Theory and Practice
An embedded lease exists when a contract that is not explicitly a lease (for example, an outsourcing or service contract) contains a portion that meets the definition of a lease. Under both IFRS 16 and ASC 842, the lessee must identify embedded leases and account for them separately (IASB, 2016; Financial Accounting Standards Board, 2016b). The criteria are the same - there is an embedded lease if
an explicitly or implicitly identified asset is part of the contract, and
the customer controls the use of that asset for a period of time (obtaining substantially all economic benefits and having the right to direct its use).
For example, a contract for IT services that gives a company the exclusive use of specific servers in a data center likely contains a lease of those servers. Similarly, a transportation contract that dedicates a particular truck to the customer might contain a lease of the truck. When an embedded lease is present:
IFRS
The lessee separates the lease component and accounts for it under the lease standard (IFRS 16) while accounting for the remainder of the contract (the service component) under other applicable standards (often IFRS 15 or as an expense as incurred) (IASB, 2016). Payments are allocated between the lease and non-lease components based on their relative stand-alone prices. IFRS does not permit combining lease and non-lease components except by use of a practical expedient limited to lessees (and even then, it’s generally discouraged if the non-lease components are significant). The goal is to ensure that the lease portion of a contract is properly capitalized and not hidden.
US GAAP
The requirements are similar in principle. However, ASC 842 provides a practical expedient allowing lessees (by class of asset) to choose not to separate non-lease components from lease components, and instead account for the entire contract as a lease (Financial Accounting Standards Board, 2016b). This can simplify accounting for contracts like building rentals that include services (maintenance, utilities, etc.), by letting the lessee include the combined payment in the lease calculation. The trade-off is that the lease liability will be larger (it captures service costs too) and asset values will be higher. Many companies with large numbers of leases have adopted this expedient to ease implementation. Nonetheless, careful consideration is needed: the expedient cannot be chosen if it would significantly affect the amount of the lease liability (for example, if a contract’s service component is substantial relative to the lease of an asset, combining them might not be appropriate). Lessor accounting for embedded leases also requires separating lease from service components, and ASC 842 provides a similar expedient for lessors in certain circumstances (Financial Accounting Standards Board, 2016b).
UK GAAP
The updated FRS 102 follows IFRS 16 – lessees (and lessors) should identify and separate lease components in a contract (FRC, 2022). The practical expedient to not separate components is not generally available under FRS 102 (just as under IFRS 16, apart from possibly some limited cost-of-implementation relief). Therefore, UK GAAP reporters will need to ensure their contract evaluation processes mirror IFRS requirements: e.g., reviewing service contracts for embedded leases and allocating payments accordingly.