Are leases embedded in your contracts?
FASB’s new leasing guidance requires lessees to record leases embedded in other arrangements on their balance sheets.
What you need to know about embedded leases
- The FASB’s new lease accounting standard requires lessees to record an asset and liability on the balance sheet for nearly all leases.
- Identifying embedded leases is important to avoid misstating the balance sheet.
- As a general rule, an embedded lease exists if there is an explicit or implicit identified asset in the contract and the customer controls use of the asset.
- If you identify an embedded lease, you may need to separate the contract into its lease and nonlease components and allocate consideration to each. Then, you need to classify each embedded lease as an operating or finance lease. Reassessment of these conclusions may be required.
- Changing certain contract terms may change the conclusion regarding whether an arrangement contains an embedded lease.
Identifying embedded leases under the new standard
An arrangement that is not a lease in form may still be subject to ASC 842 lease accounting. See this video for more details.
Does your company outsource manufacturing? Do your supply arrangements bundle services and a device? Does your company rely on suppliers for products? Do you have data center arrangements?
Under the FASB’s new lease accounting guidance, lessees will recognize an asset and liability for nearly all of their leases. This requirement also applies to any leases embedded in other arrangements, like supply contracts, data center agreements, and outsourcing agreements.
While current leasing guidance requires that embedded leases be identified and accounted for separately, most lessees were not always diligent in doing so because typically, they were offbalancesheet and did not have a material impact on the income statement. But under the new guidance, balance sheet amounts will be misstated if embedded leases are not identified and accounted for appropriately.
The requirements in the new leases standard to identify and account for embedded leases could have a significant impact on companies that rely heavily on outsourcing, data centers, bundled goods and services contracts, or other similar arrangements.
Identifying an embedded lease
There is judgment involved in assessing if an arrangement contains an embedded lease. The general rule under the new model is that an arrangement contains a lease if (1) there is an explicit or implicit identified asset in the contract, and (2) the customer controls use of the identified asset.
There is an embedded lease - what’s next?
Once you identify an embedded lease, the contract needs to be separated into its lease and nonlease components. A component is an item or activity that transfers goods or services to the lessee. Under the new guidance, items such as property taxes and insurance that the lessee pays to the owner are not separate components because the lessee does not obtain a separate good or service for them. Instead, they will be either included in contract consideration or accounted for separately as incurred depending on their nature.
The next step is to allocate the contract consideration among the identified components based on their relative, observable standalone prices. The standalone prices for the lease versus nonlease components might not be readily apparent, and you may have to get the information from the lessor, or make an estimate if the lessor is not willing to share such information. Finally, each embedded lease component needs to be classified as an operating or finance lease. The classification will determine the specific balance sheet presentation and the expense recognition model (straightline rent expense for an operating lease and frontloaded expense for a finance lease).
A lessee has the option to combine a nonlease component with the associated lease component and account for the combined component as a lease. This election must be made by class of underlying asset, which means that you will need to group your leases based on the underlying leased asset and apply this option to all leases in that group. When deciding whether to combine the components, you should weigh the impact of having a larger asset and liability on your balance sheet against the complexity involved in accounting for the components separately.
Reassessment
The new guidance adds more circumstances that require reassessment, and if necessary, reallocation and reclassification. The reassessment requirements in the new standard which go well beyond actual modifications are a significant change from today. Lessees will need new processes to monitor changes in circumstances that require revisions to lease accounting.
What lessees should consider
How an arrangement is structured can impact whether it contains an embedded lease. For example, contracts that specify particular assets may be accounted for differently than those in which the supplier can substitute the assets. Similarly, different provisions may influence the conclusion regarding whether the lessee controls the use of the asset.
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