Accounting for embedded leases is one of the most complex aspects of implementing ASC 842 and IFRS 16, as highlighted in the 2017 KPMG Accounting Change Survey. The leading concern among survey respondents is the challenge of identifying embedded leases (49%), with 78% of private companies reporting unanticipated difficulties in this assessment process. In addition to the practical implementation issues, embedded leases also have created a firestorm of analytical and structuring activity as lessors and lessees alike attempt to retain as many off-balance-sheet options as possible under the new rules.
An embedded lease represents the right to use property, plant and equipment (PP&E) in what many consider to be service contracts, pay-for-use and similar arrangements, all of which are becoming increasingly more popular in the market. In the past, any embedded leases and related services in the arrangement were usually both off-balance-sheet. Under the new leasing standards, though, lessees must recognize an asset and liability for any right to use equipment embedded in the arrangement. Although companies were required to perform embedded lease accounting under the current leasing standard, ASC 840, the new standard brings an increased focus to accurately report operating leases on the balance sheet.
An embedded lease, a term not defined in either ASC 842 or IFRS 16, represents a component of an arrangement that depends on the use of implicitly or explicitly identified assets and in which the customer controls the use of the assets. While the two conditions in ASC 842 appear similar to the requirements for identifying a lease under ASC 840, the second condition is now more closely aligned with how control is defined and applied in other topics such as revenue recognition. The concept of evaluating whether the customer has the right to direct the use of the identified asset is new to ASC 842 and is illustrated in Figure 1.
For most contracts, assessing whether a lease exists will not involve significant judgment. However, more complex scenarios may arise in arrangements in which both the customer and the supplier have decision-making rights about the use of an asset. Arrangements in which the customer makes most or all the decisions about how and for what purpose the asset will be used, but the supplier retains the decision-making rights over operations and/or maintenance of the asset, present challenges. Examples include cloud storage services and third-party logistics.
In a cloud storage service, the customer may direct the supplier to use a dedicated server for the contracted data storage (whether on customer or supplier’s premise), while the supplier does not have the right to change the contracted function of the server. Another example of a potential embedded lease is a contract with a logistics firm for warehouse storage and transportation of goods to the customer’s warehouses and retail outlets in which the storage service is provided with dedicated space in the provider’s warehouse.
The most difficult part of adopting the leasing standard is determining the full universe of what constitutes a lease. Where should a company look for potential embedded leases? Procurement systems can be a good resource for obtaining the population of purchase orders and vendor agreements such as outsourcing or service contracts that might contain embedded leases, even if they do not include the term “lease.” Companies that track their technology equipment in an IT asset management system can find valuable information about where assets, such as printers, servers, desktops, mobility devices and networking equipment, are located and who is responsible for them. Companies can also ask their IT outsourcing providers to supply a list of dedicated assets being used on their behalf to support their IT functions.
How an arrangement is structured can impact whether it contains an embedded lease. For example, contracts that specify assets may be accounted for as embedded leases, while those in which the supplier can substitute the assets may be accounted for as services, provided that the supplier’s substitution right is substantive. Similarly, different provisions may impact whether the customer controls the use of the asset. Many companies have outlined rules of the road for early engagement in structuring and pricing stages, especially if they are both a lessor and a lessee.
These companies have defined a two-part process to ensure proper financial statement recognition: work with procurement and sales teams during structuring to avoid embedded leases, and, if unable to avoid, educate these teams so they understand the data requirements needed to account for embedded leases properly. For example, procurement and sales functions are required to bring forward all procurement agreements and customer structures in which the contract has underlying assets that the supplier cannot practically substitute and the supplier does not control the assets. The process is based on questionnaires that help flag arrangements that are more likely to have embedded leases. If a bundled price cannot be avoided, pricing cases need to reflect the lease component, or the customer may request pricing information from the supplier.
What constitutes a lease was one of the thornier topics addressed in developing the new leasing standards and continues to be so as companies implement ASC 842 and IFRS 16. As highlighted above, one of the key implications of the on-balance- sheet treatment of all leases is an increased focus on the completeness of the lease population and contracts considered for lease identification analysis. If an arrangement is or contains a lease, customers may request more information from suppliers to streamline balance sheet recognition and disclosure. Last, there will be renewed focus on internal controls related to these efforts and processes. Whether a lessor or a lessee, companies must bring the appropriate resources to bear on this issue and do so on a timely basis.
NOTE: This article is provided for informational purposes only. Readers are strongly advised to consult with their own financial, tax and legal advisors in connection with the subject matter of this article.
An embedded lease represents the right to use property, plant and equipment (PP&E) in what many consider to be service contracts, pay-for-use and similar arrangements, all of which are becoming increasingly more popular in the market. In the past, any embedded leases and related services in the arrangement were usually both off-balance-sheet. Under the new leasing standards, though, lessees must recognize an asset and liability for any right to use equipment embedded in the arrangement. Although companies were required to perform embedded lease accounting under the current leasing standard, ASC 840, the new standard brings an increased focus to accurately report operating leases on the balance sheet.
An embedded lease, a term not defined in either ASC 842 or IFRS 16, represents a component of an arrangement that depends on the use of implicitly or explicitly identified assets and in which the customer controls the use of the assets. While the two conditions in ASC 842 appear similar to the requirements for identifying a lease under ASC 840, the second condition is now more closely aligned with how control is defined and applied in other topics such as revenue recognition. The concept of evaluating whether the customer has the right to direct the use of the identified asset is new to ASC 842 and is illustrated in Figure 1.
For most contracts, assessing whether a lease exists will not involve significant judgment. However, more complex scenarios may arise in arrangements in which both the customer and the supplier have decision-making rights about the use of an asset. Arrangements in which the customer makes most or all the decisions about how and for what purpose the asset will be used, but the supplier retains the decision-making rights over operations and/or maintenance of the asset, present challenges. Examples include cloud storage services and third-party logistics.
In a cloud storage service, the customer may direct the supplier to use a dedicated server for the contracted data storage (whether on customer or supplier’s premise), while the supplier does not have the right to change the contracted function of the server. Another example of a potential embedded lease is a contract with a logistics firm for warehouse storage and transportation of goods to the customer’s warehouses and retail outlets in which the storage service is provided with dedicated space in the provider’s warehouse.
The most difficult part of adopting the leasing standard is determining the full universe of what constitutes a lease. Where should a company look for potential embedded leases? Procurement systems can be a good resource for obtaining the population of purchase orders and vendor agreements such as outsourcing or service contracts that might contain embedded leases, even if they do not include the term “lease.” Companies that track their technology equipment in an IT asset management system can find valuable information about where assets, such as printers, servers, desktops, mobility devices and networking equipment, are located and who is responsible for them. Companies can also ask their IT outsourcing providers to supply a list of dedicated assets being used on their behalf to support their IT functions.
How an arrangement is structured can impact whether it contains an embedded lease. For example, contracts that specify assets may be accounted for as embedded leases, while those in which the supplier can substitute the assets may be accounted for as services, provided that the supplier’s substitution right is substantive. Similarly, different provisions may impact whether the customer controls the use of the asset. Many companies have outlined rules of the road for early engagement in structuring and pricing stages, especially if they are both a lessor and a lessee.
These companies have defined a two-part process to ensure proper financial statement recognition: work with procurement and sales teams during structuring to avoid embedded leases, and, if unable to avoid, educate these teams so they understand the data requirements needed to account for embedded leases properly. For example, procurement and sales functions are required to bring forward all procurement agreements and customer structures in which the contract has underlying assets that the supplier cannot practically substitute and the supplier does not control the assets. The process is based on questionnaires that help flag arrangements that are more likely to have embedded leases. If a bundled price cannot be avoided, pricing cases need to reflect the lease component, or the customer may request pricing information from the supplier.
What constitutes a lease was one of the thornier topics addressed in developing the new leasing standards and continues to be so as companies implement ASC 842 and IFRS 16. As highlighted above, one of the key implications of the on-balance- sheet treatment of all leases is an increased focus on the completeness of the lease population and contracts considered for lease identification analysis. If an arrangement is or contains a lease, customers may request more information from suppliers to streamline balance sheet recognition and disclosure. Last, there will be renewed focus on internal controls related to these efforts and processes. Whether a lessor or a lessee, companies must bring the appropriate resources to bear on this issue and do so on a timely basis.
NOTE: This article is provided for informational purposes only. Readers are strongly advised to consult with their own financial, tax and legal advisors in connection with the subject matter of this article.
Share:
Article Tags:
EL&F magazine article
LEASE ACCOUNTING
Financial Watch
Column
2018