What Is an Embedded Lease?

Embedded leases are one of the most commonly overlooked components of lease accounting under ASC 842. Unlike traditional real estate or equipment leases, embedded leases are not always labeled as “leases” in contracts, making them harder to identify and easier to miss.

For accounting teams, failing to identify embedded leases can lead to incomplete lease populations, misstated balance sheets, and audit findings. This article explains what embedded leases are, how to identify them, and why they matter for ASC 842 compliance.

What Is an Embedded Lease?

An embedded lease exists when a contract contains the right to control the use of an identified asset, even if the contract is primarily for services or another purpose.

Under ASC 842, a contract contains a lease if:

1. There is an identified asset, and
2. The customer controls the use of that asset for a period of time in exchange for consideration.

If both conditions are met, the contract, or a portion of it, may need to be accounted for as a lease, even if it is not explicitly labeled as such.

Common Examples of Embedded Leases

Embedded leases often appear in service or outsourcing agreements. Common examples include:

• Data center hosting agreements tied to specific servers or racks
• Dedicated equipment agreements within service contracts
• Transportation or logistics contracts with specified vehicles
• Manufacturing or production agreements using dedicated machinery
• Energy or utility agreements tied to specific infrastructure

Because these contracts are not labeled as leases, they are frequently excluded from lease inventories unless reviewed carefully.

How Embedded Leases Are Identified Under ASC 842

Identifying embedded leases requires reviewing contracts beyond traditional lease agreements.

Key questions accounting teams should ask include:

• Is a specific asset explicitly or implicitly identified in the contract?
• Does the supplier have substitution rights, and are those rights substantive?
• Does the customer control how and for what purpose the asset is used?
• Does the customer obtain substantially all of the economic benefits from use of the asset?

If the answer to these questions is yes, the contract likely contains an embedded lease.

Why Embedded Leases Matter for Lease Accounting

Under ASC 842, nearly all leases must be recognized on the balance sheet. If embedded leases are not identified, the lease population is incomplete.

This can result in:

• Understated right-of-use assets and lease liabilities
• Inaccurate disclosures
• Increased audit risk
• Last-minute adjustments during close or audit

Auditors increasingly focus on embedded lease identification, especially in industries with complex service arrangements or technology-heavy operations.

Accounting Treatment of Embedded Leases

Once an embedded lease is identified, it must be accounted for in the same way as any other lease under ASC 842.

This includes:

• Determining the lease term
• Identifying lease payments
• Selecting an appropriate discount rate
• Classifying the lease as operating or finance
• Recording a right-of-use asset and lease liability at the commencement date

In some cases, a contract contains both lease and non-lease components. These components must be separated unless the accounting policy election to combine them is applied.

Embedded Leases vs Service Contracts

Not all service contracts contain embedded leases.

A contract is generally not a lease if:

• The supplier can freely substitute the asset during the contract term, and
• The customer does not control how the asset is used

Understanding this distinction is critical, as misclassification can lead to unnecessary complexity or missed lease recognition.

Challenges Accounting Teams Face With Embedded Leases

Embedded leases are challenging because they require cross-functional visibility.

Common challenges include:

• Contracts stored outside accounting systems
• Legal or procurement teams owning service agreements
• Inconsistent contract language
• Manual contract review processes

As organizations scale, these challenges increase the likelihood of missed embedded leases.

Why Embedded Leases Are a Common Audit Focus Area

Auditors frequently test embedded lease identification as part of ASC 842 audits. This often includes:

• Reviewing service and vendor contracts
• Asking for documentation of embedded lease assessments
• Evaluating consistency across contract types

Having a documented process for identifying and evaluating embedded leases helps reduce audit friction and supports defensible reporting.

Embedded Lease FAQs

What is an embedded lease?

An embedded lease exists when a contract contains the right to control the use of an identified asset, even if the contract is primarily for services.

Are embedded leases required to be recognized under ASC 842?

Yes. If a contract meets the definition of a lease, it must be recognized on the balance sheet under ASC 842.

Where are embedded leases commonly found?

Embedded leases are often found in service agreements, technology contracts, logistics arrangements, and outsourcing agreements.

How do embedded leases affect the balance sheet?

Embedded leases result in the recognition of a right-of-use asset and a lease liability, just like traditional leases.

Final Thoughts

Embedded leases are easy to overlook but critical for complete ASC 842 compliance. Identifying them requires careful contract review, coordination across teams, and consistent accounting judgment.

For accounting teams, treating embedded lease identification as a core part of lease accounting rather than an edge case helps ensure accurate financial reporting and smoother audits.

Brooke Colglazier

Marketing Manager