Embedded Contracts Can Complicate Preparation for New Lease Rules

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By Denise Lugo

Companies that think new lease accounting rules aren’t relevant to their operations, and therefore haven’t paid much attention to them, might be in for a surprise: hidden embedded leases in contracts that can leave them with little time to prepare for the new rules.

Any company that exclusively uses solar power might have a lease in their contracts that they aren’t aware of, practitioners told Bloomberg Tax. Information technology contracts with outsourced network services and related “around-the-clock” IT maintenance support can also include an embedded lease.

Contracts with hidden leases would bring headaches, requiring more company resources, because of the level of effort it can take to adopt the rules, accountants said.

Some lease contracts, for example, can take up to four hours to read, and the implementation portion for an entire lease portfolio can take over a year. Work to adopt the rules is time consuming, from companies having to also evaluate, collect data, and ready internal accounting systems.

Companies therefore need to look more intensely into their contracts to see if they have embedded leases to avert trouble and complications down the road.

“Analyzing the specific facts and circumstances of each contract and determining if it contains an embedded lease can pose a challenge for companies,” said Anastasia Economos, partner at Ernst & Young LLP Americas in New York.

“Take for example solar power,” Economos said. “We looked at two contracts that both had solar power agreements—but we concluded that one of the contracts included a lease, but the other contract did not. So there’s complexity around the judgment and how to determine whether a lease is embedded in a contract or not,” she said.

Solar and IT Contracts

The new leases rules, effective Jan. 1, 2019, for public companies, require them for the first time to put on balance sheet leased assets and liabilities previously kept off it. The change will bring investors and analysts more clarity about those contracts—figures that can reach billions of dollars. Public companies have to make their systems ready this year.

Solar and certain IT contracts could be troublesome in lease accounting, depending on the terms surrounding the right to use a clearly identified asset, practitioners said.

Companies with solar service contracts might have not only an energy contract, but also an embedded lease for the right to the solar farm, said Carlos Pires, finance specialist in the Boston division of Aptitude Software, a London, U.K.-based software finance company whose clients include AT&T Mobility, Verizon Wireless, T-Mobile U.S. Inc. and Sprint Corp.

Solar contracts can contain a lease “because there is an identified asset explicitly specified in the contract: the customer has exclusive use of the solar farm and the right to obtain substantially all of the economic benefits, and the energy supplier does not have the right to substitute the specified solar farm,” Pires told Bloomberg Tax.

Similarly, IT service contracts can also contain an embedded lease, Pires said, because, “there is network equipment that was installed at the customer’s premise in accordance with the customer’s instructions, and the supplier substitutes the server only in the case of malfunction.”

Many Companies Lagging

It can take from four to 12 months to complete the implementation portion of lease accounting, which might not include the massive job to collect all of the data on their leases, Ross Chapman, global marketing director at Aptitude Software, told Bloomberg Tax.

Some companies that lag in their data collection process have already been providing leases disclosures, and therefore don’t believe the new accounting rules will bring any surprises, Chapman said. “But there are all these new rules about how to classify what’s a lease, what’s not a lease, and new accounting judgments to make that will affect how leases lie on balance sheets,” he said.

Deutche Telekom AG, one of the biggest telecommunications operators, for example, in January said the new lease accounting rules will affect some core financial ratios, but hasn’t yet been able to explain the direct impact.

Three Easy Steps to Get Ready

Companies that haven’t done much, but now want to get up to speed quickly, can take three steps, practitioners said:

  •  don’t try to do big system migrations or replacements: reduce the scope of the project to only required system functionality, data integrations, and reporting;
  •  choose a lease accounting software product with a reputation for quick implementation: system should include minimum required configurations and ability to connect to existing lease management systems; and
  •  partner with someone to help with policies and data system and implementation.
“There will be a crunch for implementation resources as the deadline gets closer,” said Matt Waters, Lease Accounting Specialist at CoStar Real Estate Manager, the lease management software division of Washingon-based CoStar Group Inc. CoStar’s clients include U.S. Bank N.A., Ralph Lauren Corp., Georgia-Pacific LLC, United Parcel Service Inc., and Arby’s Restaurant Group.

“The goal should be to have a system ready by September in order to test calculations, verify reporting accuracy and make any needed adjustments,” Waters told Bloomberg Tax.

To contact the reporter on this story: Denise Lugo in New York at dlugo@bloombergtax.com

To contact the editor responsible for this story: S. Ali Sartipzadeh at asartipzadeh@bloombergtax.com

Copyright © 2018 Tax Management Inc. All Rights Reserved.

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