrangement with an information technology organization to host its data on a dedicated server. Embedded within this IT hosting arrangement may be the company's right to direct the use of a specified server, which may meet the definition of a lease.
Although it's possible that some of these contracts may not meet all aspects of the lease definition after considering the specific terms, it's critical that companies engage in a thoughtful analysis to identify and document contracts that may contain embedded leases. Consider consulting with your accounting advisers to help ensure you perform this analysis appropriately, as it can involve significant judgment. Chapter 3 of Deloitte's guide "A Roadmap to Applying the New Leasing Standard" contains additional examples and considerations that may help inform your analysis.
What's an embedded lease?
Embedded leases are leases contained within larger arrangements.
Identifying embedded leases
Many companies currently have contracts that contain embedded leases. Identifying these contracts and properly accounting for them requires a diligent approach.
Leading practices include:
- Look closely at all operations. Meet with relevant departments to understand the type of service contracts that exist and discuss the specific concepts of the ASC 842 definition of a lease. Translate the technical concepts of the rules into language that non-accountants will likely understand. For example, rather than asking if contracts may contain embedded leases, ask whether any service contracts involve the use of specific assets as part of the service delivery. Surveys also provide a useful tool for identifying embedded leases.
- Assess areas of risk. Perform a risk assessment to identify areas where embedded leases are more likely to exist. Does your organization contract with third parties to manufacture a specialized product line? Is your company subject to regulations (e.g., Food and Drug Administration regulations or the Health Insurance Portability and Accountability Act) that may require dedicated equipment? Do you lease property that includes a maintenance contract?
- Review expense activity. Evaluate general-ledger expense activity to identify expenses that require analysis. Payments that recur on a monthly or quarterly basis may signal a need for review.
- Perform a physical inspection. Walk through offices or manufacturing locations to identify leased assets that might not appear on an asset listing or registry, such as a large-format printer or medical testing device.
- Examine contracts. Ask the legal department to help review and identify contracts that should be evaluated
Uncovering the embedded lease: real-world examples
Railcars: A company enters into an arrangement to transport goods using a fleet of railcars. The transportation contract contains an embedded right to use the cars during the period of the transportation contract.
Contract manufacturing: A large retailer contracts with an entity to manufacture shoes for the retailer. The contract is so large that the manufacturer has a specific facility that only manufactures shoes for the retailer. The contract manufacturer arrangement contains an embedded lease for the physical manufacturing space and equipment to produce the shoes.
IT services: A hospital subject to Health Insurance Portability and Accountability Act (HIPAA) regulations engages an information technology (IT) service provider to provide cloud-computing services. To ensure patient privacy rights are not violated, the contract requires a dedicated server be used to provide the services. The hospital decides when and how the dedicated server is used based on its instructions to the IT service provider. The contract contains an embedded lease of the dedicated server.
Ongoing accounting considerations
Outside of the implementation effort, organizations will likely need to make changes to processes and internal controls to be sure they can identify contracts that could contain embedded leases going forward. They should also consider how they will likely capture information that may trigger reassessment (and remeasurement) or modification of existing contracts that contain embedded leases.
Prefer to read this article in PDF format? Download Identifying embedded leases: Are leases hiding in your contracts?
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