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What is an Embedded Lease?

What is an embedded lease?

Not all contracts that are considered leases under GASB Statement No. 87 “Leases” (GASB-87) will include the words “lease” or “rent” to help clearly identify them as leases. Some contracts will contain the right to use an underlying asset as part of a larger agreement. This right-of-use within a contract is called an embedded lease. There are several questions that can help with identifying whether or not there is an embedded lease in a contract.

  1. Does the contract talk about a physical asset that you do not own (even if it doesn’t list one specifically)?

  2. Do you obtain all of the benefits from the asset for a period of time?

  3. Do you get to determine the way the asset gets used?

  4. Is money or other fair value exchanged as part of the contract?

If the answer to these questions is Yes, you have an embedded lease that has to be accounted for using GASB-87 requirements. The best way to understand embedded lease contracts is through some examples:

Example 1: A County enters into a  Data Hosting Agreement for the sensitive data collected by the County’s Department of Social Services. The contract is for 60 months with a monthly payment of $5,000. The hosting services include website access, data storage and application updates. The contract states that the data is stored on a server that is used exclusively for the County’s data and the County can indicate how they want the server to be used during the contract period.

  1. Yes. Even though the contract doesn’t specify the server details, it does specify the County will have access and use of a specific piece of equipment (the designated server), meaning there is an asset implied in the contract that theCounty does not own.

  2. Yes. The contract indicates the County obtains all of the benefits of the server (data storage).

  3. Yes. The contract indicates the County can determine how the server gets used.

  4. Yes. The payments made for the overall hosting agreement is value being exchanged.

The answer to all four questions from above is Yes, therefore, this example contract has an embedded lease.

Example 2: A City enters into an agreement to purchase power generated by a wind turbine owned by a local supplier. Per the agreement, the City dictates the amount of power they want the turbine to generate and the amount of hours that the turbine is in operation. The supplier is responsible for all repairs and maintenance on the turbine. The contract is for 48 months with monthly payments of $25,000 plus additional variable amounts based on the amount of power generated.

  1. Yes. The contract references a specific piece of equipment (the wind turbine), meaning there is an asset implied in the contract that the City does not own.

  2. Yes. The contract indicates the City has the right to obtain the present service capacity of the wind turbine.

  3. Yes. The contract indicates the City can control how and when the wind turbine is in operation.

  4. Yes. The monthly payment and additional variable payments indicate an exchange transaction.

The answer to all four questions from above is Yes, therefore, this example contract has an embedded lease.

The best place to start when looking for embedded leases may be the procurement and/or legal department.

Here are some common governmental contract types where embedded leases may exist:

  • Information technology contracts
  • Transportation arrangements
  • Warehousing arrangements
  • Cafeteria services
  • Advertising contracts
  • Maintenance services
  • Janitorial services
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