Embedded Leases and Their Impact on Non-Profits

Non-profit organizations navigate a unique and intricate network of business transactions, filled with specific terms and conditions often hidden in the fine print of agreements. One such term is the ’embedded lease,’ a lease agreement tucked within a larger contract, typically bundled within service arrangements. An embedded lease is a common feature in contracts that non-profit organizations often engage with, such as service contracts, outsourcing agreements, or supply contracts.

In 2016, the Financial Accounting Standards Board (FASB) enacted Accounting Standards Update (ASU) 2016-02, Leases (Topic 842). This move aimed to enhance organizational transparency and comparability by mandating the recognition of lease assets and liabilities on balance sheets and the disclosure of crucial details regarding leasing transactions, producing direct implications for non-profit organizations.

Identifying an Embedded Lease

Embedded leases can emerge in a variety of scenarios, such as when a non-profit healthcare organization rents specialized medical equipment for ongoing patient services or when a non-profit cultural society secures a unique art exhibition space for an extended period for displaying curated collections. Identifying an embedded lease requires a detailed review of the contract, with a particular focus on using and controlling a specific asset. The asset should be physically distinct or represent a significant portion of a larger asset, with the right to control the use of that asset being granted to the customer for a specified period. The right to control is based on two fundamental factors:

1. The customer has the right to obtain substantially all of the economic benefits from using the asset and,
2. The customer has the right to direct how and for what purpose the asset is used.

If these conditions are satisfied, the contract likely contains an embedded lease. However, it’s important to note that an asset’s presence in a contract does not automatically designate it as an embedded lease. If the supplier has substantive substitution rights, allowing them to substitute the asset at their discretion during the period of use, the contract may not be classified as an embedded lease.

The Importance of Understanding Embedded Leases

Embedded leases hold significant importance for non-profit organizations due to their potential financial and operational implications. Given that these leases are often tucked within larger contracts, they can be easily overlooked, leading to inaccuracies in financial reporting and non-compliance with regulations. Recognizing and properly accounting for embedded leases helps non-profits accurately reflect their assets and liabilities on their balance sheets, providing a more accurate picture of their overall financial health. Such transparency is crucial when seeking funding, as donors, grant organizations, and lenders often scrutinize an organization’s financial statements to assess stability and risk. Additionally, understanding the commitments within embedded leases allows non-profits to plan their resources and budget better, facilitating more informed and strategic decision-making for the organization’s future, while failing to account for these leases accurately can result in breaches of regulatory standards and could potentially provoke issues with lenders, donors, and oversight agencies.

Navigating the complex terrain of embedded leases is a task that requires due diligence and expert guidance. Non-profit entities must review their contracts meticulously and, if necessary, seek professional guidance to ensure all embedded leases are accurately identified and accounted for. If you have any questions or concerns about embedded leases within your contracts or need assistance identifying and accounting for them, contact your CRI tax advisor. Their expertise and insights can provide you with a clearer understanding of your obligations and potential liabilities, helping you maintain financial accuracy and make informed decisions.