Under new lease guidance a lease is defined as “a contract, or part of a contract, that conveys the right to control the use of identified property, plant or equipment for a period of time in exchange for consideration.” Not much new here, right?
But what happens if the contract has no mention of the word “lease?” The concept of an “embedded lease” is not new either. However, the failure to discover and account for embedded leases can have greater consequences under Accounting Standards Codification Topic 842, Leases (ASC 842).
In 2016, the Financial Accounting Standards Board issued its long awaited standard on accounting for leases. The leases most affected by ASC 842 are those that have not historically been presented on the entity’s balance sheet. The standard now requires the presentation of a “right-of-use” asset and lease liability for all but short-term leases, so not accounting for embedded leases can result in significant misstatements of the entity’s financial statements reported under generally accepted accounting principles. This could cause lenders and other users of the financial statements to be misinformed about the entity’s financial position, leverage and other critical financial metrics.
Many service contracts might contain embedded leases. Imagine you have just completed an analysis of your technology needs and have determined the best solution is to move your systems to the cloud under a three-year managed solutions service contract with your IT vendor and they have made arrangements to have your information stored on a dedicated server for security purposes.
Embedded in this arrangement might be the right to control the use of identified property (the server), for a period of time (three years), in exchange for consideration. You could have a contract that contains a lease component that must be presented on the entity’s balance sheet, as well as nonlease components that are expensed as incurred.
Once discovered, accounting for the lease under ASC 842 involves careful consideration of a variety of judgmental, nuanced and potentially complex terms and calculations.
Embedded leases are commonly discovered in IT contracts, outsourced manufacturing contracts, complex service contracts and advertising contracts. So, where do you go in search of these elusive embedded leases? The accounting department? The accounting department in most organizations ultimately will be responsible for successful implementation of ASC 842; however, discovering embedded leases will likely involve all departments that enter into contracts with outside vendors.
Accounting department personnel must become proficient in ASC 842 and be able to translate the technical accounting terminology to non-accountants. Rather than asking the head of the marketing department for “all contracts with embedded leases,” ask “does the company have any advertising contracts that involve the use of a specific asset as part of the advertisement?” If the answer is “does a billboard count,” you’re on the right track.
Lease accounting software solutions can benefit organizations when implementing ASC 842, as well as when analyzing contract terms prior to signing contracts so as to understand the effect on current and future financial reporting. Software solution functionality varies at different price points and can include or exclude the capability to assist in identifying embedded leases.
ASC 842 was effective for publicly held companies with a calendar year end on Jan. 1, 2019, and will be effective for privately held companies with a calendar year end in their Dec. 31, 2021, financial statements pending approval by the FASB of a recently proposed one-year delayed effective date.
Companies that have either completed the implementation or are in the process of implementing ASC 842 have indicated that identifying the existence of a lease has presented significant challenges. Organizations that have not begun implementation are encouraged to begin soon and avoid that famous phrase, “the one that got away” when hunting for the embedded lease.