ASC 842 Embedded Leases
In the realm of business, particularly for companies that engage in leasing activities, understanding the nuances of lease accounting standards is crucial. The ASC 842, introduced by the Financial Accounting Standards Board (FASB), revolutionized the way leases are reported on financial statements.
An embedded lease is a lease that sits inside a contract that does not call itself one. Under ASC 842-10-15-3, a contract is or contains a lease if it conveys the right to control the use of an identified asset. That control must last for a period of time and be in exchange for consideration. Control requires both the right to obtain substantially all of the economic benefits and the right to direct the use (842-10-15-4).
This page covers what comes next: separating the lease from the services around it, allocating the price, and how the old ASC 840 rules compare. For the identification test itself, see our guide to how to identify an embedded lease.
For how embedded leases fit the wider framework, see our ASC 842 Complete Guide.
Understanding Embedded Leases
At its core, an embedded lease exists when a contract, or part of a contract, includes the use of a distinct asset, and that use is implicitly or explicitly specified in the agreement. It's like finding a hidden lease within a broader service or purchase contract.
Imagine renting a server for your company's website; you're not just paying for the IT support but also for the use of the server itself. That's an embedded lease, but only if the server is an identified asset and your company controls its use. A hosting plan on shared servers that the provider has a substantive right to swap is a service (ASC 842-10-15-10).
The ASC 842 requires that these leases be identified and reported on the balance sheet, highlighting the rights and obligations they bring. The exception is a short-term lease for which the lessee elects not to recognize a lease liability and right-of-use asset (842-20-25-2). This move towards transparency aims to give a clearer picture of a company's financial standing.
Examples of Embedded Leases
Identifying embedded leases can be tricky, as they are not always obvious at first glance. Here are some examples to clarify:
IT Services Contract: A company signs a contract for IT support, which includes the use of specific servers that the company controls. The server use is then an embedded lease. Servers the provider has a substantive right to substitute would not be (ASC 842-10-15-10).
Manufacturing Equipment: A business enters into an agreement to use a portion of a factory, including certain machinery, to produce its products. The machinery is an embedded lease if it is an identified asset that the business controls throughout the period of use (ASC 842-10-15-3, 15-4).
Advertising Agreement: A contract for advertising services includes the exclusive use of a billboard for a month. The billboard is an embedded lease if the advertiser controls its use; at one month it is a short-term lease. The lessee may elect to keep it off the balance sheet (ASC 842-20-25-2).
How to Identify Embedded Leases
Identifying embedded leases under ASC 842 involves a systematic approach. Here's a simplified guide:
1. Analyze the Contract
The first step is to thoroughly review the contract to determine if it conveys the right to control the use of an identified asset for a period in exchange for consideration.
Control means having two rights throughout the period of use: to obtain substantially all of the economic benefits from using the asset, and to direct its use (ASC 842-10-15-4).
2. Identify the Asset
Determine if the contract involves a specific, identifiable asset. The asset doesn't necessarily have to be explicitly mentioned; it can be implicitly specified.
If the supplier has a substantive right to substitute the asset, it may not be identified (substitution rights are tested in step 6).
3. Assess the Right to Control
Evaluate whether the customer has the right to control the use of the asset.
This means looking at whether the customer can decide how and for what purpose the asset is used, within the parameters set by the contract.
4. Consider the Contract Term
Consider the period during which the asset will be used.
A lease needs a period of use, which can be stated as an amount of use such as production units (842-10-15-3). A term alone is not a sign of a lease, though, because most service contracts have one too.
5. Economic Benefits
Think output, by-products, or a lease the customer could sublet; if only the supplier gets those benefits, the customer has no control.
The economic benefits of using an asset include its primary output and by-products, and other benefits the customer could realize from a commercial transaction with a third party (842-10-15-17).
6. Substantive Substitution Rights
Check if the supplier has the right or obligation to substitute the asset for another asset during the period of use.
A substitution right is substantive only if the supplier has the practical ability to substitute throughout the period of use and would benefit economically from doing so (842-10-15-10). Substitution only for repairs or technical upgrades does not by itself mean there is no identified asset (842-10-15-14).
Challenges and Considerations
Identifying embedded leases is a nuanced process that requires judgment and understanding of the specific terms and conditions of each contract. It's important for companies to establish robust procedures and controls to ensure that all embedded leases are identified and properly accounted for under ASC 842.
What to Do Once You Find an Embedded Lease
Finding the lease does not finish the job. The contract usually also buys services, such as support or maintenance, that are not part of the lease. ASC 842 has you split the contract before you book anything.
Step 1: Identify the separate lease components. Each right to use an underlying asset is its own lease component if two things are true (842-10-15-28). The lessee can benefit from it on its own or with resources readily available to it. And the right is neither highly dependent on nor highly interrelated with the other rights of use in the contract.
Step 2: Set aside the nonlease components. Components include only items or activities that transfer a good or service to you. Administrative set-up tasks and reimbursements of the lessor's costs are not components (842-10-15-30). Nonlease components are outside the lease Topic and are accounted for under other Topics (842-10-15-31).
Step 3: Allocate the consideration. A lessee allocates the contract price on a relative standalone price basis (842-10-15-33). It uses observable prices where they exist and otherwise estimates them, maximizing observable information. A residual approach can fit when a component's price is highly variable or uncertain.
Step 4: Account for each piece. The lease component goes through the normal ASC 842 steps: classification, a lease liability, and a right-of-use asset. The service is accounted for under the Topic that governs it (ASC 842-10-15-31). The classification tests and journal entries are the same as for any other lease.
The Lessee Practical Expedient: Combine Instead of Separate
A lessee may skip the split. As a practical expedient, it can elect, as an accounting policy by class of underlying asset, not to separate nonlease components from the lease component they relate to (842-10-15-37). It then accounts for the lease component and its associated nonlease components as a single lease component.
The election is simpler, but it has a cost. KPMG's Handbook: Leases explains that the payments that would have gone to the service become lease payments, and they enter the right-of-use asset and lease liability (KPMG). KPMG adds that this can change lease classification. It also notes that combining generally produces straight-line cost for the nonlease piece.
The election applies by class of asset, so it covers embedded leases in that class too. Our page on ASC 842 practical expedients lists the other elections to settle at the same time.
Worked Example: Splitting a Hosting Contract
A company signs a 36-month contract for a dedicated server and managed support at $10,000 a month, paid at the end of each month. The server is an identified asset the company controls, so the contract contains a lease. The figures below are assumptions for illustration.
- Standalone price of the server lease: $8,000 a month.
- Standalone price of the support service: $4,000 a month.
- Incremental borrowing rate: 6% a year, applied as 0.5% a month.
Allocation. The standalone prices total $12,000, so the lease receives 8,000 / 12,000 of each payment: $6,666.67. The service receives $3,333.33. The two parts add back to the $10,000 payment.
Lease liability. The present value of 36 payments of $6,666.67 at 0.5% a month is about $219,140. That is the initial lease liability, and the right-of-use asset starts at the same amount in this simple case.
At commencement: debit right-of-use asset 219,140, credit lease liability 219,140. The support cost of 3,333.33 a month does not touch the lease balances. The support is expensed as it is received.
If the company elects the expedient. It would discount all 36 payments of $10,000, giving a lease liability of about $328,710. The difference of $109,570 is the present value of the support, now sitting on the balance sheet. Because all payments are made in arrears here, none is added or subtracted at commencement.
Embedded Leases Under ASC 840 and ASC 842
ASC 840 asked the same question and ASC 842 kept most of the answer. KPMG's Handbook: Leases says the concept of an identified asset under ASC 842 is generally consistent with the specified asset concept under ASC 840. An asset was implicitly identified if the supplier had no substantive substitution right (KPMG, 3.2.160).
The control test changed. Under ASC 840 a lease could exist solely because the customer took substantially all of the output of the asset, if the contract was priced in a particular way. Under ASC 842, the customer must also have decision-making rights over the use of the asset (842-10-15-4, KPMG Handbook 3.3.340).
So contracts that were leases under ASC 840 only because the customer took the output generally are not leases today. Examples are power purchase agreements and manufacturing supply contracts (Deloitte, Roadmap: Leases, section 3.4).
The bigger change is what happens next. KPMG notes that under ASC 840 an operating lease and a service were booked much the same way (Handbook: Leases, 4.4.170). Under ASC 842, lease components get very different accounting. An embedded operating lease that was invisible in the old books now needs a lease liability and a right-of-use asset.
Separation also tightened. ASC 840 required substantial services to be accounted for apart from the lease, but did not allow a lessee to combine them. ASC 842 allows the lessee expedient above. It also asks for more rigor on standalone prices: an entity may never default to the contract's stated amounts as standalone prices (KPMG Handbook: Leases, 4.4.180).
How ASC 840 Conclusions Carried Over at Transition
Private companies adopted ASC 842 for fiscal years beginning after December 15, 2021, and interim periods within fiscal years beginning after December 15, 2022 (ASC 842-10-65-1(b)). At adoption, an entity could elect a package of practical expedients for leases that commenced before the effective date. The first expedient says it need not reassess whether any expired or existing contracts are or contain leases (842-10-65-1(f)).
The package must be elected as a whole and applied to all of the entity's leases. A company that elected it did not retest its old contracts under ASC 842, but the package carried over only correct ASC 840 conclusions. KPMG's Handbook: Leases (Question 13A.2.100) says the election "does not grandfather errors in applying Topic 840," so a lease missed under ASC 840
KPMG adds that identifying a lease "may be the most likely area of error to which the package of practical expedients applies."
Contracts that commenced after the effective date, and any contract whose terms change, get the ASC 842 test. An entity reassesses whether a contract is or contains a lease only if its terms and conditions change (842-10-15-6). A change can also trigger a lease modification, covered on our modifications and remeasurement page.
Embedded Leases Under IFRS 16
EY's lease accounting guide says the definition of a lease is the same under IFRS 16 and ASC 842 (EY), though scope differs, for example on intangible assets (PwC, IFRS and US GAAP: similarities and differences, 14.2). Identification therefore follows the same logic.
The treatment after identification differs. EY's summary of key differences notes that lessees do not classify leases under IFRS, and that the standards differ on allocating variable consideration between lease and nonlease components.
Where to Go Next
Software and cloud contracts raise their own questions about what is the asset and what is the service. Our article on embedded leases in IT and software contracts includes a worked allocation between lease and service. For hospital equipment, see embedded leases in healthcare.
To test a contract you have in hand, try the free lease analyzer, which screens agreements for embedded leases.
How Can iLeasePro Help?
At iLeasePro, our leasing experts have worked with both ASC 840 and ASC 842 for years, and we understand the changes, the logic behind them, and why they're important.
We can help explain them to you to make sure you get them right, and we can provide the right software products to help you record and implement the ASC 842 changes correctly.
To do this, you can call iLeasePro at 888-351-4606, or you can go to iLeasePro and access our excellent information about our software products and how they can help you with ASC 842. We'll give you all the information you need to simplify the recording process and show you how to use it to improve your bottom line.