With the adoption of ASC 842 comes the challenge of identifying embedded leases. While the concept of embedded leases also existed under ASC 840, the treatment of expenses under these contracts did not vary from other operating leases, so the identification was not as critical. Both were reported on the income statement and were able to avoid the balance sheet. With ASC 842, contracts determined to be embedded leases now need to be reported on the balance sheet as a lease liability and right of use asset, making identification critical.
What is an Embedded Lease?
An embedded lease is a contract that includes the use of an asset that meets specific criteria such that it qualifies as a leased asset under ASC 842 and needs to be included on the balance sheet. What is challenging about identifying an embedded lease is these documents do not take on the title of “lease.” The most common examples of embedded leases are “service agreements” (i.e., the office copy machine) and agreements to provide supplies and materials (i.e., the office water cooler).
Identifying Embedded Leases
1. The process starts with gathering service contracts. These are typically secured through the procurement team. In organizations without a central source for contracting, the search may need to involve the accounting team to help identify recurring vendor payments on the general ledger, or a survey of department managers to unearth random service agreements.
One-time service agreements or contracts with intended durations of one year or less can be excluded since ASC 842 only requires leases of one year or longer in term to be included on the balance sheet. However, lease terms that are less than one year but anticipated to continue indefinitely may need to be included.
2. Identify the specified asset in each contract. In order to qualify as an embedded lease, there must be a specified asset that is to be used solely by the lessee for a stipulated period of time (over one year). Examples of a specified asset might include a copy machine, postage meter, computer equipment, or vehicle. If no assets are identified, the contract/service agreement can be ruled out as an embedded lease.
3. Confirm the specified asset is for your exclusive use and control. While a supplier may be using assets to service a contract, it does not necessarily mean a lease exists. One test is if the supplier has the practical ability and would benefit financially from swapping out the asset.
For example, a cleaning company might be using their equipment to perform the service, but if they control the asset and can utilize it on several contracts, it is not your asset and should not be treated as a lease. The same can be said for a shredding bin that is swapped out while service is provided. The asset (the bin) is regularly swapped out and would not qualify as an asset.
On the other hand, a copier or computer server that is for your exclusive use and not likely to be swapped out for the financial benefit of the provider would qualify as a leased asset under ASC 842.
Updating the Procurement Process
To ensure long-term compliance, companies should plan on making changes to their procurement process to include the evaluation of embedded leases. When a contract is determined to include an embedded lease, the process should ensure the agreement reaches the lease administrative team for inclusion in the calculations and reporting for ASC 842.
Determining Value of an Embedded Lease Asset
Because the asset being leased within a service contract may only play a supporting role in the overall contract value, a determination needs to be made separating the value of the asset and services being provided. If the market value of the asset is readily available, this process should not be difficult. In addition to determining the value of the asset, an evaluation will need to be made as to its economic life in relation to the contract length.
Once the lease liability and right of use asset is determined, the next step is to undergo a materiality test. Unfortunately, the threshold used for materiality is not specified by FASB, is not always black and white, and will vary by company.
While the international standard, IFRS 16, sets a materiality threshold of $5,000, those following ASC 842 need to make their own determination. Many of our lease administration clients utilize a threshold of between $3,000-5,000. The question becomes what impact the exclusion of leases below that threshold has on the big picture. For example, $5,000 might be a fine threshold for a company with a small number of leases in this range when the balance of their remaining leases total in the millions. But that threshold may not apply for a company with many $5,000 leases and which make up a good portion of their liability. Our lease administration team can help companies evaluate the impact of a potentially non-material lease on the larger total population.
For all your ASC 842 lease adoption questions and needs, reach out to an expert at National Lease Advisors today. We have the experience, and our team is ready to help.