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Accounting for Embedded Leases: Challenges and Best Practices

December 19, 2023

Wondering which of your contracts must be reported as lease obligations? This requires careful analysis. We dive into the details here.

Managers are finding that many common business contracts contain “hidden” lease components that trigger the updated lease reporting rules under U.S. Generally Accepted Accounting Principles (GAAP). This has made compliance with the rules even more complicated than expected for the unprepared.

Embedded Lease Conundrum

New lease accounting rules were approved in 2015. The updated guidance represents a major change to how companies report leases on their GAAP financial statements. It’s been in effect for public companies since 2019. However, for private companies, the updated guidance took effect in 2022, and some businesses have only recently realized the added burden of so-called “embedded leases.”

Specifically, under Accounting Standards Update (ASU) No. 2016-02, Leases (Topic 842), lessees must recognize all leases for tangible assets with terms of more than 12 months as right-of-use assets and corresponding lease liabilities. They’re also required to make additional disclosures.

The standard defines a lease as a contract — or part of a contract — that 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 such as rent. These “parts” are called embedded leases as they are leases within a larger contract arrangement which often focuses on the provision of services. Lessees must separate embedded leases from the nonlease components to properly report the former as assets and liabilities.

Embedded leases often aren’t obvious from the face of a contract. And they lurk in a wide range of arrangements, including:

  • Contract manufacturing,
  • Supply agreements,
  • IT and other service contracts,
  • Advertising contracts,
  • Transportation and delivery services,
  • Warehousing agreements, and
  • Joint operating agreements.

3 Steps to Accurate Reporting

Businesses can take three steps to reduce the risk of embedded leases falling through the cracks:

1. Cast a wide net. Don’t leave the identification of embedded leases to the accounting or legal teams alone. You need to involve representatives from purchasing, operations, IT and other departments who are likely to be more familiar with the actual nuts and bolts of an agreement. They understand not just what a vendor or supplier is providing (for example, IT or manufacturing services) but also how (for example, with specific servers or machinery).

Casting a wide net also means getting out from behind the desk. Doing regular walk-throughs of facilities may lead to the identification of leased assets not accounted for on a business’s list of assets.

2. Learn how to recognize an embedded lease. An embedded lease requires both an identified asset and the right of control. For example, a contract might include an identified asset if the supplier must use customized or dedicated machinery or other assets to complete it. Does the contract include substitution rights — or only contemplate the use of a specific asset? Is your approval required to employ a different asset?

You may have the requisite right of control if an asset is run exclusively or predominantly for your company. You also may possess the requisite right to control if your approval is required to modify or move an asset, or if the supplier provides the goods or services on an on-demand basis.

3. Implement formal contract review procedures. With the updated lease accounting requirements in full swing, companies must have formal systems in place to make embedded lease determinations early on. If you don’t, your financial reports could be inaccurate.

Purchasing and other relevant personnel should be aware of these procedures and ensure that leases receive appropriate review so that the necessary reporting information can be collected and available when needed. It’s important, though, that the accounting team educate these stakeholders on the lease rules in plain English so they know what to look for.

For More Information

Contact us to help evaluate which of your contracts — or parts of those contracts — must be reported as lease obligations under the updated guidance. Identifying and evaluating whether a contract contains an embedded lease subject to ASU 2016-02 requires careful analysis. We can help you make the determination and proceed accordingly, including valuing an embedded lease for accounting purposes.

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