They’re here! I’m talking about the issues associated with implementing ASC Topic 842 Leases (ASC 842), of course. And it appears the biggest issue of all is identifying embedded leases.
I was perusing my Twitter feed last week when something caught my eye. A poll taken during a KPMG webcast indicated that 62% of respondents cited identifying embedded leases as the most significant challenge they faced when implementing the new leases standard (ASC 842). Uh-oh! I didn’t recall this being in our training on ASC 842. How could we have missed it?
Sure, I’ve heard the term “embedded leases” used before, but I didn’t remember seeing it in the standard. I searched for the term within the FASB’s Accounting Standards Codification. Nothing. Frantically, I searched each of the Big 4 guides on the topic. Again, nothing.
You know what that means? I got a topic for my blog!
All are welcome into the Light!
Put simply, embedded leases are just leases, as defined by ASC 842, that are included (i.e. embedded) within service agreements or other contracts. At contract inception, both parties to a contract must assess whether or not a contract contains a lease.
So, what is a lease?
A lease is a contract that conveys the right to control the use of identified property, plant, or equipment (an identified asset) for a period of time in exchange for consideration.
Therefore, there are two conditions necessary for a lease to exist:
- There is an identified asset; and
- The customer has the right to control the use of such asset.
For an asset to be considered identified in the contract:
- the asset must be explicitly or implicitly specified in the contract;
- the asset must be physically distinct; and
- the supplier does not have a substantive substitution right.
An asset is typically identified by being explicitly stated in a contract, for example, using a serial number. However, an asset can also be identified by being implicitly specified at the time that the asset is made available for use by the customer. An example of this might be if the supplier only owns a single asset of that type.
The requirement that the asset be physically distinct relates to the scope of the standard. ASC 842 does not apply to leases of intangible assets, biological assets, or exploration rights.
Some contracts give the supplier the right to fulfill its obligation using an alternative asset. Even if an asset is specified, there is not an identified asset, and therefore the contract does not contain a lease, if the supplier has a substantive right to substitute the asset throughout the period of use. A substitution right would be substantive only if both of the following conditions are met:
- The supplier has the practical ability to substitute alternative assets throughout the period of use; and
- The supplier would benefit economically from the exercise of its right to substitute the asset.
What about a substitution right held by the supplier for things like malfunction or replacing an obsolete model with a newer one? These are not considered substantive as the supplier would not benefit economically from the exercise of the right.
Right to control
A contract would convey the right to control the use of an identified asset if, throughout the contract term, the customer has the ability to both:
- Derive substantially all of the potential economic benefits from use of the asset throughout the contact term; and
- Direct the use of the asset throughout the contract term.
When determining whether the identified asset provides economic benefits, the entity should only consider the economic benefits arising from the use of the asset. For example, income tax credits arise from owning the asset, not from using it, and therefore should be excluded from the analysis.
Once an entity determines what economic benefits are provided from the use of the asset, the entity must determine if they have the right to obtain substantially all of the economic benefits. What is “substantially all?” It’s not defined within ASC 842, but common practice is typically use of a threshold of 90%.
A customer has the right to direct the use of an identified asset when it has the right to direct (and change) how and for what purpose the asset is used throughout the period of use.
Determining whether a contract contains a lease is probably the most important (and judgmental) step within ASC 842. Why? Because if it contains a lease the lessee must record the right-of-use asset and lease liability on the balance sheet. However, if the contract does not contain a lease, then it is probably an off-balance-sheet commitment.
Let’s review a few class discussion questions that are included in our instructor-led training slides on the topic:
Answer: No, this contract is a service contract in which Tangina uses the equipment to meet the level of network services agreed to with Poltergeist.
Poltergeist does not control the use of the servers because Poltergeist’s only decision-making rights relate to deciding on the level of network services (the output of the servers) before the period of use—the level of network services cannot be changed during the period of use without modifying the contract. For example, even though Poltergeist produces the data to be transported, that activity does not directly affect the configuration of the network services and, thus, it does not affect how and for what purpose the servers are used.
Tangina is the only party that can make decisions about the use of the servers during the period of use. Tangina has the right to decide how data are transported using the servers, whether to reconfigure the servers, and whether to use the servers for another purpose. Accordingly, Tangina controls the use of the servers in providing network services to Poltergeist.
There is no need to assess whether the servers are identified assets because Poltergeist does not have the right to control their use.
Answer: Yes, this contract meets the definition of a lease. Poltergeist has the right to use the specific server (III-A) for three years.
There is an identified asset as the server (III-A) is explicitly specified in the contract. Tangina can substitute the server only if it is malfunctioning.
Poltergeist has the right to control the use of the server throughout the three-year period of use because:
- Poltergeist has the right to obtain substantially all of the economic benefits from use of the server over the three-year period of use. Poltergeist has exclusive use of the server throughout the period of use.
- Poltergeist has the right to direct the use of the server. Poltergeist makes the relevant decisions about how and for what purpose the server is used because it has the right to decide which aspect of its operations the server is used to support and which data it stores on the server. Poltergeist is the only party that can make decisions about the use of the server during the period of use.
We hope this post has cleared up some of the confusion about identifying embedded leases. This house is clean.
Obviously, there’s plenty of management judgment involved, so be sure to document your process and decisions! Also, be sure to check out this post where we summarize available resources to help you implement the new leases standards (ASC 842 and IFRS 16).
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