Embedded leases can be difficult to identify, but ASC 842 is making it essential to look. Most embedded leases are contained in contracts for services that involve the use of a related asset, which is controlled by the customer. Many companies are surprised to find that leased assets are “embedded” in other agreements that are often not labeled as a “lease”.
Almost any company in any industry is likely to discover embedded leases in their portfolio of service contracts. Likely places to look are within IT agreements for server space, fiber, or bandwidth.
What is the risk associated with embedded leases?
Under old lease accounting guidelines, there was not much difference in the treatment of an embedded lease component and a service component. It was really just geography on the income statement. However, under new rules, the lease component will almost always generate a lease liability and right of use asset in addition to rent expense. So, now the balance sheet is impacted, and auditors are on the lookout for unrecorded lease assets and liabilities.
How to identify embedded leases?
Many companies have had success sending surveys to business units asking if any assets have been obtained associated with contracts. It’s important to specify that the contracts don’t necessarily have to be labeled as “leases”. Basically, if an asset is obtained for company use outside of the fixed asset procurement process, the accounting team should evaluate the contact for potential lease treatment. It’s important for companies to set accounting policies around identifying and accounting for leased assets and the best practice is to discuss those policies with company auditors well in advance of the audit cycle.
Did FASB provide any practical expedients regarding embedded leases?
The answer to this is “sort of”. FASB included some language regarding materiality in ASC 842 literature, so companies have the opportunity to set reasonable thresholds to exclude immaterial assets and liabilities from consideration. FASB also offered companies the option to avoid reassessing if a contract contains a lease or not. However, this assumes the contract was assessed under the old guidance. The expedient is not indented to “grandfather” errors, and many embedded leases were simply not evaluated at all in the past. Some companies have found the practical expedient to include lease and non-lease components together as lease components useful in simplifying the compliance effort. This is less common, as it does result in a grossed-up lease liability and right of use asset. To help ensure embedded leases are identified and properly recorded, companies can rely on CoStar’s feature-rich lease accounting and lease management software.