Don’t Be Surprised by Embedded Leases under ASC 842

Imagine you’ve just gone through months of transitioning your leases from ASC 840 to ASC 842. It’s been a long, hard road but you’re finally there. Every lease now has a liability and right-of-use asset associated with it and you’ve considered all the moving parts associated with those lease contracts. Then, in a meeting with your auditor, you are asked a question that triggers a mini panic attack.

‘Did you find any embedded leases?’

A chill runs down your spine. What in the world is an embedded lease and how much extra work did this question just cost me?

This article will discuss what an embedded lease is, best practices in identifying embedded leases, and some commonly asked questions.

What is an embedded lease?

Not all contracts that meet the accounting definition of a lease are obvious. Sometimes, a contract may need to be recorded as a lease even if it is not labeled ‘lease’. According to Deloitte’s guide on ASC 842, a contract meets the definition of a lease if it ‘conveys the right to control the use of a specified asset.’

For example

Acme Co. may have entered a contract with Standard Co. to host its data on a dedicated server. If embedded within the agreement is the right for Acme Co. to direct the use of that specific server, the agreement could meet the definition of a lease and need to be recorded as a lease.

Companies looking to be compliant with ASC 842 must review contracts and investigate whether those contracts contain embedded leases. These can be difficult to identify, so many companies have elected to engage CPA firms to assist in this process.

Identifying embedded leases

Embedded leases can be tough to find. They can be a real “lease in a stack of contracts,” to coin a phrase. According to Deloitte, these are the best practices for finding them:

Investigate operations across the business. Meet with relevant departments to understand the types of contracts that currently exist. This is a great opportunity to practice discussing accounting in non-accounting language so you can get the information you need.

Assess areas of risk. Perform a risk assessment to identify areas where embedded leases are more or less likely to exist. Depending on the technical accounting knowledge of the team internally, it may be a good investment to outsource this risk assessment to a professional services firm.

Review expense activity. Investigate expenses to find areas that might require additional analysis. Specifically, look for payments that recur on a regular cadence. They could signal an embedded lease.

Perform a physical inspection. Look around the office to check for assets that aren't in the asset register. Printers and office furniture can be areas of concern.

Ask legal to help. The legal department can help in reviewing contracts and highlighting possible embedded leases.

Embedded lease examples

Here are some real-world examples of leases that fit the definition: ‘conveys the right to control the use of a specified asset.’

  • A company requires one truck dedicated to making deliveries only for that company.
  • A customer requires a dedicated production line from a manufacturer to produce a run of products. 

Is Software as a Service (SaaS) considered an embedded lease?

Thankfully, no. The right to use intangible assets is outside of the scope of ASC 842. For intangible assets, look to the ASC 350 for proper accounting standards.

Bottom Line:

Achieving ASC 842 compliance requires understanding what an embedded lease is and how to successfully identify them. Tools like NetLease by Netgain can systemize and simplify the accounting of those leases.

For more information on automating your lease accounting, schedule a conversation with one of our CPAs