Embedded Leases: Implication, Identification, and Examples

February 6, 2023
Lease Management

When it comes to ASC 842 compliance, the complications associated with accounting for known leases might be in the limelight, but recognizing contracts that include embedded leases adds a level of challenge to the issue.

Although the term "embedded leases" sounds intimidating, the premise behind them is rather simple: Leases included within broader arrangements are referred to as embedded leases.

Let's dig further into the concept. 

What is an Embedded Lease?

To successfully understand embedded leases, it is essential to keep in mind the description of a lease.

According to the Accounting Standards Codification 842 (ASC 842) definition, a lease is an agreement that, in exchange for payment, grants the lessee the authority to exercise control over the utilization of a defined piece of property, facility, or machinery for a predetermined duration.

In addition, the ASC 842 standard requires describing the asset in the contract specifications for its precise identification. 

However, it is also possible for an asset to be determined by being completely defined so that the asset becomes accessible for usage by the consumer.

When trying to figure out the nature of the lease, the two most critical factors to look for are whether the specific asset is labeled explicitly or implicitly and whether the lessee has the power to exercise control over the asset.

A simple definition of an embedded lease would be a lease contained within a more extensive contract or agreement. In accordance with the prior set of guidelines, operating leases, and service agreements were written off on the income statement as a cost, while there was no acknowledgment on the balance sheet.

Therefore, from the identification perspective, embedded leases could conceal themselves within the income statement and be reported as service agreements with relative ease. This was especially true in cases where the embedded leases in question would have been categorized as operating leases normally. 

According to the latest standard, businesses are required to report lease liabilities and right-of-use (ROU) assets for all leases, inclusive of specified embedded leases.

As a result, it's no longer acceptable for businesses to continue expensing these assets' costs without acknowledgment on the balance sheet, given that such assets aren't intended to be used for a short period.

Close up shake hands, Considering buying a home, investing in real estate. Broker signs a sales agreement. agent, lease agreement, successful deal.

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How to Identify Embedded Leases?

Several existing business contracts include embedded leases. A conscientious approach is required to identify these contracts and account for them accurately. Here's the process you can use to identify embedded leases:

  • Investigate Each Operation in Great Detail

Hold a meeting with the concerned departments to understand the many types of service contracts that exist and to explain the particular concepts contained within the ASC 842 lease definition.

Carry out a simpler translation of the technical concepts underlying the regulations that even non-accounting individuals can understand. 

For instance, instead of inquiring if agreements may have embedded leases, one may instead inquire about whether any service contracts require the use of particular assets as a component of the delivery process. Assessments also provide a helpful tool for locating embedded leases in a given property.

  • Evaluate Potential Risk Areas

Conduct a risk assessment in order to discover the sections that are more inclined to have embedded leases.

Inquire whether the company works with outside parties to develop any of its specialist product lines. It could also be highly governed by government regulations, some of which may need the purchase of specialized equipment.

Furthermore, check whether it leases out a property that comes with an accompanying service contract.

  • Analyze Expenditures

Examine the activities of the general ledger's expenses to discover the costs that need further scrutiny. There may be a requirement for review if payments are made on a regular monthly or quarterly basis.

  • Carry Out A Thorough Physical Assessment

Walk around the workplaces or production facilities to look for leased equipment that might not be included on an asset listing or registration, such as a sizable scanner or a diagnostic testing gadget.

  • Evaluate Contracts

Consult the legal department for direction in reviewing the contracts and determining which ones need to be assessed.

Implications of Embedded Leases

There has been a growing focus on embedded leases as a direct consequence of the recent changes to the definition and spectrum of agreements that can be recorded as leases.

In the past, specific contracts that were not often considered leased are now treated as leases in the current accounting system.

accounting concept. businesswoman working using calculator with money stack in office

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Which Types of Contracts Typically Include Embedded Leases?

Businesses that have switched to the provisions of ASC 842 are required to analyze new contracts to identify any possible embedded leases. The following are some examples of popular forms of contracts that might contain embedded leases:

  • Transportation and delivery services (e.g., railways, trucking, and other logistics solutions)
  • Contract manufacturing agreements that give sole use of certain machinery or facilities within a manufacturer's site
  • Warehousing and inventory management agreements
  • Marketing and advertising (like billboards)
  • Satellite and cable services
  • Contracts involving the use of assets to offer a product or service, as well as those that combine the provision of a service with the purchase of equipment.
Rental lease agreement form on an office desk.

Image source

Understanding Embedded Leases with Examples

Let's study these two examples to better comprehend embedded leases.

Example 1

A data hosting contract is established between a city and a third party for the safe and secure storage of user data gathered by one of the administrative departments.

The length of the contract is sixty-five months, and the monthly payment is ten thousand dollars. Accessibility to the hosted website, data storage systems, and application upgrades are all included in the hosting services.

Following the terms of the contract, the data will be kept on a server dedicated solely to the storage of the municipality's data. The municipality will have the authority to provide input regarding how they would like the server to be utilized during the term of the contract. 

So, in this case:

  • Although the agreement does not provide any information regarding the server itself, it does state that the municipality will have access to and use a particular piece of hardware (the dedicated server).
  • This indicates that the contract implies the existence of an asset the municipality doesn't own.
  • According to the contract terms, the municipality is entitled to receive all of the advantages of the server (data storage).
  • According to the contract, the municipality can decide how the server is put to use.
  • The value traded is represented by the payments made for the hosting agreement as a whole.

So we may conclude that this example contract contains an embedded lease.

Example 2

A city government and a regional supplier sign a contract for the city to purchase electricity produced by the supplier's wind turbine.

Following the terms of the contract, the city government will decide the total quantity of electricity that will be generated by the turbine, as well as the total number of hours that it will be operational. It is the responsibility of the supplier to undertake any necessary maintenance or repairs on the turbine.

The contract duration is sixty months, and the fixed monthly payment is $35,000. Further, additional variable payments are based on the total amount of electricity generated.

Considering this case:

  • Since the contract refers to a particular type of equipment - the wind turbine), it is clear that the city government does not currently possess the asset that is being referred to in the contract.
  • According to the contract, the city government has the authority to acquire the wind turbine's existing service capacity.
  • According to the agreement, the city government will have the power to determine how and when the wind turbine will be operational.
  • Also, an exchange transaction is indicated by the recurring monthly payment and any additional variable payments.

So this case is also an ideal example of an embedded lease contract.


The company's financial consultants should effectively identify embedded leases to facilitate the transition to the new lease accounting requirements.

The aforementioned stages in lease identification should be repeated until businesses are certain that no other materially embedded leases remain undetected.

Lessees, going ahead, should collaborate with executives and, if available, an internal audit department to establish safeguards for spotting embedded leases in future contracts.

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