Embedded Leases – Identification and Separation under ASC 842 and IFRS 16

An embedded lease is a lease component within a broader contract that is not structured as a formal lease agreement but still conveys the right to control the use of an identified asset in exchange for consideration. Both U.S. GAAP (ASC 842) and IFRS (IFRS 16) require entities to identify and separate embedded leases from service contracts and apply lease accounting to the lease component.

This article explains how to identify embedded leases, separate lease and non-lease components, and account for them properly, with practical guidance and examples.

1. What Is an Embedded Lease?

An embedded lease exists when a contract that is not titled as a lease nonetheless conveys the right to control the use of a specific asset during a period of time.

Common examples:

✦ Contract manufacturing with use of a dedicated facility

✦ Outsourcing arrangements involving dedicated equipment

✦ Power purchase agreements (PPAs) tied to a specific generator

✦ Transportation or logistics contracts using dedicated trucks

2. Criteria to Identify an Embedded Lease

Both ASC 842 and IFRS 16 use a two-step test to determine whether a contract contains a lease:

Step 1: Identified Asset

✦ The asset must be explicitly or implicitly specified in the contract

✦ Substitution rights must be not substantive (i.e., supplier cannot substitute freely)

Step 2: Right to Control Use

The customer must have:

✦ Right to obtain substantially all economic benefits from use

✦ Right to direct how and for what purpose the asset is used

If both steps are met, the contract contains an embedded lease.

3. Separation of Lease and Non-Lease Components

Once an embedded lease is identified, the entity must separate lease and non-lease components.

Lessee Accounting:

✦ Allocate consideration to lease and non-lease components based on relative stand-alone prices

✦ Lessees may elect to combine components as a practical expedient, but this increases the lease liability

Lessor Accounting:

✦ Similar allocation of consideration

✦ Stand-alone selling prices used if known

✦ Revenue from lease and non-lease elements presented separately

Example: ✦ Outsourcing contract includes use of a dedicated server (embedded lease) and IT support services (non-lease) ✦ Total contract: $200,000 ✦ Stand-alone price: server use = $120,000; IT services = $80,000

Allocation:

✦ Lease component = 60% of $200,000 = $120,000

✦ Non-lease = 40% = $80,000

Journal entry (lessee): Dr. ROU Asset – $120,000 / Cr. Lease Liability – $120,000.

4. Accounting and Reassessment

If an embedded lease is identified:

✦ Apply lease accounting to the lease portion (ROU asset, lease liability)

✦ Apply ASC 606 / IFRS 15 to the non-lease service portion

✦ Reassess only if the terms of the contract change significantly or a modification occurs

5. Disclosure Requirements

Entities must disclose:

✦ Policy for identifying embedded leases

✦ Use of the practical expedient to combine lease and non-lease components

✦ Amounts recognized for embedded leases

✦ Nature of non-lease services in mixed contracts

Disclosure example: “The Company has identified embedded leases within certain service contracts. The lease component has been separated based on observable stand-alone prices. Right-of-use assets and lease liabilities related to embedded arrangements totaled $2.8 million at year-end.”