Scope and identifying a lease: identified asset, control and embedded leases

• Apply the ASC 842 scope exclusions to a contract population
• Determine whether a contract involves an identified asset, including substitution rights
• Evaluate whether the customer has the right to obtain benefits and direct use
• Identify embedded leases in service and supply contracts

Scope comes first

Topic 842 applies to all leases, including subleases (842-10-15-1). It does not apply to leases of intangible assets, rights to explore for or use minerals, oil, natural gas and similar nonregenerative resources, leases of biological assets including timber, leases of inventory, or leases of assets under construction. A software license is an intangible and falls outside the Topic. A cloud hosting arrangement that gives use of specified servers needs the full analysis below.

The definition

A contract is or contains a lease if it conveys the right to control the use of identified property, plant or equipment for a period of time in exchange for consideration (842-10-15-3). The period can be expressed as an amount of use, such as a number of production units. The entity makes this determination at inception of the contract (842-10-15-2) and reassesses only if the terms and conditions change (842-10-15-6).

Test 1: is there an identified asset?

An asset is identified when it is explicitly specified in the contract. It is also identified when it is implicitly specified at the time it is made available for use (842-10-15-9). A specified asset is still not identified if the supplier has a substantive substitution right. Under 842-10-15-10 the right is substantive only if both conditions hold:

• the supplier has the practical ability to substitute alternative assets throughout the period of use, and
• the supplier would benefit economically from substituting.

The evaluation uses facts at inception and ignores future events that are not likely at that date. A capacity portion of a larger asset (for example, a share of a fiber cable) is an identified asset only if it is physically distinct or represents substantially all of the capacity.

Test 2: does the customer control the use?

Under 842-10-15-4 the customer must have both of the following throughout the period of use:

1. The right to obtain substantially all of the economic benefits from use of the identified asset.
2. The right to direct the use of the identified asset.

The right to direct exists when the customer decides how and for what purpose the asset is used, or when those decisions are predetermined and the customer either operates the asset or designed it in a way that predetermines its use (842-10-15-20). Protective rights of the supplier, such as limits on mileage or maintenance requirements, do not by themselves take away the customer's right to direct.

Embedded leases

The harder audit risk is not the signed office lease. It is the lease buried in another contract:

• A logistics agreement that dedicates specific trucks to one customer.
• A supply agreement under which a vendor's equipment sits in the customer's plant and produces only for that customer.
• A data center contract that assigns specified racks the customer controls.
• A related party arrangement for a building, sometimes with no written lease.

For each, walk the two tests. If a supplier keeps a substantive right to swap the trucks and does so in practice, there is no identified asset and the contract is a service. If the trucks are specified, cannot be swapped, and the customer schedules their routes, there is a lease.

Audit angle

Inquiry alone does not find embedded leases. Read significant service and supply contracts, scan the vendor payment listing for recurring fixed payments to the same counterparty, and review board minutes. The lease PBC request list has the documents to ask for, and Lesson 9 of this track covers the completeness procedures in full.

Dedicated trucks at Harbor Point Foods, LLC