As companies face the significant challenges in adopting Accounting Standards Codification (ASC) Topic 842, “Leases,” little has been written about the challenge posed by the requirement to evaluate whether embedded leases exist in supply or service contracts. While a similar requirement previously existed under ASC Topic 840, many companies did not search for embedded leases because there was no meaningful difference between the accounting for operating leases and the accounting for executory contracts. Under ASC Topic 842, however, it is critically important to identify embedded leases because the guidance related to embedded leases has changed and operating leases must now be reported on the balance sheet. In addition, the number of contracts containing embedded leases will likely increase as companies increasingly rely on outsourcing through the use of supply and service contracts, many of which may now qualify as leases.
This article will help CPAs understand the new lease definition and related guidance in ASC Topic 842, how to apply it to their contracts, and how to identify leases that are embedded in their contracts. It also discusses practical considerations for the processes and procedures to follow for companies that execute large numbers of contracts annually. Nonaccountants (e.g., the legal team, procurement, supply chain staff), preparers, and auditors must all be involved in lease identification efforts.
The focus of this article is on a customer’s (i.e., a potential lessee’s) examination of a supply or service contract that it has with a supplier, though lessor companies must also examine their new contracts. Fortunately, FASB has allowed a practical expedient [ASC 842-10-65-1(f)(1)] that states, “An entity need not reassess whether any expired or existing contracts are or contain leases,” so entities that have elected the package of practical expedients only need to focus on new, modified, and renewed contracts.
Definition of a Lease
ASC 842-10-15-3 describes the scope of the definition of a lease: “A contract is or contains a lease if the contract conveys the right to control the use of identified property, plant, or equipment (an identified asset) for a period of time in exchange for consideration.” FASB has revised the definition to include any contract, even if it is not explicitly considered a lease contract, that conveys control of the use of an identified asset. Thus, two criteria must be met for a contract to contain an embedded lease: the contract must involve an identified asset (Criterion 1), and the contract must convey the right to control the use of the identified asset (Criterion 2). ASC Topic 842 provides guidance for determining if these two criteria are met.
Identified Asset (Criterion 1)
In evaluating whether Criterion 1 is met, ASC Topic 842 describes two factors that indicate that the fulfillment of a contract depends on the use of an identified asset: the asset is explicitly or implicitly specified, and the supplier does not have substantive substitution rights.
Explicitly or implicitly specified asset.
An asset may be explicitly specified in the contract (e.g., by serial number) or implicitly specified (e.g., by delivering an asset to the customer’s location). A specified asset can be a portion of a larger asset, as long as the specified asset is “physically distinct.” For example, one floor of a building could be a specified asset because it is a physically distinct part of the larger building asset.
ASC Topic 842 provides guidance about an exception to the physically distinct requirement: “A capacity or other portion of an asset that is not physically distinct … is not an identified asset, unless it represents substantially all of the capacity of the asset” (ASC 842-10-15-16). An example of a capacity portion of an asset would be a transportation contract for some portion of a natural gas pipeline; any capacity portion that represents less than substantially all of the pipeline would not represent a specified asset because a contracted portion of the pipeline is not physically distinct. When the customer has contracted for substantially all of the capacity of the asset, however, the asset can be an identified asset, even though it is not physically distinct. ASC Topic 842 uses the term “substantially all” in multiple contexts, but only defines it in the context of asset fair value and lease classification. The relevant paragraph states “one reasonable approach … would be to conclude … ninety percent or more of the fair value of the underlying asset amounts to substantially all of the fair value of the underlying asset” (ASC 842-10-55-2). While this guidance refers only to “substantially all” of the fair value of the asset, the Big Four appear to be applying the 90% benchmark more generally whenever the term “substantially all” is used in ASC Topic 842.
No asset substitution.
Even when the customer has determined that an asset has been explicitly or implicitly specified, the asset is not considered identified if the supplier has a substantive right to substitute another asset to fulfill its obligations under the contract. The supplier has the substantive right to substitute if both of the following conditions exist: the supplier has the practical ability to substitute alternative assets throughout the period of use, and the supplier would benefit economically from the exercise of its right to substitute the asset. This second condition involves a relatively high hurdle, which is new in ASC Topic 842. The customer must be able to positively demonstrate that, from the supplier’s perspective, the economic benefits associated with substituting the asset are expected to exceed the associated costs; only then would the second condition hold and the substitution right be considered “substantive.”
ASC Topic 842 provides additional guidance to help determine whether a right to substitution is substantive. First, when evaluating the potential right at the inception of the contract, unlikely future events should be ignored. Second, if the asset resides at the customer’s premises, the supplier most likely does not have a substantive right to substitute, given the likelihood that the costs of substituting another asset would exceed the potential financial benefit. Third, if the supplier can only provide the substitute asset after a specified date or event, this does not constitute a substantive right throughout the period of use, and therefore there may be an identified asset only for the period in which the supplier cannot substitute another asset. Finally, the responsibility of the supplier to substitute an asset as part of its repair or maintenance practices does not constitute a substantive right to substitute (ASC 842-10-15-11–14).
Right to Control the Use of the Identified Asset (Criterion 2)
Although a supply or service contract may include an identified asset, in order for an embedded lease to exist, ASC Topic 842 also requires that a customer have the right to control the use of the identified asset. The guidance provides two requirements that determine whether the customer has the right to control the use of an embedded asset. First, the customer must have the right to obtain substantially all of the economic benefits from the use of the identified asset; second, the customer must have the right to direct the use of the identified asset.
Right to obtain substantially all of the economic benefits.
To satisfy this portion of Criterion 2, the customer is required to have the right to obtain substantially all (as defined earlier) of the economic benefits from the use of the asset throughout the period of use. These benefits can be obtained either directly (e.g., manufacturing or delivering goods) or indirectly (e.g., subleasing the asset). The economic benefits to be considered include not only the asset’s primary output but also any byproducts that it produces.
Two criteria must be met for a contract to contain an embedded lease: the contract must involve an identified asset, and the contract must convey the right to control the use of the identified asset.
Right to direct the use of the identified asset.
ASC Topic 842 provides guidance for determining when a customer can direct the use of an identified asset. This determination can be made more difficult by the fact that the entity may be considered to control an asset’s use, even though it is not actually operating the asset.
If the customer can direct how and for what purpose the asset is used throughout the period of use, the customer is considered to have the right to direct the use of the asset. If, however, the relevant decisions about how and for what purpose the asset is used are predetermined by the terms of the contract, further analysis will be required to determine if the customer has obtained the right to direct the use of the asset. If the use is predetermined, either of two possible conditions will lead to the customer having the right to control the asset’s use: the customer operates the asset without the supplier having a right to change the way the asset is used, or the customer designed the asset in a way that predetermines how and for what purpose the asset will be used. It should be noted that the supplier’s obligation to operate or maintain the asset does not, in and of itself, give the supplier the right to control the asset.
Obtaining substantially all of the economic benefits of the asset and having the right to direct the use of the asset are required in order to meet Criterion 2. If the customer has the right to control the use of an identified asset for only a portion of the contract term and all of the other lease criteria are met, however, the requirement to account for the contract as a lease only applies to that portion of the contract term for which the customer has the right to control the asset.
While not related to identifying embedded leases, it is important to note that once the customer determines that an embedded lease exists, it will need to determine what portion of the contract payments represents consideration being paid to the supplier for the use of the asset. This is necessary to calculate the resulting lease obligation and right-of-use asset that the customer must record. The next section applies the guidance in ASC 842 to several examples.
Independent Examples of Applying ASC 842 to Supply or Service Contracts
Contract 1: Identified asset, right to control use of asset.
Customer A is an electric utility that has recently converted a generating facility’s fuel source from coal to natural gas. As part of the conversion, Customer A constructed and owns a gas lateral (pipeline) that connects its facility to a major regional gas pipeline owned by TransportCo. Customer A entered into a 10-year metering agreement with TransportCo, which will provide metering services to measure the quantity of natural gas delivered to Customer A through its gas lateral. Although not stated in the agreement itself, to fulfill its obligations under the agreement, TransportCo constructed a metering station that it will own, operate, and maintain for the exclusive use of Customer A. The metering station is considered a permanent installation due to the high cost to remove or replace it. Customer A will pay TransportCo a monthly fixed amount and a variable amount based on the quantity of gas metered each month.
The metering agreement contains a lease under ASC 842. Criterion 1 is met because, while the metering station is not explicitly specified in the agreement, the asset is implicitly specified when the metering station is constructed, and given the capital-intensive nature of the metering station, TransportCo does not have the ability to substitute other assets in order to fulfill its obligations under the agreement. Criterion 2 is met because Customer A has the right to control the use of the metering station, even though it does not operate the asset. Customer A obtains substantially all of the economic benefits from the use of the asset as the exclusive user, since TransportCo has dedicated the metering station solely to Customer A’s facility. Furthermore, Customer A has the right to direct the use of the metering station because the metering station only operates when Customer A chooses to transport natural gas to its facility to generate electricity. While TransportCo is responsible for the day-to-day operations of the metering station, it does so under the direction of Customer A. Thus, both criteria are met, and Customer A has a lease.
It is important for companies to examine material new, modified, or renewed service and supply contracts to detect the presence of embedded leases.
Note that Customer A must evaluate the terms of the agreement to determine what portion of the consideration due to TransportCo represents payment for the use of the metering station. Based on its evaluation of the nature of the agreement, Customer A determines that the fixed monthly charges are intended to compensate TransportCo for the construction of the metering station. Accordingly, Customer A uses the future fixed monthly charges due over the term of the agreement to calculate its lease obligation and the resulting right-of-use asset.
Contract 2: Identified asset, no right to control.
Customer B is a national retail chain that has entered into a 20-year power purchase agreement with Winds-R-Us to purchase all of the power produced by a wind farm in Oklahoma. Customer B will pay a fixed amount per megawatt hour for all of the power delivered from the wind farm, even if it is not able to use all of the power delivered. Customer B does not have the ability to refuse (curtail) energy produced by the wind farm. Winds-R-Us cannot supply power from any other generation source.
The power purchase agreement does not contain a lease. Under the terms of the agreement, Criterion 1 is fulfilled because both requirements are met to make the wind farm an identified asset. The wind farm is explicitly specified in the agreement, and Winds-R-Us does not have the ability to substitute other assets in order to supply Customer B with power. Criterion 2, however, is not met. While Customer B does obtain all of the economic benefits of the wind farm as its exclusive user, it does not have the right to direct the use of the asset. Customer B cannot control when power is delivered or how much power is delivered. It must take all of the power generated by the wind farm without the right to curtail the delivery of power. Because Criterion 2 is not met, Customer B does not have a lease.
Contract 3: No identified asset.
Customer C entered into a three-year agreement with TruckHaulCo for waste-hauling services. Customer C’s production process generates waste that requires special handling; TruckHaulCo provides this by using specialized tractor-trailers that ensure safe transportation of waste to the disposal site. TruckHaulCo maintains a fleet of 20 specialized trailers in the area where Customer C’s production facility is located, and any of the 20 trailers can be used to fulfill the agreement. The number of trailers actually used on a daily basis will depend on the amount of production at Customer C’s facility. At full production, TruckHaulCo will dedicate 12 trailers per day to haul waste from the facility, while lower production levels will only require the use of 4 trailers. Since the trailers are identical and are dispatched from TruckHaulCo’s local terminal, TruckHaulCo’s daily decision about which trailers to use for Customer C’s waste will be based on various factors, including maintenance schedules and the desire to balance the amount of wear and tear among the entire fleet.
The agreement does not contain a lease. Criterion 1 is not met because no trailers are specified in the agreement, either explicitly or implicitly. There is no implicit specification because TruckHaulCo is free to use any of its 20 specialized trailers to satisfy Customer C’s daily needs. Also, because trailers can be freely substituted from day to day as TruckHaulCo provides services to other customers, the second requirement for Criterion 1 is not met. Neither of the two Criterion 1 requirements is met, so Customer C does not have a lease, and no examination of Criterion 2 is necessary.
As another example, assume, instead, that the agreement did explicitly specify the serial numbers of the 20 tractor-trailers to be used to haul waste for regulatory reasons, eliminating the possibility of substitution. Also assume that TruckHaulCo’s fleet is regularly deployed to serve customers other than Customer C. Both Criterion 1 requirements—asset specification and no substitution—are now met. Criterion 2, however, is not met. Customer C does not obtain substantially all of the economic benefits from the use of the trailers because TruckHaulCo also uses them to serve other customers. In addition, Customer C does not have the right to direct the use of the asset, as TruckHaulCo directs how and for what purpose the trailers are used. Because both requirements for Criterion 2 are not met, Customer C does not have a lease in this revised scenario.
Auditors must also be prepared to attest to the sufficiency of controls associated with identifying embedded leases.
From the perspective of internal controls, it is vitally important that companies establish policies and procedures in conjunction with the adoption of ASC Topic 842 in order to identify embedded leases. Given the thousands of contracts that companies execute each year, establishing procedures to identify these agreements can be a daunting task. Therefore, it is important that companies carefully evaluate their options from a cost-benefit perspective to ensure that only those agreements that could be considered material are identified for further review. Companies should take a risk-based approach by identifying the types of contracts that are more likely to rely on the use of assets and by implementing appropriate dollar thresholds for contract review. For smaller organizations, new procedures may be limited to adding requirements to the accounting review checklist. In larger organizations, new procedures will involve nonaccountants (e.g., legal team, procurement, supply chain staff) who will need to understand the nature of the ASC Topic 842 requirements. Nonaccountants will also need practical parameters that will allow them to consistently identify potential embedded leases. Ultimately, the goal is to ensure that all material contracts that may contain embedded leases are identified for an accounting review.
All Hands on Deck
ASC Topic 842 presents several challenges to financial statement preparers and auditors. For example, the practical challenge of identifying and incorporating operating leases that have previously been managed in a decentralized way was previously discussed in The CPA Journal (Dennis Chambers, James Dooley, and Catherine A. Finger, “Preparing for the Looming Changes in Lease Accounting,” January 2015, http://bit.ly/2NZUcZv).
The challenge of embedded leases, however, has not received as much attention. ASC Topic 842 significantly changes the scope of what is considered a lease for reporting purposes. It is important for companies to examine material new, modified, or renewed service and supply contracts, and for preparers to develop and document controls, to detect the presence of embedded leases. These efforts will often require cooperation between preparers and the purchasing/supply chain function to effectively and efficiently identify, for further analysis, contracts that require the other party to use assets to fulfill its obligations.
Auditors also face a challenge in attesting that clients have successfully evaluated these contracts and have found all of the material embedded leases associated with them. Auditors must also be prepared to attest to the sufficiency of controls associated with identifying embedded leases.
Useful Questions to Ask
To determine if an asset is identified:
- Specified asset: Are assets explicitly specified in the agreement? Are assets implicitly specified in the agreement (e.g., are there only certain assets that could fulfill the contract)? Does the contract convey substantially all of the capacity of the asset from supplier to customer? (This is used to determine whether an asset that is not physically distinct can be considered identified.)
- Substitutability: Is the identified asset the only one that the supplier can use to meet the specifications in the arrangement? If there is a substitute available, is the supplier economically better off having the ability to substitute the identified asset to satisfy the contract? Does the contract permit substitution only if the asset is obsolete or needs repair? Does the asset reside at one of the customer’s own facilities? (If so, it will be more difficult for the supplier to substitute assets.)
To determine if the customer has the right to control the use of the asset:
- Obtaining economic benefits from the asset:Does the contract convey substantially all of the asset’s economic benefits to the customer?
- Right to direct the use of the asset: Is the supplier unable to outsource its obligation to deliver the product or service? Does the customer operate the asset without interference from the supplier? Does the customer direct the use of the asset (i.e., determine how the asset is managed, how much is produced, when it is produced)? Did the customer design the asset (e.g., the production-line layout) or determine whether the asset will be used in a specific way? Can the supplier only make decisions to protect its interests, while the customer decides how to use the asset?