EMBEDDED LEASES - ARE YOU AWAKE

Embedded leases are a much loved topic of mine. I have been connected with this term ever since EITF 01-08 was issued in end of 2001. This was followed by pronouncements under IAS as well. The best part which fascinated me towards this topic is that this issue on embedded lease has come to be discussed only after close to three decades of FASB 13 coming into existence.

All GAAP’s (incl. Indian GAAP) in the world describe a lease as an agreement which conveys the right to use property, plant or equipment usually for a stated period of time. (mark the words right to use). Embedded leases are typically embedded in the definition of right to use.

So how does one transliterate the meaning of right to use. The pronouncements (FAS and IAS) both laid down the following guidelines.
1.The arrangement involves the right to use property plant and equipment (PP&E)
2. This PP&E is explicitly identified in the agreement
3. The lease conveys the lessee to use the specified PP&E at all times.

To explain the GAAP rules, lets discuss an embedded lease example.

Company A is in the business of manufacturing specialized products. A major (say 90%) of the finished good is outsourced by the Company to various vendors. The terms of the agreement Company A, has with the vendors are the following
1. Term of agreement are for a period of 5 years (non cancelable by the vendor);
2. Vendor’s production methodology is to be on the guidelines as laid Company A;
3. Vendor is to enter into an exclusive production contract with the Company;
4. All produce from the Vendor is to be sold exclusively;
5. Minimum guarantee given by Company A for production by the vendor;
6. Company A has the right to inspection of the PP&E at all times
7. Vendor charges on a cost plus mark up model (costs include all labour, overheads and raw Material costs, interest etc) on the basis of the planned production and guarantee.

The contract by a first reading may give reason to believe that it is a outsourcing contract for manufacture of goods & the moneys to be paid by Company A to the vendor would typically go into a cost of goods sold account in the P&L, but if were to scan thru this agreement, there is an embedded lease element.

1. The above agreement gives the Company the right to use all the PP&E of the vendor (incl machines/real estate)
2. The vendors return on equity in the project has been guaranteed by Company A on the basis of the Cost + mark up model
3. The PP&E is for exclusive use by Company A for a period of 5 years.

Now that we have identified that the agreement has an element of lease, our next step is to identify the classification of this lease. This can be done in three simple steps
Split the cost of the vendor into three
capex recoveries (depreciation/interest) ;
opex costs (labour, overheads).
Mark up (return of equity which the vendor expects on his efforts)
This data should be normally available when Companies tie up exclusively with vendors, as all price negotiations calculations will lead to cost plus mark up model.
Analogize the capex costs to minimum lease payments (MLP) while retaining the opex costs and mark ups as cost of goods sold

Now that we have the MLP’s (capex costs) , we can apply the rules of FAS 13 in determining the classification of this lease.

Impact of embedded leases on financials

Most of the embedded leases result in the classification of a substantial portion of the contract as a finance lease

Lets put down numbers on the above illustration (for a year of operations)
Total price charged by the vendor (vendor) is Rs. 100 (opex 50+capex+30+markup 20). If this agreement were to be classified as finance lease then the financials will look like this



Though the above P&L is neutral on PAT terms, but there is a significant difference in the EBITDA numbers and the balance sheet numbers, as well as the turnover for the lessor which are very important financial gauge for a lot of Companies with their investors. (in this case the vendor).

Other examples where one could potentially unearth an embedded lease could be in the ITES and BPO sectors. Most of these agreements are structured on a cost+ mark up model with a clause on exclusivity (mainly to protect commercial interests)

With larger agreements, you can also view these contracts to be a bigger part of consolidation when you apply FIN 46. Now that’s an another substance over form issue aint it.