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How To Address Embedded Leases

How to address embedded leases

Embedded leases can be difficult to identify, but the new FASB lease accounting guidelines are making it essential to look.  Most embedded leases are contained in contracts that involve the use of a certain asset and where the user controls that asset. What companies don’t realize is that these leases are contained in service contracts and aren’t identified simply with the term “lease.”

While not all companies have embedded leases, industries such as banking, retail, manufacturing, restaurant, energy, healthcare and logistics/transportation tend to have a greater number of service contracts with embedded leases.

Currently, service contracts with embedded leases aren’t treated much differently than those without.  New FASB lease guidelines require companies to divide the contract into the lease and non-lease components. Then, the embedded lease component must typically be recorded as a lease liability and right of use asset on the balance sheet.

How to identify embedded leases?

First, pinpoint any identified assets in the contract. In doing so, identify if it is explicit, when the asset is actually identified in the service contract, or implicit, when the only way the contract obligations can be satisfied is to utilize the asset. Also consider if the vendor has the right and a potential economic incentive to substitute the asset.

Second, decide if the lessee gains control of the asset and all its economic benefits.

If there is identification, control, and the company acquires the economic benefits, then it is a lease.

Where are embedded leases found?

Most embedded leases are found in service contracts. Therefore, companies need to have open discussions with supply chain, procurement and/or requisition departments, since they typically manage the service contracts. The accounts payable team needs to be included in order to identify the payments being made to service contracts. Common terms to look for since most aren’t directly identified by the term “lease” are: “solely,” “exclusive” use or “identification number.”

What makes the new rules related to embedded leases difficult?

Well, the FASB included practical measures declaring it’s not necessary for companies to re-evaluate expired or existing contracts, however, there is one caveat: errors are not exempt from the new rules. But how does a company know its service contracts are error-free without re-evaluating? The new rules assume companies have error-free contracts, yet these contracts are the ones that have historically been given very loose treatment. Therefore, many companies are performing a comprehensive review all service contracts to confirm they have a complete record of all embedded leases. To help ensure embedded leases are identified and properly recorded, companies can rely on CoStar’s feature-rich lease accounting and lease management software.

Matt Waters, CPA

Lease Accounting Subject Matter Expert with over 15 years of Management Experience in Accounting and Finance