No matter how many lease accounting deadlines have passed, the new lease accounting standards remain challenging due to their complexity. One of the top aspects that remains difficult in these new rules is identifying embedded leases.
First, it’s important to note that not all contracts that are considered leases under Governmental Accounting Standards Board (GASB) Statement No. 87, “Leases” (GASB 87), will include the words “lease” or “rent” to identify them as leases. Some contracts will contain the right to use an underlying asset as part of a larger agreement.
This right of use within a contract is called an embedded lease. Because not all leases are easily identifiable, several questions can help you identify whether or not there is an embedded lease in a contract.
If the answer to these questions is “yes,” you have an embedded lease that has to be accounted for using GASB-87 requirements.
The best way to understand embedded lease contracts is through some examples.
A County enters into a data hosting agreement for the sensitive data collected by the County’s Department of Social Services. The contract is for 60 months with a monthly payment of $5,000.
The hosting services include website access, data storage, and application updates. The contract states that the data is stored on a server that is used exclusively for the County’s data, and the County can indicate how they want the server to be used during the contract period.
The answer to all four questions above is “yes,” therefore, this example contract has an embedded lease.
A City agrees to purchase power generated by a wind turbine owned by a local supplier. Per the agreement, the City dictates the amount of power they want the turbine to generate and the number of hours the turbine is in operation.
The supplier is responsible for all repairs and maintenance on the turbine. The contract is for 48 months with monthly payments of $25,000 plus additional variable amounts based on the amount of power generated.
The answer to all four questions above is “yes,” therefore, this example contract has an embedded lease.
Procurement or legal departments are the best places to start when looking for embedded leases, as these departments play a critical role in identifying embedded leases within contracts.
Then, to validate the information you discover, partner with accounts payable to obtain a list of all the payments made on service contracts. This will help you determine if any additional contracts should be evaluated.
Embedded leases may exist in several governmental contract types, such as:
Recognition of embedded leases is essential for accounting and compliance with GASB-87 standards. After implementing a new lease accounting standard, it’s essential to continue identifying embedded leases as they come in to ensure you stay compliant.
The examples above should help you navigate the decisions that must be made to determine if your leases qualify under the GASB standard. This worksheet will guide you through the process of determining if your contract includes an embedded lease under GASB-87.
Click the button below to download this free infographic to help determine whether your contract is a lease under the lease accounting standard.
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