Demystifying embedded leases: Top five insights, key indicators and accounting lessons learned

Identifying embedded leases often requires broader discussions throughout the organization beyond the accounting function, involving procurement, legal, engineering, manufacturing, IT and more to identify and evaluate arrangements. Physical inspection may be necessary in some cases to understand the nature and function of assets as well as the related output.

Identifying dedicated or specialty equipment may be clear, however asking the right questions may identify more assets subject to lease arrangements. An embedded lease contains two pieces:

• Identified asset

• Right to control

See below for example indicators to consider.

The devil is in the details. Each arrangement will need to factor in specific facts and circumstances. A blanket conclusion on a broad range of contracts (e.g., by arrangement type) may not sufficiently eliminate the risk of an embedded lease.

The new leases standard includes significantly enhanced lessee and lessor disclosure requirements that would apply to in scope arrangements, including embedded leases.

• Lessees record right of use assets and lease liabilities based on lease payments.

• Consider differences in timing and the financial statement line items in which lease expense and income are reported. 

• Embedded leases typically include variable lease costs, a required lessee disclosure.

• Narrative disclosures, weighted average lease term, and weighted average Incremental Borrowing Rate may be impacted by embedded leases.

• The machinery is run exclusively (or almost exclusively) for a single customer.

• The supplier frequently provides goods or services on demand, or as needed by the customer.

• The supplier has limited excess inventory space beyond the customer’s expected order forecast trend, including contractually required safety stock, such that the supplier will likely manufacture at the customer’s demand.

• The arrangement restricts the supplier from modifying or relocating equipment once it has been installed.

• The supplier’s decision affecting the use of the assets must be approved by the customer.

• Customers participate on joint committees and boards, meaning that the supplier doesn't have the unilateral right to make changes.

• There is no PP&E used in fulfilling the contract with the customer or lessee. 

• The supplier or lessor has multiple assets that can be used in fulfilling the contract. Use of the other assets would not increase supplier cost substantially more than had the original asset been used, and customer approval is not required in changing assets.

• The supplier has the right to change when the output is produced and the quantity of that output (i.e. supplier can front load, backend load or otherwise produce as they see fit) without input from the customer.

It is also important to consider whether the supplier has the ability to change when the output is produced. So ask yourself: Are lead times sufficient? Is physical capacity sufficient to allow for inventory stocking to support ramp up assertions?