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.
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.
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:
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.
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.
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.
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.
Consult the legal department for direction in reviewing the contracts and determining which ones need to be assessed.
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.
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:
Let's study these two examples to better comprehend embedded leases.
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:
So we may conclude that this example contract contains an embedded lease.
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:
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.