Embedded Lease Requirements for Private Construction Companies (ASC Topic 842)
Private company construction entities are now required to adopt ASC 842 – Leases effective January 1, 2022, with first reporting period generally as of December 31, 2022. Many construction entities have been actively compiling a list of their traditional lease agreements, for example: office, warehouses, equipment, etc. for analysis under this new standard. However, a significant challenge under ASC 842 will be the requirement to identify and account for “embedded leases” that could exist in other types of agreements (non-traditional lease agreements). An embedded lease is a contract for the use of an asset that meets all the same criteria that qualifies it as a leased asset under ASC 842. While the concept of embedded leases also existed under ASC 840 (previous guidance), identification of these arrangements was not as critical as generally the accounting treatment under these contracts did not vary significantly from other operating leases, i.e., expensed as incurred.
Common areas of embedded leases may include an of the following arrangements: information technology contracts, cable and satellite services, advertising arrangements (billboards), transportation and delivery services, service contracts, contract manufacturing arrangements, or joint-operating agreements. Contracts common to construction entities include agreements for scaffolding, cranes, dumpsters, temporary fencing, and trailers.
Some practical considerations to assist in identifying potential embedded leases:
- Gather all service-type or non-traditional lease (i.e., agreements that do not state or contain the term “lease” in the document) contracts and review for embedded leases.
- Reviewing expense activity in the general ledger can help identify expenses that may require further analysis as payments that recur on a monthly or quarterly basis are often indicative of a leasing arrangement.
- A physical inspection can be performed of offices or job sites to identify assets that have not been identified by the entity as leased.
- Review of subcontractor agreements as potential leases.
Subcontractor agreements that could contain potential leases for consideration
- Cranes – most likely a lease as there is no right of substitution. Need to consider any non-lease components (operator) and how to quantify.
- Scaffolding – most likely a lease as there is no right of substitution once delivered/installed on the site.
- Portable toilets – probably not a lease and there could be periodic substitution.
- Temporary fencing – most likely a lease as there is no right of substitution once delivered/installed on the site.
Two final points to consider when assessing embedded leases under ASC 842:
- For leases with a term of 12 months or less, a lessee is permitted to make an accounting policy election by class of underlying asset not to recognize lease assets and lease liabilities.
- For leases that are quantitively and qualitatively immaterial to the financial statements, a lessee should consider whether accounting under ASC 842 is necessary.
If a lessee makes either of these elections, it should continue to recognize lease expense for such leases generally on a straight-line basis over the lease term.
Questions on proper adoption of the new lease requirements for your construction business? Contact your Keiter Opportunity Advisor.
About the Author
The information contained within this article is provided for informational purposes only and is current as of the date published. Online readers are advised not to act upon this information without seeking the service of a professional accountant, as this article is not a substitute for obtaining accounting, tax, or financial advice from a professional accountant.