While embedded leases are not a new concept in accounting, they are now receiving a lot more attention. In the past, operating leases weren’t recorded on the balance sheet, so embedded leases were generally ignored. That's changed: standards like ASC 842, IFRS 16, and FRS 102 now require them to be identified and recorded.
Determining whether a contract contains an embedded lease can be difficult and time-consuming, particularly for those not as well-versed in lease accounting guidelines.
That’s why Crunchafi created a checklist to make identifying potential embedded leases within contracts vastly simpler and quicker over doing so manually.
What is an embedded lease?
An embedded lease occurs when an organization has a contract with a vendor that uses an asset as part of the value provided and the use of that asset meets the definition of a lease.
Lease standards like ASC 842, IFRS 16, and the revised FRS 102 Section 20 require that organizations record most leases on the balance sheet to more fully reflect the company’s assets and liabilities.
The first step to implementing the new standard is for organizations to conduct an inventory of all their current leases, which includes any leases that may be embedded within service contracts.
The Embedded Lease Checklist
Crunchafi's Embedded Lease Checklist eliminates the confusion from this process.
Simply answer five easy questions about each contract to get a definitive answer about whether the contract contains a lease or not, and why. Document your findings to demonstrate for audit purposes that each contract was evaluated, along with the result (lease or no lease).
CPA & Chartered Accountancy firms:Send this list to your clients to help them get started reviewing their lease portfolio in advance of implementing the lease standards.
1. Does the contract include any sort of physical asset being used on your behalf?
Pay for items used (such as soda or disposables in a hospital), where equipment (soda machine or heart monitoring equipment) is included at no additional charge.
Computer equipment, services, dedicated data lines or pipelines.
Warehouse space, billboard space.
Non-tangible assets, like Software as a Service.
Leases to explore for or use non-renewable resources (e.g., oil, natural gas, etc).
Leases of biological assets (e.g., timber, livestock, etc.).
Leases of inventory or assets under construction.
Note: A "period of time" might not be the full length of the overall contract.
2. Do you have the right to substantially all of the economic benefits from that physical asset through a period of time?
Answer YES if you have any of the following:
Answer NO if you have any of the following:
You have a dedicated data line that is only used by your organization.
A piece of equipment is located on your property the entire time it is in use - even if it's there for 18 months and the overall contract is for 24 months.
You rent a plane that is only used by you during the contract.
The data line to the office building is used by several other tenants as well.
A piece of equipment is brought on site sporadically for use during the contract and is used by other organizations as well.
You rent a plane that is used by others as well during the course of the contract.
3. Do you have the right to direct the use of the identified asset?
Answer YES if you have any of the following:
Answer NO if you have any of the following:
Your property is stored in particular part of the warehouse.
You are the only tenant using the space you rent.
You are not operating the equipment, but the contract identifies the required output from the equipment.
Your property can be stored anywhere inside a warehouse at the owner's discretion.
You rent office space, but where you and/or employees sit is on a "first come, first served" basis.
You rent office space, but where you and/or employees sit is on a "first come, first served" basis.
4. Is the asset explicitly identified?
Answer YES if you have any of the following:
Answer NO if you have any of the following:
The contract results in one specific vehicle or piece of equipment that is used for the entire term.
You rent the northwest corner of a warehouse for your product.
You are not operating the equipment, but only one piece of equipment can produce the required output.
A data center doesn't explicitly say where data is stored, but privacy and security requirements mean that it has to be stored in one particular area.
The contract might specify a particular model, but the actual equipment used is interchangeable and still satisfies the contract.
Your product is stored anywhere in rented warehouse space, at the owner's discretion.
You are not operating the equipment and there are many pieces of equipment that can produce the required output.
A data center can store data on any of its servers.
5. Are there substantive substitution rights as part of the contract?
Answer YES if you have any of the following:
Answer NO if you have any of the following:
The supplier has an economic incentive to make a substitution even without your approval.
It's likely that a newer piece of equipment will result in lower operating costs for the supplier.
Warehouse space is specified, but can be moved and the storage company frequently reorganizes client storage locations.
The supplier can only make a substitution with your approval.
The supplier can make a substitution if the equipment breaks, but has no economic incentive to make a substitution for any other reason.
The supplier can make a substitution after a specific period of time, but would have no clear economic incentive to do so.
Note: Substitution rights are considered substantive when the supplier has the practical ability to substitute the asset AND the supplier benefits economically by substituting the asset.
The Embedded Lease Checklist Results
Use your answers to the questions above to determine the status of your lease.
If you answered YES to questions 1-4 and NO to question 5:
This contract does contain a lease that has to be recorded
This is because:
The contract includes a physical asset being used on your behalf.
You have the right to substantially all of the economic benefits for a period of time.
You have the right to direct the use of the identified asset.
The asset is explicitly identified.
There are no substantive substitution rights as part of the contract.
If you answered NO to questions 1-4 or YES to question 5:
This contract does not contain a lease that has to be recorded
These are possible reason why:
The contract does not include a physical asset being used on your behalf.
You do not have the right to substantially all of the economic benefits for a period of time.
You do not have the right to direct the use of the identified asset.
The asset is not explicitly identified.
There are substantive substitution rights as part of the contract.
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