Introduction

Within the accounting and financial reporting arena, specifically according to the guidelines set by the Financial Accounting Standards Board (FASB) and the International Accounting Standards Board (IASB), the matter of embedded leases has drawn a lot of interest. An embedded lease is a condition wherein a lease is part of an agreement that seemingly exists in the form of a service agreement mostly. The difficulty for corporations is to locate these embedded leases and differentiate them from ordinary service contracts. This article attempts to present a general description of embedded leases and the conventions to distinguish them from service contracts.

What is an Embedded Lease?

An embedded lease occurs when a contract, not necessarily a lease, involves the right to direct the use of a specific asset for a term in return for consideration.

Key Features of an Embedded Lease

In determining whether there is an embedded lease or not, the following needs to be fulfilled:

  1. Identified Asset: The agreement should have an identified asset either expressly or implicitly. The asset may be one piece of equipment, a vehicle, or a portion of property that can be easily identified.
  2. Right to Control: The customer is supposed to possess the right to control the utilization of the recognized asset. It is the right to control the use of the asset and the right to get substantially all of the economic advantages resulting from the utilization.

 How to Determine an Embedded Lease

  1. Read the Contract: Start with taking a careful read of the contract to see whether any assets have been referred to. Check for explicit references or implicit hints at specific assets being utilized to fulfill the conditions of the agreement.
  2. Measure Control Rights: Consider whether the customer has control rights over how the asset will be used. This entails having rights over decision-making authority for the purpose and manner the asset will be used during the period it will be used.
  3. Analyze Economic Benefits: Consider whether the customer is able to enjoy substantially all economic benefits of use of the identified asset. Consider whether benefits accrued from the asset are, significantly, for the customer’s advantage.

Distinguishing Embedded Leases from Service Contracts

While embedded leases are concerned with the right to control an identified item, service contracts are contracts wherein the supplier is offering a service but not giving up control over a specified asset.

The following are some of the differences:

  1. Nature of Agreement: Service contracts are concerned with making available a service and not delivering an asset. The overall objective is to do tasks or activities.
  2. Control Over Asset: In a service contract, the supplier retains control over any asset used to deliver the service. The customer has no right to control how any particular asset is used or receive the economic benefits of any particular asset.
  3. Contractual Terms: Service contracts are more likely to include performance measures, levels of service, and outcomes in lieu of utilization of an identified asset.

Practical Examples

Example 1: Embedded Lease

A corporation signs a five-year agreement with a transport corporation.

The agreement calls for the transport company to employ a specific vehicle to transport goods solely for the company. The company can determine the routes and timing of deliveries. In this case, the vehicle is a specific asset (though the rate of transportation is measured in terms of per kilometer/mile or per hour usage), and there is restriction over its utilization by the company, which shows an embedded lease.

Example 2: Service Contract

A company hires a cleaning service provider for its office. The agreement covers the extent of cleaning and frequency of the same but not equipment or assets involved. The service provider has discretion to select tools and materials. Such a situation is a service contract, since no asset is specified under the customer’s ownership.

Conclusion

Identification of embedded leases and their separation from service contracts is called for in order to ensure correct financial reporting and keeping in accordance with accounting standards. While the terms of an embedded lease, i.e., a recognized asset and the right to control usage, are met, businesses can maintain accurate recognition and treatment of such arrangements on the books of accounts. Service contracts emphasize more on the provision of services without transferring control over certain assets.

Clear distinction between these two categories of agreements facilitates attainment of transparency and consistency in financial reporting.