One of the topics in the new FASB guidelines getting a lot of attention these days involves ASC 842 embedded leases--those provisions that are often hidden or buried in a larger service or supply contract that grant a lessee the right to use an asset for a specified term.
In fact, in a 2018 KPMG poll, over 60% of respondents indicated that the most significant challenge they encountered in ASC 842 implementation was identifying embedded leases.
The requirement to identify embedded leases is not altogether new. Under ASC 840, embedded leases, like operating leases, were to be included only in the footnotes. And because they had little impact on financial statements, many companies may not have been diligent in their efforts to identify all their embedded leases.
However, the new lease accounting standard calls for virtually all leases over 12 months to be recognized on the balance sheet with a right-to-use lease asset and lease liability.
It doesn’t matter if an embedded lease is classified as an operating lease or a finance lease, the accounting for it must happen on the balance sheet.
The recognition of embedded leases has financial professionals concerned for several reasons:
- As noted above, these types of leases were often overlooked as simply part of a service agreement or treated as operating leases--which up till now were accounted for off-balance sheet. There could be a myriad of embedded leases that need to be discovered.
- Locating them is difficult, partly because many contracts with an embedded lease may not even contain the words “lease” or “rent.”
- Failure to include an embedded lease could possibly have a material impact on a company’s financial statements.
Private companies in the midst of implementing the FASB guidelines for compliance, need to take the identification of all their embedded leases seriously.