With the new ASC 842 Lease standard now required for all entities, certain issues have emerged related to the identification and treatment of embedded leases.

During the ASC 606 implementation, entities were required to assess their customer and supplier contracts for embedded equipment or property leases to ensure such leases were properly accounted for under either ASC 606 or ASC 840. For example, if the equipment or property provided is utilized as part of an overall solution or completion of a performance obligation (“PO”), then the revenue stream would be accounted for under ASC 606. However, if the equipment or property was determined to be a standalone PO and capable of being “physically distinct”, then the accounting under ASC 840 (now ASC 842) was typically applicable as a lessor.

As part of the adoption of ASC 842, the assessment of lease classification including embedded leases was broadened to cover more arrangements and an additional lease test was added compared with ASC 840. Under ASC 840, a lease was deemed to be a capital lease if any one of the following conditions were met: (1) title transferred; (2) agreement contained a bargain purchase option; (3) lease term was 75% or more of the useful life of asset; or (4) present value of the lease payments was 90% or more of the fair value of the lease.  Under ASC 842, condition number (2) above was expanded to include any option to purchase the lease that is deemed reasonably certain of exercise, and conditions number (3) and (4) related to the lease term and present value were broadened to be a “major part” of the economic life and “equals or exceeds substantially all” of the fair value (75% and 90%, respectively, remain commonly accepted thresholds, however, the use of these legacy ASC 840 thresholds may have to be justified). The additional test that was added covers an asset that is of such a specialized nature that it is expected to have no alternative use at the end of the lease term. In both ASC 840 and ASC 842, if an embedded lease meets at least one of the tests discussed above then the lease will be treated as a sales-type lease with immediate recognition of profit at the lease commencement date.  

Another issue that has emerged is the assessment of option years within a government contract. Unlike most commercial contracts, government contracts frequently include option years in addition to the base year of the contract. The accounting impact under ASC 842 may be different compared to ASC 606, especially if there are option periods under the lease that are reasonably certain of exercise. Under ASC 606, contractors account for each option year as a separate contract. Under ASC 840 and 842, the option periods that are reasonably certain of exercise should be factored into the determination of the lease term. 

For example, a lease of computer equipment with a five-year life is provided under an initial three-year contract with two option years. Under ASC 842, equipment may be required to be treated as a sales-type lease depending on the expected term or use of the asset under the contract including other factors. In this example, all option years are reasonably certain of exercise. Under ASC 842, the equipment would be accounted for as a sales-type lease as the expected contract period of five years makes up a substantial portion of the asset’s useful life. Therefore, revenue, cost and selling profit would be recognized upfront for the entire five-year period at the commencement of the lease as opposed to recognizing revenue proportionally over the five-year period of performance under ASC 606.

Lastly, the stand-alone selling price of the equipment or asset related to an embedded lease must be considered. Government contracts frequently bundle services and equipment. Government contracts that were not built up using cost or pricing data according to FAR part 15.4 may include unbalanced pricing between the related equipment and services provided under the contract. This occurs when the prices are significantly understated for some contract items and significantly overstated for other contract items. In these cases, the contract price related to the embedded equipment lease may not represent the true stand-alone selling price of the equipment on its own and therefore the contract should be reassessed to properly allocate the total contract price between the equipment and services when separate performance obligations have been identified to accurately reflect revenue recognition under ASC 606 and ASC 842.

Based on the issues discussed above, customer and related supplier contracts should be re-evaluated as appropriate to determine if they include any embedded leases, whether the accounting should be treated under ASC 606 or ASC 842, and if under ASC 842, whether the underlying asset should be treated as a sales-type lease, direct financing type-lease or operating lease and lastly, that the contracts stand-alone selling prices have been properly allocated.  In addition, relevant policies and procedures should be updated as needed to ensure the proper analysis of new customer contracts is performed to identify and account for embedded leases properly.  

At Chess Consulting, our team has experience solving complex accounting issues surrounding the implementation of, and updates to, the new lease standard. We can review customer and supplier contracts for embedded leases, evaluate contract option years, and prepare solutions to handle both the lease and non-lease portions of contracts along with their stand-alone selling prices. We are trained and certified in several lease software packages, so we provide tailored advice on the best software for a firm to choose and offer support in implementing and using each software. Additionally, Chess Consulting provides a variety of other technical accounting consulting services including purchase accounting, audit readiness support, government contract accounting, investigation, and regulatory compliance.