The notion of so-called “embedded leases” has received a lot of attention lately — all in response to the new Financial Accounting Standards Board (FASB) guidance in ASC 842, Leases(ASC 842).
An embedded lease is a provision within a broader service agreement that grants the customer the right to use an identifiable asset throughout the term of the contract. For example, as part of a remote monitoring contract, the customer may be granted the exclusive use of cameras and other identifiable assets throughout the term of the agreement.
Interestingly, many embedded leases identified under ASC 842 would have also qualified for lease accounting under legacy GAAP (ASC 840). So why is there suddenly a focus on identifying embedded leases?
Prior to ASC 842, the accounting for an embedded lease as a service arrangement was not substantially different than an operating lease agreement. Both resulted in costs being recorded as an operating expense, on a straight-line basis, in the income statement. Neither the service agreement nor the lease required recognition on the balance sheet under ASC 840.
Today, assets and liabilities still are not recognized for service agreements. However, under ASC 842, lessees are required to record a right-of-use asset and a lease liability for all leases longer than 12 months. This accounting is required no matter whether the lease is classified as operating or finance. As a result, the failure to identify an embedded lease could now potentially have a material impact on an entity’s financial statements.
This article will explore two examples of embedded leases and provide guidance on the steps to identify leases in accordance with ASC 842.
A local hospital has a contract with a vendor to provide coffee to its employees and patients for a period of three years. The vendor supplies and installs the equipment necessary to brew the coffee, and, in return, the hospital pays the vendor a monthly fee to provide coffee filters, grounds and maintenance and cleaning services.
Does the scenario described contain a lease as defined by ASC 842? Yes, it does. To understand how the service contract could include an embedded lease, it is helpful to outline the lease definition under ASC 842.
ASC 842-10-15-3 states, “A contract is or 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.”
The coffee-making equipment comprises the identified assets, and we will assume the hospital controls the use of this equipment during the time it is housed on campus. The monthly payments made to the vendor are not just for maintenance and cleaning services, supplies and grounds; there is an implied element of each payment that compensates the vendor for the hospital’s use of its coffee-making equipment.
Admittedly, this example may not represent a material lease when compared to the financial statements as a whole. However, it does provide a good example of a lease embedded within a service agreement that may not be obvious at first glance.
Now, let’s explore a second, more significant example.
Two companies (“Manufacturer” and “Retailer”) enter into a production agreement under which Manufacturer agrees to manufacture specific products for Retailer over a period of 10 years.
The product designs will be determined and provided by the Retailer. Manufacturer will use its own personnel and equipment to fulfill any product orders placed by Retailer. In fact, Manufacturer has installed a dedicated production line that will be used to fulfill only Retailer orders during the contract term. The fee that Retailer will pay for each product manufactured is designed to compensate Manufacturer for its product costs, including depreciation on the dedicated production line equipment.
Does the service agreement contain an embedded lease?
Let’s break the components of a lease as defined by ASC 842-10-15-3 into individual steps.
Step 1— Is there an identifiable asset?
Yes — the equipment utilized to produce the specified goods.
Step 2— Is there control over the underlying asset?
Yes — Retailer controls the use of the equipment over the term of the contract.
According to ASC 842-10-15-4, the determination of whether a contract conveys the right to control the use of an identified asset requires both of the following to be present throughout the period of the contract:
a. The right to obtain substantially all of the economic benefits from use of the identified asset
b. The right to direct the use of the identified asset
The production equipment will be solely used to manufacture the goods ordered by Retailer under the production agreement. This would mean all the economic benefits (output) from the use of the equipment would be for the benefit of Retailer.
The “right to direct the use” is defined in ASC 842-10-15-20 as having the right to direct how and for what purpose the asset is used throughout the period of use. Because the equipment will be exclusively used to satisfy Retailer orders, Retailer can direct how and for what purpose the equipment is being used throughout the contract term (e.g., whether the equipment is used to manufacture part A, part B, etc. and in what quantities).
When evaluating whether Retailer has the right to direct the use of the equipment, it is not relevant that Manufacturer, and not Retailer, will actually operate the equipment.
Step 3— Does the contract span a period of time?
Yes — the service agreement is for 10 years.
Step 4— Is there consideration paid in exchange for the identified assets?
Yes — the payments that Retailer will make under the production agreement will compensate Manufacturer for its manufacturing services, as well as for the right to exclusively use the dedicated production line during the term of the contract.
To summarize, the production agreement contains an embedded lease for the equipment exclusively used by Manufacturer to fulfill orders placed by Retailer.
Note that if the facts had been changed even slightly, a different accounting outcome might result. For example, if Manufacturer had the ability to use the equipment to fulfill orders from other customers, Retailermay not obtain substantially all of the economic benefits from the use of the asset, and, if so, the contract would not qualify as a lease under ASC 842.
Therefore, it is important to thoroughly examine each agreement when evaluating whether it is or contains a lease.
Being able to identify embedded leases is now critical to ensuring the balance sheet is not materially misstated under ASC 842.
While the failure to record a right-of-use asset for a single coffee maker probably won’t result in a material misstatement, a full assessment of a company’s contractual agreements may expose embedded leases that collectively result in a significant dollar amount.
Therefore, financial statement preparers should take the time to evaluate their various agreements to properly identify and account for embedded leases.
If you have any questions about ASC 842 and how to identify embedded leases, contact us. Or read more about ASC 842 here:
Side effects to adopting ASC 842, leases: Healthcare entities
New lease accounting: Top 10 FAQs surrounding ASC 842