In accordance with ASC 842, an entity is required at contract inception to identify whether a contract contains a lease. As discussed in depth within the Steps to Identify a Lease article, there are three requirements 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 use of the PP&E
3) the customer has the right to direct the use of the PP&E.
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. For example, supply agreements, power purchase agreements (PPAs), and oil and gas drilling contracts may contain leases (i.e., there may be an embedded lease of a manufacturing facility, generating asset, or drill rig, respectively). If an entity identifies PP&E in an arrangement (either explicitly or implicitly), the customer and supplier must both determine whether the customer controls the use of the PP&E throughout the period of use.
Further, certain contracts may not be wholly a lease or wholly a service; in fact, it is not uncommon for some service arrangements to contain a right to control the use of an asset. An entity may enter into a service arrangement that involves PP&E 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. On the other hand, when the customer conveys control of PP&E to the service provider to facilitate the delivery of the service, it is less likely that there is an embedded lease in the arrangement.
Often, the assessment of whether a contract is or contains a lease will be straightforward. However, the evaluation will be 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. Examples of these more ambiguous and complex arrangements include those that involve cloud computing services (i.e., if there is a lease of the supporting equipment, such as mainframes and servers) and cable television services (i.e., if the cable box provided to the customer is a leased asset. If you are just getting started with your transition to ASC 842 lease accounting standards, then this blog post will help.
Embedded Lease Example
Advertising billboard: 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.
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.
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.
How to find 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 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 evaluate