The Challenge of Embedded Leases

Leases May Be Hiding in Supply and Service Contracts

Dennis J. Chambers, PhD, and Catherine A. Finger, PhD, and Jeff Horne

As companies face the significant challenges in adopting Accounting Standards Codification (ASC) Topic 842, “Leases,” little has been written about the challenge posed by the requirement to evaluate whether embedded leases exist in supply or service contracts. While a similar requirement previously existed under ASC Topic 840, many companies did not search for embedded leases because there was no meaningful difference between the accounting for operating leases and the accounting for executory contracts. Under ASC Topic 842, however, it is critically important to identify embedded leases because the guidance related to embedded leases has changed and operating leases must now be reported on the balance sheet. In addition, the number of contracts containing embedded leases will likely increase as companies increasingly rely on outsourcing through the use of supply and service contracts, many of which may now qualify as leases.