AND BENJAMIN CUTLER

Estimated reading time: 7 minutes

The article in brief:

• ASC 842 continues to have financial transparency and lease management implications for private and public companies.
• In a history review of the accounting standards updates (ASU), we highlight the private and public company impacts and identify practical shifts and clarifications for lease accounting.
• Determining the incremental borrowing rate (IBR) continues to be challenging, but with a comprehensive approach, clients can get help to overcome it.
• VRC has developed a dual methodology approach for IBR determination to help clients stay ahead of ongoing regulation updates and consider factors like market access, credit rating, and property-specific and currency risks to provide accurate IBR conclusions closely aligned with the FASB’s guidance.

Since its inception, the spirit of ASC 842 has been to improve the precision and comparability of financial statements concerning the treatment of lease obligations. Over the past few years, updates to the lease accounting standard have quietly shaped how businesses approach leases and financial transparency. While the revisions may seem subtle, the implications are profound and influence how organizations manage and disclose their leasing activities.

The nuanced landscape of ASC 842 has received five updates since VRC’s first published guidance on the standard in late 2019. In first stepping through its recent history, we’ll uncover the emerging practical shifts and strategic considerations that have led us to our present-day IBR considerations and methodology.

ASU-2019-10: Practical Implementation Shifts

The FASB slated ASU-2019-10 to come online in Q1 2019 for public companies and YE 2019 for private organizations. However, in late 2019, the FASB responded to strong stakeholder feedback indicating several practical ASC 842 implementation difficulties.

With a collective sigh of relief, private company CFOs and controllers saw the deadline shift ahead by an entire year, allowing non-public entities additional time to implement the sweeping lease update. Public companies did not receive this extension as the update occurred after the effective date for such entities.

ASU-2020-05: Addressing Pandemic Challenges

Amid the pandemic, CFOs and financial market participants faced unprecedented disruptions and challenges. The capital markets were exceptionally volatile and, at times, illiquid and disjointed, and financial regulators were aware of the unprecedented fiscal and monetary policy actions of the Fed and the U.S. Government. Still, the FASB quietly released a form of economic relief largely unknown to professionals outside of accounting departments – they acknowledged the undue private company burden if the Board demanded a major accounting change amid the macroeconomic turmoils and uncertainty associated with the global pandemic.

A major accounting update like ASC 842 would require significant company resources and focus, particularly for smaller and non-public companies scheduled to complete the update by the end of 2020. Once again, the FASB weighed the costs of lower comparability of financial statements against those of the companies that would bear the implementation costs.

One lesson learned during this implementation phase was that financial users and analysts must have a granular understanding of accounting guidance since differences in effective dates can materially impact the presentation of lease obligations.

ASU-2021-05: Clarifying Variable-Based Leases

By mid-2021, private companies were implementing ASC 842; meanwhile, public entities were required to comply with the standards for over two years. As part of the FASB’s routine post-implementation review (PIR) process, the Board responded to hundreds of technical questions as part of ASU-2021-05. As pandemic-related disruptions continued and technical questions grew, many private company accounting departments likely hoped for another implementation deferral, but the FASB did not defer the standard any further.

ASU-2021-05 had a minor legislative impact in clarifying the accounting of certain variable-based leases that aren’t index rate-dependent and would have resulted in a selling loss at lease commencement if classified as a sales-type or direct financing lease.

On the surface, this ASU appeared very narrow in scope, only impacting entities with specific types of leases; the administrative impact was rather significant, considering the FASB answered hundreds of technical questions and dedicated a portion of its website to the PIR. This proved to be useful in clarifying many areas of complication as private companies approached the implementation deadline.

ASU-2021-09: Flexibility for Private Companies

In November 2021, on the eve of the twice deferred private company implementation deadline, the FASB released yet another significant ASU aimed at providing companies with implementation assistance while maintaining high-quality, comparable financial statements. Under ASC 842, public companies must calculate the company’s incremental borrowing rate (IBR) to be used as the basis for discounting lease liabilities when the implicit rate for a lease is not readily determinable. The original guidance:

1. Allowed for a practical expedient for non-public entities that allowed these companies to use the risk-free rate when an implicit rate is not readily determinable and
2. It required private companies that made this election to apply it on the company level across all leases.

In connection with ASU-2021-09, private companies received the flexibility to apply this standard by different classes of leases. This update allowed companies to reap the cost-saving benefits of the risk-free expedient for small frequent leases without preventing them from pursuing an IBR calculation for a large lease.

As previously discussed in our articles, Evaluating Private Company Lease Accounting Options and Simplifying the IBR Debacle, since the IBR is higher than the risk-free rate, using the practical expedient can inflate the leverage that a company appears to have. This update allowed companies to save resources on routine leases while enabling them to focus resources on larger material ones.

ASU-2023-01: Related Party Arrangements

March 2023 brought the most recent update to the accounting standard with ASU-2023-01, the newest regulation touches on determining and classifying related party arrangements between entities under common control. The update provides a practical expedient for cases in which a written agreement exists. The nuances of this regulation are complex and beyond the scope of this article, and we recommend clients consult with their accounting and audit experts to navigate this newest update.

Since VRC’s initial ASC 842 review, there have been multiple material changes to the accounting standards, and we continue to monitor any updates to the guidance. The post-implementation phase requires a multiple-disciplinary approach to stay compliant and up-to-date with the latest guidance. VRC remains focused on providing best-in-class IBR analyses to assist our clients.

Overcoming Remaining IBR Gray Areas

Little has changed regarding our last article containing IBR guidance; many open questions raised in that update remain unanswered. (Readers will certainly recall that the IBR is the discount rate most companies will need to use to discount cash flows from a lease to quantify their balance sheet’s lease liabilities.)

When does a company NOT need to calculate IBR?

• If available, a lessee company should discount lease payments using the interest rate implicit in the lease. This approach, however, requires that the company knows the fair value of the leased asset.
• However, unless the transaction is a sale/leaseback—where the property is sold at fair value, and a discount rate can be easily determined by referencing the term of the lease, the lease payments, and the residual value—the lessee generally will not have that information and must, instead determine its incremental borrowing rate.
• Private companies may opt for the risk-free expedient, either on a company level or an asset class basis.

Private organizations should consider the long-term impact of utilizing the risk-free expedient. While the appeal of simplicity and cost savings from the risk-free expedient is strong, private companies may subject themselves to various risks. These risks include a potential need to implement IBRs retroactively if the company goes public, incurring substantial costs. Moreover, they might experience a decrease in potential M&A buyers due to heightened integration expenses for public companies. Managers may experience challenges in comparing leverage profiles to those of comparable companies, which could reduce company valuations if the leverage profile is suboptimal.

Determining the Incremental Borrowing Rate

FASB’s ASC 842 guidance defines the incremental borrowing rate as:

“The rate of interest that a lessee would have to pay to borrow on a collateralized basis over a similar term an amount equal to the lease payments in a similar economic environment.”

For lessees with outstanding bonds or bank loans, they have a good place to start calculating the IBR. However, companies that don’t have outstanding debt will need to do some homework or work with outside experts to determine the IBR.

Companies likely will need to look to an index of borrowing costs for comparable companies in the same industry with similar credit ratings. Then, make adjustments that should be based on:

i) the underlying asset that is being leased
ii) the terms of the lease, and
iii) differences between the lessee and the comparable companies used in the index

Or the company will need to get the borrowing costs from a lender.

VRC’s Dual Methodology

ASC 842 requires the consideration of the following variables, on which VRC continues to focus in providing a compliant IBR:

• Period. Because the risk profiles differ, a hypothetical lender would demand different terms for a two-year loan than a 20-year loan.
• Market Access. A lessee may need to adjust their IBR upward if the comparable borrowers are larger companies with access to the public syndicated loan market. In contrast, the lessee would be more likely to tap the pricier private credit market for financing.
• Credit Rating. Similarly, the lessee should consider their credit rating if they tapped the credit markets, compare this synthetic credit rating to comparable companies in the reference index, and adjust their IBR estimate accordingly.
• Property-Specific Risks. Because the IBR should reflect the cost of borrowing secured by the asset being leased, it must reflect risks associated with the property unrelated to the lessee. For example, in a retail center, are the surrounding properties distressed or at risk of becoming distressed? [Or if the asset is outside the U.S., what is the sovereign risk for that country?]
• Currency Risks. What are the currency translation risks if a lease is outside the U.S.? Lessees may need to look to the futures or derivatives markets for an indication of their potential currency exposure.

As the FASB addresses technical ASC 842-related questions and challenges and as companies have more time to refine the implementation process, VRC believes it will become even more necessary to have quantitative and qualitative support for an IBR.

As such, VRC has developed a dual approach towards IBR determination where we consider all outstanding public or private debt a subject company has on its balance sheet and its credit profile. On a high level, our analysis attempts to proactively address frequent areas of audit pushback by implementing a dual approach to benchmark curve selection using market data in conjunction with the existing debt to select a reasonable benchmark curve. We achieve confirmation by using a synthetic credit rating analysis. After identifying the appropriate benchmark, we make necessary adjustments for country risk, collateralization, and idiosyncratic risks. We then construct a curve utilizing our adjustments and our benchmark curve.

Using this approach, we can deliver incremental borrowing rate conclusions that closely mirror the theoretical ideal rate discussed in the FASB guidance.

To discuss your financial reporting and valuation needs, including best practices in implementing the ASC 842 lease accounting standards and guidance in documenting calculations for determining your company’s incremental borrowing rate, we invite you to contact the article authors Benjamin Cutler, Matthew McCloskey, and Ryan MacLean or any VRC professional nearest you.