The FASB issued ASC 842, Leases, in February 2016. As companies prepared for adoption and certainly post adoption, contracts that include or may include leases have been subject
to significant scrutiny both by the issuer of financial statements as well as the industry that audits them. One area of particular focus has been the proper identification and treatment of service contracts distinctly from leases. This article will highlight
some of the similarities and differences in the contracting and accounting between these two common types of arrangements.
Although leases and service contracts may be, and often are, combined under a single arrangement, they are both unique types of agreements that require consideration in the contracting phase and when accounting either as the lessor/service provider or as the lessee/customer.
At its most basic level, a lease agreement provides the lessee with the use of some identified physical asset owned by another party (lessor) in exchange for a fee. A service contract, on the other hand, is an agreement under which a service provider will use their unique skill to provide a service (e.g., consulting, data processing, website hosting, cleaning and maintenance, etc.) to a customer or service recipient.
In addition to differences described above, service contracts and lease agreements also have different disclosure requirements, which need to be evaluated against the relevant guidance.
In conclusion, determining the nature of a contract requires more than simply reading the name at the top of the document. Many of the contractual elements in the document need to be analyzed to determine if a service contract or a lease exists. Under old accounting guidelines this should have been done, but in practice, was glossed over because the accounting treatment was the same for service contacts and operating leases. The balance sheet presentation under ASC 842 brings the distinction to the forefront as leases are capitalized and service contracts, which are not included in ASC 842, are not.
Although leases and service contracts may be, and often are, combined under a single arrangement, they are both unique types of agreements that require consideration in the contracting phase and when accounting either as the lessor/service provider or as the lessee/customer.
At its most basic level, a lease agreement provides the lessee with the use of some identified physical asset owned by another party (lessor) in exchange for a fee. A service contract, on the other hand, is an agreement under which a service provider will use their unique skill to provide a service (e.g., consulting, data processing, website hosting, cleaning and maintenance, etc.) to a customer or service recipient.
Contract Considerations
Although both service and lease contracts generally provide that one party (lessor/service provider) provide something of value to another party (lessee/customer) for a fee, there are meaningful differences between the two agreements. All agreements need to be evaluated in detail as often a single contract contains elements of both types of agreements. For example, a lease may include both lease and non-lease components or a service contract could include an embedded lease. Some of the unique differences that should be considered during contract evaluation, include:
- Specified asset: To qualify as a lease under ASC 842, the agreement between the parties needs to identify the specific asset which the lessee will have the ability to control the use of over the term. This is not the case in a service contract where the service provider generally has more latitude in determining which specific assets will be used to satisfy the contract.
- Service level requirements: Whereas leases are generally focused on which assets will be conveyed to the lessee for their use, service contracts generally focus on the quantity and quality of a particular service to be delivered.
- Substitution rights: Since the purpose of the lease is to transfer right to use a specified asset, the transferor (i.e., lessor) generally must forego their rights to remove and replace the asset that is specified in the agreement. A service agreement on the other hand, does not transfer the right to use the asset and the service provider is normally free to use alternative assets to provide the contracted service so long as they meet the service level requirements of the agreement.
- Rights to direct how and for what purpose an asset will be used: The ability of a lessee to determine how and for what purpose it wants to use an asset under a lease is fundamental to determining which party controls the use of the asset. Without having the ability to control the use of the asset, you cannot have a lease. If the supplier has the decision-making rights over when, whether, and how a particular asset is used over the contract term and the arrangement is deemed not to be a lessee, then the agreement is most likely a service contract. This does not mean that lease contracts will not include protective rights such as limits around usage or required maintenance, but the more of these rights that exist and the more restrictive they are, the more likely the contract is a service agreement.
In addition to differences described above, service contracts and lease agreements also have different disclosure requirements, which need to be evaluated against the relevant guidance.
In conclusion, determining the nature of a contract requires more than simply reading the name at the top of the document. Many of the contractual elements in the document need to be analyzed to determine if a service contract or a lease exists. Under old accounting guidelines this should have been done, but in practice, was glossed over because the accounting treatment was the same for service contacts and operating leases. The balance sheet presentation under ASC 842 brings the distinction to the forefront as leases are capitalized and service contracts, which are not included in ASC 842, are not.
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EL&F magazine article
LEASE ACCOUNTING
Financial Watch
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2022