Video: Leasing - Identifying embedded leases under the new standard
A contract may have an embedded lease. Identifying all leases, including embedded leases is critical under the new leases standard (ASC 842) since virtually all leases will be on a lessee’s balance sheet. The new lease identification guidance is different from the existing model. Companies will need systems and processes to identify leases.
Hello, I am Ashima Jain, a Managing Director in PwC's national office.
In this video, I will spend a few minutes discussing how to determine whether an arrangement is, or contains, a lease under the new leases standard.
It is important to realize that even though an arrangement may not be a lease in form, it could still be within the scope of lease accounting.
And determining whether an arrangement is a lease or contains a lease is likely to be much more important than previously because, under the new leases guidance, virtually all leases will be on a lessee’s balance sheet.
Now, identifying whether there is a lease is different from the current accounting guidance.
At a high level, under the current guidance an arrangement is a lease, or contains a lease, if the customer (that is, the potential lessee) has either:
- The right to control the use of a specified asset, or
- Obtains substantially all of the asset's economic benefits.
But under the new guidance both these conditions must be met. In other words, the new guidance requires an "and" not an "or".
The lease identification analysis is required to be done at the inception date of the arrangement which is the same as under the current guidance.
While there is no definition of inception date in the new guidance, we believe that the definition in the current guidance should generally be used. That means, the inception date is the date when the arrangement is signed or when a written commitment, which has the principal terms and conditions, is signed.
Let's now go through in more detail the criteria that need to be met for an arrangement to be, or contain, a lease for accounting purposes. Let's look at a flowchart.
For an arrangement to be, or contain a lease, the underlying asset in the arrangement should be identified. And to be identified:
- An asset must be specified either explicitly, that is the arrangement specifies the asset, or implicitly, meaning once it is made available for use, and
- The supplier (that is, the potential lessor) must not have a substantive right to substitute the asset with alternative assets to fulfill the arrangement.
An arrangement that does not contain an identified asset is not a lease.
The customer (that is, again, the potential lessee) should also have the right to substantially all of the economic benefits from the use of the asset throughout the period of use.
If not, the arrangement is not a lease.
The customer and supplier must also determine who has the right to direct how and for what purpose the asset is used.
If the customer has this right and if all other conditions are met, the arrangement is or contains a lease. If not, the arrangement is not a lease.
Now sometimes the relevant decisions about how and for what purpose the asset is used are predetermined. In that case, the customer has the right to direct how and for what purpose the asset is used if the customer either:
- Has the right to operate or direct the operations of the asset, or
- The customer has designed the asset (or specific aspects of the asset) that predetermines how and for what purpose the asset will be used.
Remember, although we have covered the criteria sequentially, they do not need to be followed in any particular order.
Inventorying arrangements that are not a lease in form, and analyzing them for embedded leases can be a challenging and a time consuming exercise.
Many common arrangements such as:
- Outsourced arrangements for business operations and support,
- Supply arrangements
- Data center, hosting and other IT arrangements,
may contain embedded leases.
There could also be other arrangements that contain embedded leases. So companies will need to build identifying a lease as a step into their systems and processes or fine tune their systems and processes as they prepare to adopt the new leases standard.