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Embedded Leases: Pro Tips for Navigating the New Accounting Standard

Embedded leases and the new accounting standard

There’s a critical - yet extremely overlooked - piece of FASB ASC 842 implementation.

It’s lease type.

In fact, the 43% of companies estimate they only have 1-200 leases, but they may not be considering that FASB ASC 842 covers not just real estate leases, but equipment leases, vehicle leases and embedded leases, too.

And embedded leases - service contracts that contain a lease asset - have presented the biggest headaches for implementation.

Under the new lease accounting standards, reporting for embedded leases has changed dramatically. They must be reported on the balance sheet. Many companies lean heavily on supply and service contracts that contain embedded leases.

Because understanding this topic is essential to success with the new lease accounting standards, we’re diving into the specifics about embedded leases, their impacts on accounting, and a plan of attack for applying them.

Identifying Embedded Leases

Although determining what qualified as an embedded lease was somewhat convoluted for the first round of FASB ASC 842 reporting, the guidance is now clear about how to identify this lease type.

Two criteria must be met in order to qualify as an embedded lease: 

  1. The contract must involve an identified asset.
  2. The contract must convey the right to control the use of the identified asset for a period of time in exchange for consideration.

The latter criterion also includes the right to collect basically all of the economic benefits from the asset.

If this sounds confusing, you’re not alone. You can ask yourself these useful questions if you need help determining if an asset is identified and if you have the right to control the use of the asset. 

Examples of contracts where you can find embedded leases include transportation service agreements, information technology (IT) service contracts, and contract manufacturing arrangements. Another case may be when a vendor provides equipment that coincides with the purchase of consumable material or a rendered service. 

Often in these scenarios, leases are hidden in plain sight. That in itself has presented a significant challenge for many companies going through ASC 842 implementation.

Determining the value of an embedded lease is different from other lease types, too:

  1. You must evaluate all significant service contracts that may contain an identified asset.
  2. You must decide which purchase commitments or service fees apply to lease liability.
  3. You must analyze the financial repercussions if you can’t attain the required purchase levels for the consumables in the contract.

To say embedded leases are complex is an understatement.

It’s imperative companies give enough time, resources, and planning to this intricate piece of the FASB ASC 842 puzzle.

 

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Impacts to Your Business

Embedded leases are a fly in the ointment for private companies who have a compliance deadline of early 2021.

If you have just 1 lease and/or 1 service contract, the rulebook says you must comply.

And if your company executes large numbers of contracts annually, locating your embedded leases should be at the top of your priority list. 

For the healthcare industry, the impact will be significant.

Although every industry will have contracts to sift through to find embedded leases, healthcare will have a veritable mountain of paperwork to dig through. There’s a lot of technology and equipment contracted out. 

On top of that, more and more medical suppliers are offering what’s known as a “no-cost” contract where you pay nothing for one piece of equipment as long as you promise to purchase more in the future. The identified asset needed for FASB ASC 842 reporting is buried in the fine print.

One of the saving graces is that the FASB doesn’t require you to reassess expired or existing leases. You just need to address new, modified, and renewed contracts for potential embedded leases.

Because time is so tight and there will be a lot of contracts to sort through, it’s important companies be smart about evaluating the agreements that could be considered material or the biggest contracts in their possession.

Joshua Reisz, Manager of Global Financial Reporting at Kennametal, Inc. said his company addressed this problem by completing a review of its largest contracts, regardless of whether they thought the agreement contained a lease or not.

“We engaged with our procurement team to review the terms and conditions in those contracts and to get a good understanding of what it was we were buying,” said Joshua.

Auditors will be especially wary to look for controls associated with identifying embedded leases.

According to Mike Handley, CPA and Senior Manager at CFGI, embedded leases have become more of a focus of auditors given the impact to the balance sheet. He advises to plan early and get ahead of these challenges sooner rather than later.

 

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Plan of Attack

Including embedded leases on the balance sheet is one of the reasons the new lease accounting standard has caused so many waves. It’s the first time these types of leases have had to be reported this way. 

Because no one has ever had to do this before, organizations must be bull-headed about forming new processes and controls to complete this task with efficiency and accuracy.

The first step in your plan of attack will be to complete an analysis of all material service contracts.

Joshua Reisz from Kennametal, Inc. said his team spent a good amount of time analyzing purchase arrangements and service agreements. They worked closely with auditors - even going all the way up to their national office - with respect to this challenge. 

He said another hurdle when it came to embedded leases was changing the way they thought about leases and what types of arrangements contain leases, like some of its IT agreements, for example.  

The next step is getting your teams on the same page about the urgency and accuracy of gathering this data. 

Lease management has traditionally been the realm of the property team, while balance sheet reporting is the responsibility of finance. With FASB ASC 842, these departments - including supply chain, purchasing, operations, and information technology - will have to collaborate closely. 

“I’d emphasize the importance of being upfront about the requirements that are going to be needed, getting buy-in from upper-level management, and setting a charter. Set the tone from the start that the project is a priority and it’s something you’re going to need everyone’s help with," says Mike Handley from CFGI.

As important as it is for companies to examine service and supply contracts, it’s just as important for companies to develop and document controls to track embedded leases in the future.

Whether locating embedded leases now or in the future, take heed from the lessons public companies have learned: Compliance is an interdepartmental effort.

 

Conclusion: Difficult, But Not Impossible

There’s no doubt managing the embedded leases portion of FASB ASC 842 implementation will be challenging for your team. 

Which means waiting to start is a recipe for disaster.

FASB ASC 842 is a ticking time-bomb. All considered, there’s not much time to execute this complex element that’s even been a burden for financially sophisticated companies: Just over 1 year with 6 months estimated to complete the basics.

And like most good things, there’s no silver bullet for doing it fast AND accurately. 

What we’ve learned over the past few years helping hundreds of companies implement the new lease accounting standards is that those who start now will gain the upper hand, but lollygagging will cost you.

Don’t be another statistic. Take the first step to kickstart your FASB ASC 842 implementation by chatting with one of our lease accounting experts

Talk to us today!

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Posted on 12/2/19 7:00 AM by Taft Tucker in Lease Accounting

Taft Tucker

Written by Taft Tucker

Taft is the Chief Customer Officer at AMTdirect and is a resident expert about lease administration and accounting. Taft's passion is to share practical, helpful information about our industry.