What are embedded leases?
An embedded lease exists when an organization enters into an agreement and, in connection with that agreement, receives a specific asset that it controls over a period of time in exchange for consideration. It’s not uncommon for healthcare organizations to enter into service or supply contracts that give the healthcare organization the right to use a specified asset during the contract term. As an example, your organization might enter into a contract with a supplier for both a piece of equipment — say, a diagnostic machine used in the lab — and the medical supplies (in this case, the reagents used to perform the respective tests on the aforementioned machine) necessary to use it.
Balance sheet amounts will be misstated if embedded leases are not identified and accounted for appropriately.
What’s the issue?While the requirement to identify embedded leases under ASC 842 is not new, failure to identify them will have a more significant impact on your organization’s financial statements than under ASC 840.
Previously, under ASC 840, embedded lease transactions were required to be analyzed and broken out. However, many healthcare organizations may not have focused on identifying the lease and nonlease components since the amounts were expensed in a similar manner.
Now that, under ASC 842, all operating and financing leases are to be recorded on the balance sheet, the balance sheet amounts will be misstated if embedded leases aren’t identified and accounted for appropriately.
How can my organization identify embedded leases?
Many healthcare organizations have contracts that contain embedded leases. To identify contacts with embedded leases, healthcare entities will need to undertake a robust analysis of both their service and supply contracts to identify those contracts with embedded lease arrangements.
It’s important to begin this process promptly, since it can be time-consuming if the information isn’t easily obtained from the systems your organization currently uses.
As your organization is assessing its contracts for potential embedded leases, you may find that some leases that qualified as capital leases under ASC 840 were incorrectly omitted from the balance sheet. Within these services or supplies agreements, your organization may see that the contract provided for a bargain purchase option at the conclusion of the contract, or for title to simply transfer to the organization at the conclusion of the agreement. Detailed review of contact terms is required to ensure proper lease classification.
Healthcare entities will need to undertake a robust analysis of both their service and supply contracts to identify those contracts with embedded lease arrangements.
Ok, my organization has identified embedded leases. Now what?
Once embedded lease contracts are identified, healthcare organizations are required to review the contracts and allocate the consideration provided to the lease and nonlease components on a relative standalone-price basis.
This allocation may be a difficult for healthcare organizations to perform if the standalone prices aren’t readily available or if they’re highly variable. A residual estimation approach may be appropriate when the standalone price for a component is uncertain.
And, here’s a caveat with respect to the embedded lease analysis: Variable costs in the contract wouldn’t need to be analyzed under the new standard, since variable consideration isn’t included in the calculation of the lease liability.
Let’s take a specific example: A hospital enters into an agreement with a vendor for a blood analyzer. As a part of the agreement, the hospital is provided the analyzer at no charge but is required to purchase the reagents from the vendor.
In the contract, the analyzer has a stated rental value of $100 per month, but this amount isn’t actually charged to the healthcare organization. Let’s assume in our example that the organization incurs $1,000 of expenses per month — the fixed monthly minimum stated in the contract — for the supplies it uses and the standalone price for the supplies is unknown.
Using the residual estimation approach, we determine the lease cost is $100 per month. In our example, the $100 would be allocated to the lease component, while $900 would be allocated to the nonlease component. The residual estimation approach is appropriate in this case since the standalone pricing for the lease component is highly variable or uncertain.
Can you put this into perspective?We recently completed an analysis of the new lease account standard for a health system with approximately $600 million in annual revenue. During the analysis, we interviewed over 35 executives and directors from all functional areas of the organization. Our analysis identified more than 40 contracts that needed to be reviewed, and over two dozen embedded leases were uncovered. The asset values of the individual leases ranged from less than $1,000 to over $1.3 million.
In all, we spent over 150 hours conducting interviews, reviewing related contracts, and quantifying the respective lease amounts. In other words, the process of identifying and quantifying embedded leases isn’t a quick one, and if misstated on the balance sheet, the dollar amounts involved could potentially have a significant impact.
What do healthcare organizations need to do now?
First things first:
- Take time to understand the new standard, including how the new rules affect your organization. This may require training your team and educating key stakeholders who will be involved in the process.
- Understand your implementation dates and formulate a timeline. This will likely require assembling a team. Take proper care to ensure the implementation team includes appropriate individuals from across the organization.
- As with any standard that impacts the balance sheet and potential metrics related to debt covenants, discuss the effects with respect to bond covenants with bond counsel and the respective issuing authorities.
- When an asset that you control is provided in a contract, ensure you thoroughly review the contract terms in order to understand proper operating or financing lease treatment.
- Formulate a control or process so that, going forward, you’re able to identify embedded leases at contract initiation.
- Know that once you examine potential embedded lease arrangements, determining the appropriate consideration to be allocated to the respective lease and nonlease components in each agreement will likely require further time and analysis, including potential consultation with the respective vendors.
- If you’re going to track your organization’s compliance with the new standard using software, review the accounts payable and supply chain software your organization currently uses to determine whether you already have a lease module. If external software is desired, get started on deciding which software to use.
- Once you develop your plan for complying with the standard, discuss it with your auditors to ensure concurrence with your methodologies and approach — and to prevent issues at year end.
Implementing ASC 842 will likely involve an investment of time. Taking the steps above can help smooth the road ahead and ensure you don’t miss any embedded leases lurking in your organization’s blind spot.
If you have any questions or would like assistance with implementation, give us a call.