Five FAQs about Embedded Leases

#1: What is an Embedded Agreement?

According to ASC 842, a contract contains a lease if, “the contract conveys the right to control the use of identified property, plant, or equipment (an identified asset) for a period of time in exchange for consideration.” This definition includes any agreement, even those that are not specifically lease agreements.

Companies should have always classified their contracts as lease contracts if they met the above definition; however, since operating leases weren’t recorded on the balance sheet, companies often didn’t classify their contracts as such.

The new lease standard, ASC 842, makes it imperative that companies account for all leases in their contracts. Read more about the new standard and how it’s changing lease accounting here.

Agreements with embedded leases are contracts that have leases in them, but they might be a bit hard to properly identify. In order for a contract to be considered to have an embedded lease, it must:

Involve an identified asset

Assets in a lease can be identified either explicitly, with something like a serial number, or implicitly, such as delivering an asset to a customer’s location. However, if a lessor has the substantive right to substitute the asset mentioned in the contract, the asset is no longer considered identified.

Convey the right to control the use of the identified asset

For a lessee to have the right to control the use of an asset, they must have the right to obtain substantially all the economic benefits from the asset as well as the right to direct the use of the identified asset.

Have an identified period of time for the contract

The contract should state a period of time during which the lessee has control over the lessor’s asset. This period of time can be different from the length of the overall contract itself.

Include an exchange of consideration

An exchange of consideration would be the exchange of a right, interest, or benefit that the lessor gives to the lessee in the contract.

#2: Where Do Embedded Leases Usually Hide?

Embedded leases can usually be found in things such as:

Information technology contracts (servers)
Cable and satellite services (set-top boxes)
Advertising (billboards, signage, naming rights)
Medical consumables (medical devices included in contracts)
Joint-operating agreements (drilling rigs)
Construction contracts (cranes or other equipment)
Complex service contracts/managed services (specified equipment)
Contract manufacturing arrangements (dedicated production)
Transportation, storage, and delivery services (carriers and warehousing)
Power purchase agreements (power plants, easements)

#3: What are Some Embedded Lease Examples?

An example of an embedded lease in a contract would be a contract manufacturing agreement that has the following terms and conditions:

The lessee specifies that a dedicated production line must be used by the supplier, the manufacturer has to use their employees to produce units, and the lessee controls the periods that the production equipment is idle or operational. All of these requirements mean the lessee has full control over the asset.
The lessee specifies which production line is used by the manufacturer and the manufacturer is not able to change production to another line means the identification of the asset is present in the contract.
A three-year contract manufacturing term is agreed upon and stated in the contract means the period of time is known.
The agreement specifies payments to the supplier, indicating that there is an exchange of consideration in the contract.

#4: How Do I Find an Embedded Lease?

There are a few different best practices one can deploy when trying to find embedded leases in contracts. Some of these are:

Looking closely at all agreements and ensuring that technical concepts in contracts are fully understood,
Assessing the organization for the types of activities where embedded leases are more likely to exist,
Reviewing general-ledger expense activity to identify expenses that require analysis,
Performing a physical inspection of different locations where the organization operates to identify assets that might not appear on a leased asset registry,
Having an attorney examine contracts to ensure nothing is missed.

#5: What are the Consequences of Missing an Embedded Lease?

The failure to identify a lease under ASC 842 means that an entity is in noncompliance with generally accepted accounting principles (GAAP) and is understating the assets and liabilities on its balance sheet.

This consequence is the reason why ensuring accuracy in accounting for all leases, embedded or otherwise, is important for both your bank and your investors.

If you have any questions or if you would like to discuss the possibility that you may have an embedded lease, please reach out to the BMSS Assurance team by calling (833) CPA-BMSS or visit the Accounting and Auditing page of our website.