How to Address Embedded Leases Under ASC 842
Embedded leases can be difficult to identify, but ASC 842 is making it essential to look. Under modern lease accounting standards, companies must identify and account for lease components that exist within broader service or outsourcing contracts.
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”.
What Is an Embedded Lease?
An embedded lease occurs when a contract that is primarily structured as a service agreement actually contains the right to control the use of a specific asset.
In these cases, the customer effectively receives the economic benefit of the asset and directs how it is used, even though the agreement may be labeled as a service contract.
ASC 842 requires organizations to evaluate contracts to determine whether:
- A specific asset is identified in the contract
- The customer has the right to control the asset’s use
- The customer receives substantially all economic benefits from the asset
If these criteria are met, the contract contains an embedded lease that must be accounted for under ASC 842.
What is the risk of missing 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. This means organizations must carefully review contracts to avoid unrecorded lease liabilities, which auditors are increasingly focused on identifying.
Failure to identify embedded leases can lead to:
- Balance sheet misstatements
- Audit findings
- Compliance risks during financial reporting
Common Embedded Lease Examples
Embedded leases often appear in contracts that are not traditionally considered leases. Organizations frequently discover them during ASC 842 adoption or internal lease portfolio reviews.
Common embedded lease examples include:
- IT hosting agreements that specify dedicated servers or data center racks
- Telecommunications contracts that include dedicated fiber lines or bandwidth infrastructure
- Transportation agreements where specific vehicles or equipment are assigned
- Manufacturing or supply contracts involving dedicated production equipment
- Energy or utilities contracts tied to specific infrastructure assets
Because these agreements are often managed by procurement, IT, or operations teams, accounting departments may not initially be aware they contain lease components.
How to Find 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 contract for potential lease treatment.
Dependent upon the size and sophistication of the current lease management system, this list can be a starting point to use as a guide when determining the process of searching for potential sources of lease data:
- Legacy real estate system
- Repositories of scanned agreements, such as SharePoint sites
- Fixed asset records for existing capital leases
- Surveys sent out to the field asking for various departments/locations to identify leases siloed under their control
- Lease footage and disclosure work papers from previous years
- Vendor software, as some lessors offer online tools to track leases
- P&L, starting with the financial statements and tracing back to the source
- For companies still recording leases on paper, physical files in desks and cabinets
Embedded Lease Identification Checklist
Accounting teams can use the following checklist when evaluating contracts for potential embedded leases:
- Is a specific asset explicitly or implicitly identified in the contract?
- Does the customer control how and when the asset is used?
- Does the customer receive substantially all economic benefits from the asset?
- Can the supplier substitute the asset without significant cost or operational disruption?
If the answer to the first three questions is “yes,” the contract likely contains an embedded lease under ASC 842.
Practical Expedients for Embedded Leases Under ASC 842
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.
How Lease Accounting Software Helps Identify Embedded Leases
Manually reviewing thousands of service contracts for embedded leases can be time-consuming and error-prone.
Lease accounting and lease management software can help organizations:
- Centralize contracts across departments
- Identify potential lease components during contract intake
- Automate lease classification and calculations
- Maintain ASC 842 compliance across the lease portfolio
- Generate audit-ready documentation
To help ensure embedded leases are identified and properly recorded, companies can rely on CoStar’s feature-rich lease accounting and lease management software.
See how CoStar REM helps accounting teams centralize contracts, identify embedded leases, and maintain ASC 842 compliance.
