How to Identify Embedded Leases

Last Updated on May 25, 2023 by Morgan Beard

With the new lease accounting standard ASC 842 comes the requirement for entities to identify whether a contract contains a lease. This lease identification is to be done at the time of contract inception.

The Financial Accounting Standards Board (FASB) developed the changes from ASC 840 to ASC 842, and came up with three requirements that must be met for a lease to exist: 

1. The contract depends on an identified asset.
2. The customer has the right to obtain substantially all of the economic benefits from the use of the asset.
3. The customer has the right to direct the use of the asset.

Identifying and collecting the contracts that may contain leases can be tricky, and that’s because not all contracts  or service agreements that meet the ASC 842 definition of a lease contract may be labeled as a lease. When a contract is not explicitly stated to be a lease but contains leased assets, this is known as an embedded lease.

For example, supply lease agreements, contract manufacturer arrangements, power purchase agreements (PPAs), and oil and gas joint operating agreements may contain leases. There may be an embedded lease of a manufacturing facility, generating asset, or drill rig, respectively. 

Some service contracts may not be wholly a service or wholly a lease; in fact, it is not uncommon for some service arrangements to contain a right to control the use of an asset, making it an embedded lease arrangement.

An entity may enter into a service arrangement that involves PP&E (property, plant, and equipment) necessary to meet the contract’s performance obligations. When the service provider also conveys control of PP&E to a customer, an embedded lease (to the customer) is likely to exist.

You might find embedded leases in:

• Information technology contracts: A contract for IT services might contain servers or other hardware housed at a property such as a data center.
• Transportation, procurement, or delivery services: Embedded assets can include vehicles and railcars.
• Complex or unique service contracts: Highly specialized services might depend on proprietary equipment that qualifies as a leased asset.
• Advertising billboard: Although this agreement could be written as an advertising service contract, the right to exclusively use the billboard may meet the definition of a lease agreement.

Properly classifying leases and identifying embedded leases are now top priorities because ASC 842 requires all lessees to recognize lease liabilities and leased assets on the company balance sheet. This includes operating leases, which were only recorded as notes in financial statements under ASC 840. 

The FASB’s new standard went into effect for public business entities for fiscal years starting after December 15, 2018. For private companies, ASC 842 went into effect for fiscal years beginning after December 15, 2021. These deadlines are well in the past, so all new leases should be accounted for under ASC 842 guidelines.

How to find embedded leases

Often, the assessment of whether an existing contract is (or contains) a lease is straightforward. However, the evaluation becomes more complicated when a service arrangement involves a specified physical asset or when both the customer and the supplier make decisions about the use of the underlying asset. In these cases, professional advisory services, such as those provided by Certified Public Accountants (CPAs), are recommended to ensure your company is complying with ASC 842.

Examples of these more ambiguous and complex arrangements include those involving cloud computing services. If there’s a lease of supporting equipment, such as mainframes and servers, you have an embedded lease. Another typical example is cable television services. If the cable company provides a cable box to the customer, it’s a leased asset. 

Here are some general tips to help you identify embedded leases:

Look closely at all operations 

Meet with relevant departments to understand the type of service contracts that exist and discuss the specific concepts of ASC 842’s lease definitions. Translate the technical concepts of the rules into language that non-accountants can understand. For example, rather than asking if contract terms might contain embedded leases, ask whether any service contracts involve the use of specific assets as part of the service delivery. Surveys also help identify 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 compliance regulations? For instance, the Food and Drug Administration (FDA) and Health Insurance Portability and Accountability Act (HIPAA) both 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 monthly or quarterly 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.

For more information on ASC 842 and lease accounting, check out our Lease Accounting Compliance Hub or chat with our in-house lease accounting specialist, Lauren Covell, during her office hours.