ASC 842 Lease Accounting: Simplifying the Incremental Borrowing Rate Debacle

By: Ryan MacLean | Peter Morrison | Kevin Rowley

(Estimated reading time: 4  minutes 16 seconds)

The article in brief:

  • ASC 842, the new guidance on accounting for leases and capitalizing them on balance sheets is coming in the New Year.
  • Many aspects are straightforward and mechanical once all of the assets are identified, the contractual obligations are understood, and the appropriate discount rate is determined.
  • The discount rate (or incremental borrowing rate) appears to be a quasi-market participant rate that changes based on the asset category, location, and lease term. This, however, is impacted by company-specific factors (credit rating).
  • The incremental borrowing rate is determined by company-specific factors, as well as factors particular to the asset being leased.

Doubtless, many CFOs of companies with extensive lease agreements woke up on New Year’s Day with a headache—and not because of too much champagne. Instead what is likely ailing them is ASC 842, the new lease accounting standard from the Financial Accounting Standards Board (FASB), which calls for all but the shortest-term agreements to be capitalized and reflected on company balance sheets.

The guidance takes effect in 2019 for most companies—in the first quarter for public companies and by year-end for private companies.

FASB finalized ASC 842 in early 2016, so companies have had plenty of time to study the guidance (not to mention the reams of practical advice published by major accounting firms) and to plan for implementation, which is, for the most part, a straightforward exercise of modeling out cashflows that are no more or less complicated than the underlying lease itself.

However, the one area where we see many companies still struggling is coming up with the applicable “incremental borrowing rate” (IBR)—effectively the discount rate most companies will need to use to discount those cash flows and quantify their lease liabilities for display on their balance sheets.

When Does a Company NOT Need to Calculate Its Incremental Borrowing Rate?

If it is available, a lessee-company should discount lease payments using the interest rate implicit in the lease itself. 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.

Incremental Borrowing Rate Considerations

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

Companies likely will need to look to an index of the costs of borrowing for comparable companies in their same industry with similar credit ratings to their own. 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.

FASB's ASC 842 guidance takes effect in 2019 for most companies - in the first quarter for public companies and by year-end for private companies

Specific adjustments might include:

  • Period. Because the risk profiles are different, a hypothetical lender would demand different terms for a two-year loan than for a 20-year loan.
  • Market Access. A lessee may need to adjust their incremental borrowing rate upward if the comparable borrowers are larger companies that, say, have access to the public syndicated loan market, while the lessee would be more likely to tap the pricier private credit market for financing.
  • Credit Rating. Similarly, the lessee should consider what their credit rating would be if they tapped the credit markets and then compare this synthetic credit rating to that of the comparable companies in the reference index and adjust their incremental borrowing rate estimate accordingly.
  • Property-Specific Risks. Because the incremental borrowing rate should reflect the cost of borrowing that is secured by the asset being leased, it must reflect risks associated with the property that is 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.  If a lease is outside the U.S., what are the currency translation risks? Lessees may need to look to the futures or derivatives markets for an indication of their potential currency exposure.

Open Questions

There are still a few gray areas around ASC 842 where additional guidance may still be forthcoming (and would be welcomed). For example, some practitioners have suggested a two-step approach for leases of real property where the lessee first models out its incremental borrowing rate for a standard mortgage secured by the property.

However, to the extent most mortgages are for only a percentage of the property value—say, 65 to 70 percent LTV—it would then need to undertake a second calculation of the IBR on the balance, presumably financed on a second lien or even an unsecured basis.

In our view, this approach is overkill; a single calculation identifying secured borrowing rates available to the company is most appropriate.

Additionally, for lessees with a large number of leases—for example a retailer with leased stores all across the country—there has been discussion of employing an approach where leases/properties with similar characteristics are grouped into cohorts, and its value is calculated (and recalculated, since lessees will need to update their numbers quarterly or at least annually) on a portfolio basis.

Additional guidance would clarify the advisability of this approach.

Summary

ASC 842 promises to make 2019 an interesting year for companies with a lot of leasing activity. Whether “interesting” is positive or negative will depend on whether they are ready for the changes and, if not, whether they get the help they need.

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

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