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Demystifying embedded leases: Top five insights, key indicators and accounting lessons learned
Observations from the front lines
Background
It has been quite some time since public companies first adopted ASC 842, and embedded leases continue to be a topic of discussion. Companies continue to face complexities with identifying, recognizing and accounting for embedded leases. To provide some guidance, we’ve summarized top insights into lessons learned regarding embedded leases—one of the most challenging details of ASC 842.
Top five embedded lease insights
- 1. Where embedded leases may be hiding
- 2. Involve business units beyond accounting
- 3. Ask the right questions
- 4. Beyond policy: One size may not fit all
- 5. The consequences of getting it wrong
1. Where embedded leases may be hiding
Consider establishing processes to help identify embedded leases that could exist in a wide variety of arrangements, including:
- Contract manufacturing (e.g., dedicated production)
Transportation and logistics (e.g., carriers and warehousing)
Supply agreements (e.g., oil pipelines)
Advertising (e.g., signage, naming rights, billboards)
Power purchase agreements (e.g., power plants, easements)
Information technology (e.g., servers, data centers, cloud)
Managed services (e.g., specified equipment)
Cable and satellite (e.g., set-top boxes)
2. Involve business units beyond accounting
Identifying embedded leases often requires broader discussions throughout the organization beyond the accounting function, involving procurement, legal, engineering, manufacturing, IT and more to identify and evaluate arrangements. Physical inspection may be necessary in some cases to understand the nature and function of assets as well as the related output.
3. Ask the right questions
Identifying dedicated or specialty equipment may be clear, however asking the right questions may identify more assets subject to lease arrangements. An embedded lease contains two pieces:
Identified asset
Right to control
See below for example indicators to consider.
4. Beyond policy: One size may not fit all
The devil is in the details. Each arrangement will need to factor in specific facts and circumstances. A blanket conclusion on a broad range of contracts (e.g., by arrangement type) may not sufficiently eliminate the risk of an embedded lease.
5. The consequences of getting it wrong
The new leases standard includes significantly enhanced lessee and lessor disclosure requirements that would apply to in scope arrangements, including embedded leases.
Lessees record right of use assets and lease liabilities based on lease payments.
Consider differences in timing and the financial statement line items in which lease expense and income are reported.
Embedded leases typically include variable lease costs, a required lessee disclosure.
Narrative disclosures, weighted average lease term, and weighted average Incremental Borrowing Rate may be impacted by embedded leases.
The devil is in the details. Determining whether a contract provides the customer the right to control identified assets requires a careful analysis of the facts and circumstances of the arrangement and the nature of the asset(s). The following indicators may be able to assist companies in evaluating the potential for embedded leases in their arrangements.
What we’re seeing: indicators of embedded leases
- Indicators of an identified asset
- Indicators of customer control
- Indicators that there is no identified asset
- Indicators of supplier control
Indicators of an identified asset
The contract requires highly customized or dedicated machinery, tooling, physical servers or other assets to fulfill the contract to the customer or lessee’s specifications.
The supplier or lessor has only a limited number of assets that could meet the requirements to fulfill the contract.
There are no substitution rights in the contract or it would be impractical for the supplier or lessor to use another asset to fulfill the contract. For example, using an alternative asset would cause the supplier to incur losses or decreased profits.
The customer or lessee must review alternative assets and approve of them prior to the supplier or lessor using those assets to fulfill the contract.
The supplier is legally or contractually prohibited from using another asset.
A warehousing agreement defines rack space that is dedicated to the customer.
Indicators of customer control
The machinery is run exclusively (or almost exclusively) for a single customer.
The supplier frequently provides goods or services on demand, or as needed by the customer.
The supplier has limited excess inventory space beyond the customer’s expected order forecast trend, including contractually required safety stock, such that the supplier will likely manufacture at the customer’s demand.
The arrangement restricts the supplier from modifying or relocating equipment once it has been installed.
- The supplier’s decision affecting the use of the assets must be approved by the customer.
- Customers participate on joint committees and boards, meaning that the supplier doesn't have the unilateral right to make changes.
Indicators that there is no identified asset
There is no PP&E used in fulfilling the contract with the customer or lessee.
The supplier or lessor has multiple assets that can be used in fulfilling the contract. Use of the other assets would not increase supplier cost substantially more than had the original asset been used, and customer approval is not required in changing assets.
Indicators of supplier control
The supplier has the right to change when the output is produced and the quantity of that output (i.e. supplier can front load, backend load or otherwise produce as they see fit) without input from the customer.
It is also important to consider whether the supplier has the ability to change when the output is produced. So ask yourself: Are lead times sufficient? Is physical capacity sufficient to allow for inventory stocking to support ramp up assertions?
Key takeaway
Identifying embedded leases requires judgement and a deep understanding of the business. Companies may need to assess for embedded leases each time contracts are entered into or modified to help determine necessary disclosures.
How PwC can help
Our Capital Markets and Accounting Advisory Service (CMAAS) professionals have experience helping our clients navigate the key areas of judgment related to embedded leases.
Further, our capabilities extend into the use of digital tools to further assess a population for risks of embedded leases. Contact us to learn how we can assist with your leasing adoption challenges.
“Observations from the front lines” provides PwC’s insight on current economic issues, our perspective regarding the financial reporting complexities, and what companies should be thinking about to effectively address those issues. For more information, visit www.pwc.com/us/cmaas.
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