Understanding Embedded Leases for Businesses

Introduction to Embedded Leases

We are all familiar with the concept of a lease – whether it is renting a home, leasing a factory, or hiring a car. However, what many may not be aware of are embedded leases. Understanding embedded leases is crucial for businesses, as they could have significant implications for those unaware of their existence and requirements. In this blog, we explore the definition of embedded leases and their impact on businesses.

What is an Embedded Lease?

An embedded lease is an agreement that exists within a contract, where the main subject of the contract is not primarily a lease, but it contains provisions that grant one party the right to use a specific asset for a period in exchange for consideration. In many instances, the agreement does not even specify the word ‘lease’, so it does not trigger any thought on the potential for an embedded lease existing.

Essentially, it means a part of a broader service or supply agreement implicitly includes the lease of an asset, even if the word ‘lease’ is never mentioned. Importantly, the asset being ‘leased’ does not have to be used exclusively by the user, but the user has a substantial interest in and use of the asset.

Key Characteristics of an Embedded Lease

Under accounting standards like International Financial Reporting Standards 16 (IFRS) (which deals with leases), identifying an embedded lease involves assessing whether a contract contains a lease. A contract is, or contains, a lease if it conveys the right to control the use of an identified asset for a period in exchange for consideration (ie a fee or similar).

IFRS applies to companies that are required or choose to use International Financial Reporting Standards for their financial reporting. It is commonly adopted by companies in many countries around the world as the basis for preparing their financial statements. It therefore does not apply to all companies.

Let’s now break down the requirements for embedded leases:

Identified Asset

• The contract must depend on a specific, identifiable asset. This could be explicitly stated (eg Server X or equipment A) or implicitly specified (eg the only piece of equipment that can fulfil the contract).

• A supplier's right to substitute the asset is a key consideration. If the supplier has a substantive right to substitute the asset (meaning they have the practical ability to substitute and would benefit economically from doing so), then an identified asset may not exist, and thus no lease. In contrast, if the supplier has no such right without the customer’s consent, then an embedded lease is likely to be triggered.

Right to Control the Use of the Identified Asset

This is crucial and has two components:

• Right to obtain substantially all of the economic benefits from use of the asset. The customer (lessee) has the exclusive right to the benefits derived from using the asset throughout the period of use. For example, if the contract is for data processing services, and a specific server is dedicated to the customer, the customer gets substantially all the output of that server.

• Right to direct the use of the asset. The customer has the decision-making authority over how and for what purpose the asset is used throughout the period of use. This might mean deciding what output is produced, when it is produced, or how the asset is operated. If the supplier, on the other hand, directs the use of the asset, it's more likely to be classified as a service contract than an embedded lease.

• For a period. The contract must specify a period during which the right to use the asset is granted.

• In exchange for consideration. There must be payment or other consideration exchanged for the right to use the asset.

  
  

Why are Embedded Leases Important?

The primary significance of identifying embedded leases relates to accounting, particularly under IFRS 16 (and ASC 842 under US GAAP for US companies or US-listed companies). These standards require companies (lessees, ie the customer) to recognise most leases on their balance sheets by recording a right-of-use asset and a corresponding lease liability.

• Financial reporting accuracy. Failure to identify embedded leases means a company's assets and liabilities could be understated, leading to a misrepresentation of its financial position and leverage. A restatement of the financial accounts will be required to ensure accuracy and full disclosure to shareholders and authorities.

• Comparability. Recognising embedded leases ensures that financial statements are more comparable between companies that lease assets versus those that purchase them or enter service contracts with embedded leases.

• Impact on financial metrics. Recognising these leases can affect key financial metrics like debt-to-equity ratios, asset turnover, and EBITDA.

Examples of Contracts that Might Contain Embedded Leases

• Service contracts. A contract for data storage services might involve the use of specific servers dedicated to the customer.

• Transportation agreements. A contract where a supplier agrees to transport goods using a specific vehicle or pipeline for a customer's exclusive use over a period.

• Manufacturing agreements. A contract where a supplier uses specific machinery exclusively to produce goods for a customer, and the customer dictates the operation of that machinery.

• Energy supply contracts. A contract for the output from a specific power plant, where the customer has the right to direct the use of the plant.

• IT outsourcing. Agreements where specific IT equipment is dedicated to a customer, eg a dedicated server.

Identifying Embedded Leases Can Be Challenging

It often requires careful examination of the terms and conditions of contracts that are not explicitly labelled as leases. Companies need to implement processes to review various types of agreements to ensure any embedded leases are properly identified and accounted for. It is therefore important for both lawyers reviewing the agreements and the business managers to understand embedded leases and timeously disclose them to the finance team for assessment and disclosure in the applicable reporting standards like IFRS and US GAAP.

Are Embedded Lease Requirements Applicable to All Companies in South Africa?

Not all companies in South Africa are required to apply full IFRS. The financial reporting framework a company must use is largely dictated by the Companies Act of 2008 and its accompanying regulations.

While companies that report under full IFRS must identify and disclose embedded leases in accordance with IFRS 16, there is a separate, simplified standard – IFRS for SMEs (International Financial Reporting Standard for Small and Medium-Sized Entities) – designed for smaller and medium-sized entities.

To determine whether IFRS for SMEs applies, a company assesses its Public Interest Score. If a company's Public Interest Score falls below 350, it will generally qualify to use IFRS for SMEs. Under IFRS for SMEs, there is no specific requirement to identify or disclose embedded leases as mandated by IFRS 16. The lease accounting under IFRS for SMEs (specifically Section 20, Leases) differentiates between finance and operating leases, without the same ‘right-of-use asset’ and ‘lease liability’ recognition model for all leases that full IFRS requires.

However, if a company does not qualify to use IFRS for SMEs – for instance, if its Public Interest Score is 350 or above, or if it is a public or state-owned company – then it must comply with full IFRS. This includes all the requirements relating to embedded leases under IFRS 16, which necessitate a detailed review of contracts to identify and account for any embedded lease components. 

Embedded Lease Identification Checklist

(For businesses and legal advisors applying IFRS 16 and/or US GAAP)

• Does the contract involve the use of an identifiable asset?

  • Is a specific asset explicitly or implicitly mentioned?

  • Can the supplier substitute the asset during the contract term (and do they have a practical ability to do so)?

• Does the customer obtain control over the asset’s use?

  • Can the customer direct how and for what purpose the asset is used during the contract period?

  • Does the customer get substantially all the economic benefits from using the asset?

• Is the asset used for a defined period?

  • Is there a clearly stated lease term, or is it implied by the nature of the arrangement?

• Is the arrangement labelled as a service contract or supply agreement?

  • Even if not called a ‘lease’, could the agreement effectively convey the right to use an asset (eg transport services, IT servers, equipment use)?

• Does the contract include both lease and non-lease components?

  • Are there bundled services (eg maintenance, personnel) alongside the use of an asset?

  • Can the lease component be separated and accounted for?

• Does your accounting framework require lease identification?

  • If applying full IFRS, embedded leases must be identified.

  • If applying IFRS for SMEs, this analysis is generally not required.

If the answer to any of the above questions is ‘yes’ or uncertain, the legal and business teams should flag the contract to the finance team for further assessment. This ensures that any potential embedded lease is properly identified and accounted for under IFRS 16 (if applicable).

Summary

An embedded lease is a lease that is hidden within a larger contract. Identifying these is crucial for accurate financial reporting under applicable accounting standards. The flow diagram below will assist in getting you started. Ensure you contact your finance and legal teams to assess contracts for potential embedded leases.

The information provided is for information purposes and does not constitute legal advice. Contact a lawyer should you require assistance. Legal Dynamix is not a law firm and does not provide legal advice on the subject matter contained herein.