Identify An Embedded Lease within contract
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Embedded Lease Within a Contract

How Audit Firms in Dubai Can Identify An Embedded Lease Within a Contract

It is important for audit firms in Dubai to find embedded leases in contracts to avoid miscalculating the balance sheet, and plenty of judgment is involved. In this article, we shall walk you through the process of identifying embedded leases within a contract in Dubai.

Embedded Leases: What Are They?

In an embedded lease, a vendor uses an asset as part of the value provided and the use of that asset is within the definition of a lease. According to ASC 842, Dubai and UAE companies are required to include all lease agreements on the balance sheet to more fully reflect the company’s assets and liabilities.  

For accounting services in Dubai and UAE  to comply with the new standard, the first step is to review and inventory all their existing leases, including any that are embedded within service agreements.

The Impact Of Embedded Leases Under The New Leasing Standards

For accounting services with hundreds to thousands of leases, the need to be ready to comply with I FRS 16 or ASC 842 is keeping accounting teams busy. Accounting and financial services that have not yet adopted ASC 842 but must do so by December 15, 2021, still have many tasks to accomplish, including:

  • Collecting all the necessary information regarding the leasing of property and equipment
  • Using technology to perform all the calculations and create journal entries
  • Deciding how to amend policies and procedures

The issue is further complicated by the requirement to report embedded leases that may appear in other types of contracts, particularly those with service providers. The new accounting standards introduce operating leases, and even some types of service contracts, onto the balance sheet. 

Although you may have done embedded lease accounting in the past, it now poses a much greater issue. In that case, embedded lease accounting has a much greater impact on your income statement under the new rules.   

ASC 842 Disclosure: How Dubai Accounting Services Can Avoid Pitfalls

Embedded Lease Example

Advertisement on a billboard: A company uses a billboard to advertise. The right to use a billboard may fit the definition of a lease even though this could be a contract for advertising services.

An information technology (IT) service provider offers cloud computing services to hospitals subject to Health Insurance Portability and Accountability Act (HIPAA) regulations. The contract requires a dedicated server so that patient privacy rights are not violated. The hospital instructs the IT service provider how and when to use the dedicated server. In the contract, the server is leased.

Large retailers often contract with companies to make shoes for them. As a result of the contract, the manufacturer has a separate facility that produces only shoes for the retailer. The contract manufacturer arrangement contains an embedded lease for the physical manufacturing space and equipment to produce the shoes.

How To Find Embedded Leases:

Examine Operations Closely

Discuss the specifics of the ASC 842 lease definition with relevant departments. Transform the technical terms of the rules into terms that non-accountants can understand. Do not ask if contracts include embedded leases; instead, ask whether any contracts include asset-based service contracts. Embedded leases can also be identified through surveys.

Analyze Risk Areas 

Assess the risk of embedded leases by performing a risk assessment. Are any of your products manufactured by a third party? Does your company need special equipment to comply with regulations (including the Food and Drug Administration rules or the Health Insurance Portability and Accountability Act)? What about leases that come with maintenance contracts?

Review Expense Activity

Determine which general-ledger expenses require further analysis. Recurring payments may indicate a need for review.

Perform A Physical Inspection

Locate leased assets in office or manufacturing locations that aren’t listed on an asset listing, such as large-format printers or medical testing devices.

Examine Contracts

Review and identify contracts that need evaluating by the legal department.

Three Important Questions

To determine if a contract is or contains a lease, one must identify an asset and the associated control of the said asset.

  1. Is There An Identified Asset? 

In most contracts, you’ll find that the asset involved and its intended use are spelled out explicitly. Suppose a manufacturer was given the right to use ten specific rail cars to ship widgets.

In some cases, however, the contract will specify an asset. Here’s an example: a retailer signs up to take a certain volume from a manufacturer, who only has one factory where those shirts are produced. This implies that the plant is the asset used to perform the contract. It takes judgment to identify implied assets.  

  1. Is There A Right To Obtain Substantially All Of The Identified Asset’s Economic Benefits? 

During the contract term, one must have the right to obtain “substantially all” of the economic benefits of an asset. By taking the shirt example, if the factory can produce twice the number of shirts the retailer has agreed to buy, the retailer does not own substantially all the factory’s economic benefits. For example, if the warehouse promises to fill 90 percent of its capacity, the rules indicate that the retailer has secured substantially all of the plant’s economic benefits.  

  1. Who Has The Right To Direct The Use Of The Identified Asset? 

Control is the right to direct how an asset is used. If the retailer is allowed to decide during the contract how and for what purposes the factory operates, without allowing the owner to change these instructions, the leasing rules indicate the retailer controls the factory. If the supplier retains the right to direct the factory’s use, it is unlikely that the retailer will recognize the facility as leased property.

Ervee is a CPA with international experience in Tax and Accounting. He has over 12 years of experience in accounting and bookkeeping and over a year in VAT implementation, registration, and accounting in UAE. He regularly drives out inefficiencies in company operations and loves the challenge of helping clients find additional ways for an easier and improved compliance and verification of transactions. Read more