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Why contractors need to start looking for embedded leases now

INSIGHT ARTICLE  | 

Many contractors are not adequately preparing for yet another accounting change coming their way, namely the new lease accounting standard published by the Financial Accounting Standards Board (FASB) known as ASC 842. ASC 842 governs the way that companies account for leases, requiring businesses to recognize lease-related assets and liabilities on their balance sheets. The impact of the standard on contractors will depend on the size and terms of their lease portfolio.

Placing obligations on the balance sheet

The intention of ASC 842 is to make it easier to compare the financial position of two companies that may structure their equipment acquisitions differently but otherwise operate in similar manners.

Under legacy guidance, companies with operating leases showed no balance sheet effect for the right to control an asset and the obligation to make lease payments, while companies that purchased their assets using traditional financing recorded an asset and liability.

Under ASC 842, companies will need to put a lease liability and a right-of-use asset on their balance sheets, subject to limited practical expedients like the right to elect to exclude short-term leases. This change represents a significant accounting shift in a lessee’s balance sheet, and one that’s proving harder to put into place than some had expected.

Contractors and ASC 842

ASC 842 can expand a company’s lease portfolio beyond its application to operating leases and those previously identified as capital leases. It can also change conclusions reached under the legacy lease guidance in ASC 840 regarding embedded leases; that is, leases such as service agreements contained within larger contracts or arrangements.

Like all leases under ASC 842, embedded leases must meet two requirements:

  1. There is a specified or identified asset as part of the agreement
  2. The lessee has the right to control the use of that asset for a period of time in exchange for consideration, including when, where and how the asset will be used or the output produced by the asset

Contractors need to be aware of agreements that involve the use of an asset that they have previously considered a service contract. For example, if a contractor has a contract with a company to bring heavy materials to their site (i.e., a transportation service contact), the right to use the transportation equipment might be an embedded lease if the agreement requires the use of specific trailers, railcars or barges. Similarly, contractors might have embedded leases within a service agreement with a tech company that requires the use of the IT firm’s servers.

Timing

Public companies have already worked through implementation of the new standard, which they had to complete for fiscal years starting after Dec. 15, 2018. For private companies, ASC 842 was previously scheduled to take effect for annual financial reporting periods beginning after Dec. 15, 2019 (2020 for calendar year-end companies), and interim periods after Dec. 15, 2020. Recently, however, the FASB proposed delaying the effective date for private companies for one year, based in part on the struggles public companies experienced with adopting and complying with the new lease standard and private companies are having with ongoing implementation of the new revenue standard (ASC 606).

With the proposed delay, it may seem like contractors have plenty of time to get their lease accounting in place. But the experience of public companies has shown that transitioning to this model for lease recognition is more difficult than it appears. It can be an intensive process to identify all leases and get them properly recorded under the new standard. Implementation could take from six months to more than a year, and many contractors have not even taken the first steps to meet the new requirements.

Getting started

The first step companies need to take is collect the necessary documents for review. Those documents include not only standard real estate or traditional equipment leases, but every contract involving the possible use of an asset. Just because an agreement doesn’t use the words “lease” or “rent” in it doesn’t exclude it from consideration for an embedded lease if any assets are used the provision of the contract service.

The company should identify a team to work on its ASC 842 implementation. The team will need to examine each contract to determine whether it contains an embedded lease. Then, after establishing their policies and elections under the new lease standard, they will need to apply their policy to the terms of all leases, and ultimately determine the proper way to record them on the books.

Going forward, contractors will need to consider processes to evaluate new contracts for potential embedded leases and the impact of those leases on the company’s balance sheet. They will also need controls in place to make sure that they are properly recognizing all new and ongoing leases as well as accounting for any potential changes to contracts and expected terms.

While it is possible to track a limited lease portfolio via spreadsheets, companies with larger lease portfolios should seriously consider supplementing their systems with specially designed lease-accounting software. Such applications can help companies comply with the new accounting and disclosure requirements as well as help make ongoing reporting requirements easier to meet. Installing and properly using such software can take time, however, and the lesson to be learned from public company implementations is get started now rather than later.

The bottom line

Embedded leases is one of the trickier aspects of implementing the new lease standard. 

While the deadline for private contractors to transition to ASC 842 may seem distant, the implementation will likely require more time, work and capital than most contractors realize. The sooner that they can begin taking a serious look at the requirements, developing their policies, collecting documents and researching potential software solutions if needed, the better prepared they will be to meet the requirements of the standard.

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