How Audit Firms Identify an Embedded Lease Under IFRS 16 in UAE

What Is an Embedded Lease Under IFRS 16?

An embedded lease is a lease that sits inside a wider commercial agreement, most often a service or supply contract, rather than a standalone lease document. Under IFRS 16, the accounting standard that governs lease recognition in the UAE, a contract contains a lease if it conveys the right to control the use of an identified asset for a period of time in exchange for consideration. That right can exist even when the word “lease” never appears anywhere in the agreement.

This matters because IFRS 16 replaced IAS 17 for reporting periods beginning on or after 1 January 2019 and requires almost all leases, including those buried inside other contracts, to be recognized on the balance sheet as a right-of-use asset and a corresponding lease liability. Only short-term leases (12 months or less) and leases of low-value assets remain off balance sheet. A company that never looks for embedded leases inside its service, manufacturing, and IT contracts can materially understate both its assets and its liabilities without ever signing a document titled “lease.”

Why Identifying Embedded Leases Matters for UAE Businesses

Missing an embedded lease is not a cosmetic error. It changes the shape of the financial statements: assets and liabilities are understated, EBITDA is distorted because what should be depreciation and interest expense instead sits inside operating cost, and key ratios used by banks, investors, and free zone authorities no longer reflect the company’s real financial position.

For UAE entities, the consequences extend beyond financial reporting. Under Ministerial Decision No. 84 of 2025, all Qualifying Free Zone Persons, entities with revenue above AED 50 million, and all Tax Groups must prepare audited financial statements for tax periods starting from 1 January 2025 onward, regardless of whether they previously required an audit. Financial statements that omit embedded leases will not pass audit scrutiny, and the resulting restatement can also affect Corporate Tax computations, since depreciation on right-of-use assets and interest on lease liabilities are treated differently from a straight operating expense under Federal Decree-Law No. 47 of 2022.

Also check: Real Estate Audit Services

Common Examples of Embedded Leases in Contracts

Embedded leases tend to hide in agreements that are negotiated by procurement, operations, or IT teams rather than finance, which is exactly why they get missed. Three patterns come up repeatedly during audits in the UAE:

• Outdoor advertising and billboard arrangements. A media contract that assigns a company the exclusive use of a specific, physically identified billboard or panel for a fixed term typically meets the definition of a lease, even though it is invoiced as an “advertising service.”
• IT and cloud hosting contracts with dedicated infrastructure. If a technology vendor allocates specific, identifiable servers to a single client rather than pooling capacity across many customers, and the vendor has no practical ability to substitute that equipment, the arrangement can contain a lease of the server hardware.
• Contract manufacturing and toll processing agreements. When a manufacturer dedicates a production line or facility exclusively to one customer’s output for the life of the contract, and the customer effectively directs how and when that capacity is used, the arrangement can embed a lease of the production asset.

In each case, the contract is drafted and priced as a service, and the finance team only discovers the embedded lease when someone asks the right questions about the underlying asset.

The Three-Part Test to Identify an Embedded Lease

IFRS 16 sets out three conditions that must all be met for a contract, or a component of a contract, to be classified as a lease. Auditors and finance teams work through each one in sequence.

1. Is There an Identified Asset?

The contract must relate to a specific, identifiable asset, either explicitly named in the agreement or implicitly identified because the supplier has no practical ability to substitute an alternative asset and would not benefit economically from doing so. A vague reference to “server capacity” from a shared pool is not an identified asset; a named unit in a named rack that the vendor cannot swap out without the customer’s consent typically is.

2. Does the Customer Obtain Substantially All the Economic Benefits?

The party using the asset must have the right to obtain substantially all of the economic benefits from its use throughout the period of use. This is assessed within the defined scope of the customer’s right, not against the asset’s total theoretical output. For example, a company that contracts for a warehouse and uses roughly 90% of its usable capacity would ordinarily be considered to obtain substantially all of the economic benefits, even though a small portion of space remains unused.

3. Who Directs How and For What Purpose the Asset Is Used?

Control also requires the right to direct the use of the asset, meaning the customer (not the supplier) makes the decisions that matter most to the economic outcome of that use, such as what is produced, when, and how. If the supplier retains the substantive right to change how the asset is used during the period, or to substitute it at its own discretion, the arrangement generally fails this condition and remains a pure service contract.

Worked example: A UAE distributor signs a three-year contract with a logistics provider for “dedicated cold storage services.” The contract names three specific chambers in a named facility, gives the distributor the right to store its own stock exclusively (roughly 95% of the chambers’ usable volume), and lets the distributor’s team decide what goes in, when, and how it is arranged, with the provider only handling security and temperature monitoring. All three conditions are met: an identified asset (the three named chambers), substantially all the economic benefit (95% utilization), and the right to direct use (the distributor controls what is stored and when). The distributor should recognize a right-of-use asset and lease liability for the chambers, even though the invoice reads “logistics service fee.”

Must check: External Audit Services

Step-by-Step Process for Finding Embedded Leases in Contracts

Because embedded leases are, by definition, not labeled as leases, finding them requires a structured review rather than a search for a specific contract type. Audit firms in the UAE typically work through five stages:

1. Map operations against contract types. Translate the IFRS 16 lease definition into plain language for procurement, operations, and IT staff, then survey every department for service, supply, or outsourcing contracts that involve the use of physical or dedicated technical assets.
2. Prioritize by risk. Focus first on categories with a known history of embedded leases: third-party manufacturing and toll processing, equipment installed to meet regulatory or compliance requirements, and “all-inclusive” maintenance contracts that bundle equipment use with servicing.
3. Review recurring expense activity. Scan the general ledger for fixed, recurring payments to the same vendor over a multi-year term. A flat monthly or annual fee for what is described as a “service” is a common signal that an asset is being used exclusively, rather than shared.
4. Perform physical verification where practical. Site visits and asset walkthroughs can surface equipment, vehicles, or facilities that are in use under a contract but never appear on the fixed asset register or lease schedule.
5. Review the underlying contracts. Legal and finance teams jointly assess flagged agreements against the three-part IFRS 16 test above, since the outcome depends on contract wording and practical substitution rights, not on the invoice description.

Embedded Lease vs Service Contract: Key Differences

The table below summarizes the practical distinctions that separate a genuine service arrangement from a contract that embeds a lease.

Common Mistakes When Identifying Embedded Leases

Even experienced finance teams miss embedded leases for predictable reasons. The most frequent pitfalls include:

• Relying on the contract title. A document labeled “Service Agreement” or “Facilities Management Contract” can still embed a lease; the classification depends on substance, not the heading.
• Treating “substantially all” as 100%. Teams sometimes assume any shared or partial use disqualifies a lease. In practice, benefit thresholds well below full capacity, such as the 90-95% range in the examples above, can still satisfy the “substantially all” condition.
• Ignoring practical substitution rights. A contract may technically allow the supplier to substitute the asset, but if doing so would be costly or impractical for the supplier, that substitution right is not treated as substantive under IFRS 16.
• Reviewing only new contracts. Embedded leases are frequently found in long-running legacy agreements that were never reassessed when IFRS 16 first took effect or when renewed.
• Leaving the review entirely to finance. Procurement and operations teams negotiate the contracts and understand the operational detail; excluding them from the review process is one of the most common reasons embedded leases go undetected.

How Auditors Test for Embedded Leases During an Audit

During a statutory or external audit, auditors do not simply accept a client’s lease schedule at face value. Testing for unrecognized embedded leases typically involves:

• Contract population review. Auditors request a full listing of service, supply, and outsourcing contracts above a materiality threshold and select a sample for detailed review, focusing on multi-year agreements with fixed recurring fees.
• Substance-over-form testing. Selected contracts are assessed against the three-part IFRS 16 test regardless of how they are titled or coded in the accounting system, since the completeness assertion is at risk wherever an asset is used but not on the lease register.
• Recalculation of right-of-use assets and liabilities. Where a previously unrecognized embedded lease is identified, auditors recalculate the right-of-use asset, lease liability, depreciation, and interest expense, and assess the resulting impact on the balance sheet and income statement.
• Inquiry across departments. Auditors interview procurement, operations, and legal personnel, not only finance, since the operational teams that negotiated the contract are often the first to know whether a dedicated asset is involved.
• Corroboration through site visits and vendor confirmations. Physical inspection and third-party confirmation are used to verify whether equipment or facilities described in a contract are, in practice, dedicated to a single customer.

Where an audit identifies a material unrecognized embedded lease, the client is generally required to restate the affected balances before the financial statements can be finalized, particularly where those statements will support a Corporate Tax filing or a mandatory audit obligation under Ministerial Decision No. 84 of 2025.

See also: Audit Services in UAE

Frequently Asked Questions (FAQs)

How Farahat & Co. Can Help

Farahat & Co. supports UAE businesses with contract reviews, lease identification assessments, and statutory and external audit engagements that test for unrecognized embedded leases under IFRS 16.

Contact Farahat & Co. today to discuss your embedded lease identification and audit requirements.