Identifying an Embedded Lease
Spotting an embedded lease within a service contract requires careful review of the agreement's language and structure.
The key is to determine whether the contract grants your organization control over a specific, identifiable asset for a period of time in exchange for consideration.
Here are the main steps to help identify an embedded lease:
- Is there an identifiable asset?
Look for a clearly specified asset in the contract (ex. a vehicle, building, or piece of equipment). The asset can be explicitly named or implied but it must be distinct and physically or functionally separable.
- Does your organization control the use of the asset?
Control means your organization has the right to direct how the asset is used and derive most of the economic benefits from it during the period of use. Ask:
- Can we decide how and for what purpose the asset is used?
- Are we the primary or sole beneficiary of the asset’s output or service?
- Is the use of the asset dedicated to your organization?
If the asset is used exclusively by your organization throughout the term of the contract, and the supplier cannot substitute the asset without your approval, this supports embedded lease classification.
- Is there a specified period of use and exchange of consideration?
An embedded lease typically covers a set period of time and includes payments made in exchange for the right to use the asset—separate from the broader service provided.
- Are the lease and service components distinguishable?
If the contract includes both the use of an asset and additional services (like staffing or maintenance), determine whether the lease component can be accounted for separately. If so, you may need to split the contract into lease and non-lease components.
Why Embedded Leases Matters
Identifying embedded leases is crucial for compliance with accounting standards like GASB 87 and ASC 842. Failure to recognize embedded leases can result in understated liabilities and inaccuracies in financial statements.
Proper identification ensures transparency, regulatory compliance, and effective lease management.
What’s important here?
An embedded lease is hidden within larger contracts and provides implicit rights to control or use specific assets. Recognizing embedded leases is essential for accurate financial reporting, compliance, and effective management in public finance sectors.