By Mike Hammerslag
When it comes to understanding embedded leases, the question is whether you, the business user, can find (identify) the asset and who controls it.
Let’s start the review. Any legal document (agreement) that meets the necessary and sufficient rules to be considered “a lease” is required to be disclosed to avoid a misstatement of the balance sheet.
The moniker “Embedded Lease(s)” is simply a label type classification assigned to a group of agreements that meet a lease’s necessary and sufficient conditions, but do not explicitly say “Lease” at the top of the document.
Embedded Lease Checklist
The necessary and sufficient conditions for determining whether a lease is “embedded” are generally whether the agreement:
1) identifies whether an explicit or implicit asset is contained in the document,
2) gives the right to the business user to obtain substantially all the benefits of the asset, and
3) whether the business user controls the use of the asset.
But also, whether the business user:
4) can operate the asset, or
5) designed the asset.
Embedded, then what’s next? Well, for one, you will no longer be considered just the “business user” or “party to the contract,” but you will now correctly be considered the “lessee.” Once it has been determined that a document (agreement) does in fact contain the necessary information to be a lease, you must account for it on the balance sheet.
You will need to generate a schedule which is not overly difficult in the general case. But in the case of embedded leases, one must be particularly careful to make sure the consideration in the document is correctly allocated to the lease and non-lease components contained within the document.
Furthermore, you must still address standard finance and operating considerations as well as whether separating the components provides enough of an employee savings that the resulting increase in the balance sheet is not consequential.
Where to look. When looking for embedded leases, one should draw a keen eye towards agreements focused on outsourcing: this includes property operations, data centers, services contracts, and 3PL (third-party logistics) contracts as well as manufacturing contracts, among others.
Impact to consider. Overall, will it be embedded leases that have the largest potential impact for balance sheet misstatement or will it simply be leases (likely equipment leases at that) that are too dispersed to be found and included in the firm’s disclosures?