One of the trickier aspects of the new lease standard is the concept of embedded leases. Like many components of the new standard, identifying an embedded lease takes human judgment—and there are few shortcuts to simplify the process.
This article examines the basics of embedded leases and how to identify them, so you can help your clients with this complex aspect of implementing the new lease standard.
What is an embedded lease?
Embedded leases are a new concept for many people. Though organizations were always supposed to disclose all leases, in the past the operating leases - which is what most embedded leases will likely be - weren’t recorded on the balance sheet and therefore received less attention.
An embedded lease occurs when an organization has a contract with a vendor that uses an asset as part of the value provided and the use of that asset meets the definition of a lease.
Example: A service provider does regular deliveries on your company’s behalf and you pay them per delivery. They have a fleet of vehicles with one truck dedicated solely to making deliveries for your company. Does that qualify as an embedded lease on that truck? Possibly. We’ll explore more throughout the blog.
What is required for it to be an embedded lease?
Like nearly everything with the new lease standard, determining if something is an embedded lease requires some judgment and evaluation on a case-by-case basis. However, there are a few considerations that can help identify an embedded lease.
1. A qualifying asset exists as part of the overall value provided in the contract.
- In our example, yes, the truck is a physical asset. For many consulting contracts, there may be no qualifying assets as part of the services delivered.
2. The company (lessee) must have control over the asset or the use of it, which means it has the right to substantially all of the economic benefits during the contract term and has the right to direct the use of the identified asset.
- In our example, yes, you have control over the use of the truck because you are receiving substantially all of the economic benefits of having a truck, as well as directing its use to make deliveries on behalf of your organization.
3. The asset must be explicitly identified in the contract. The important point to keep in mind here is whether the supplier has the practical ability to substitute out the asset and the supplier could benefit from doing so (in which case the asset is not explicitly identified).
- Going back to our example, in many cases it is feasible that the supplier could swap out the delivery truck for a new one, perhaps one with better gas mileage. If this is true, then it is not an embedded lease, even though it met the other criteria.
- If the truck had been significantly modified to meet your specific delivery needs, perhaps the supplier can’t derive economic benefit by swapping it out with other trucks and therefore it might be an embedded lease. This is why analyzing the facts of each situation is so important.
How prevalent are embedded leases?
When the new lease standard was introduced, many organizations feared they might have thousands of embedded leases in their service contracts. So far, that doesn’t seem to be the case based on the high threshold for what defines a lease.
However, it’s still critical for every organization to review each service contract (and unfortunately we haven’t yet discovered a shortcut for this step) because a human needs to make a judgment. Your auditor will want to know that you’ve done a thorough analysis to look for embedded leases.
How do I account for an embedded lease?
Good news! Once an embedded lease has been identified, it is treated just like any other lease. That sounds simple, but now there’s often a new challenge to calculate the lease vs. non-lease payments in the contract, along with the fair value and economic life of the asset. When the underlying asset is readily available for purchase on the market and there are clear and generally accepted guidelines for its useful life, this is less complicated. If you do have an embedded lease, we strongly recommend reaching out to your CPA firm to ensure that your valuation methodology meets the nuances that can exist with these requirements.
Want to see how operating leases are treated on the balance sheet and income statement? Check out this guide to see side-by-side examples of financial statements before and after applying the new lease standard.