CNM Thought Leadership Accounting Alert – Implementation of ASC 842, Leases, for Operating Leases by a Lessee

Have you given enough consideration to your incremental borrowing rate?

Background

ASC 842, Leases, is effective for calendar year-end public business entities starting January 1, 2019.  Non-public business entities with a calendar year-end have an additional year to implement the new guidance starting January 1, 2020.

ASC 842 requires lessees to record a right-of-use (ROU) asset and a lease liability for contracts identified as operating leases.  The lease liability is measured first and represents a substantial portion of the initial measurement of the ROU asset, which generally is comprised of:  (1) the initial lease liability, (2) any lease payments made at or before the commencement date net of any lease incentives received, and (3) any initial direct costs incurred by the lessee.

The lease liability is defined as a lessee’s obligation to make lease payments arising from the lease, measured on a discounted basis.  In other words, it represents the present value of the remaining lease payments.  If readily available, the discount rate applied in calculating that present value is required to be the interest rate implicit in the lease.  However, as that rate often cannot be determined by the lessee, as the lessee is not privy to all the information used by the lessor to determine that rate, ASC 842 states that “if the rate implicit in the lease is not readily determined, a lessee uses its incremental borrowing rate.”  (However, as a practical expedient, a lessee that is not a public business entity is permitted to use a risk-free discount rate.)

ASC 842 defines the incremental borrowing rate (IBR) 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.”

What You Should Consider

While the determination of an IBR might seem like a relatively simple exercise on the surface, we are finding that it requires a great deal of thought and analysis and is likely to be closely scrutinized by external auditors and regulators, which could catch some companies by surprise.

Here are some of the things that we think you should consider in determining an appropriate IBR for measuring the initial lease liability:

  1. The IBR represents a collateralized borrowing rate, although the collateral of the referenced rate does not need to match or be similar to the leased asset. If a company wants to reference a rate from an unsecured borrowing or a secured borrowing that is over or under collateralized, that rate must be adjusted to reflect a fully (100 percent) collateralized borrowing.
  2. The IBR must reflect a current rate as of the commencement date of the operating lease. If a company does not have a recent secured borrowing, an adjustment must be made to reflect the current interest rate environment.
  3. The IBR must reflect a term that is similar to the term of the operating lease. If the company references a rate for a collateralized borrowing that has a significantly longer or shorter term, an adjustment will be needed to reflect the term of the lease.
  4. The IBR must reflect a collateralized borrowing for a principal amount that is similar to the total lease payments under the operating lease. Otherwise, an adjustment will need to be made to reflect the rate for a similar principal balance.
  5. Unless a company has an active and sophisticated Treasury function, it may not have internal resources with the requisite knowledge to develop an IBR without assistance from external experts.
  6. Banks may be reluctant to provide a rate quote for the purpose of developing an IBR and unwilling to defend the rate to external auditors or regulators.
  7. A lessee must consider whether the payment pattern underlying a referenced rate used to derive an IBR is similar to the lease payments. For example, if a zero coupon Treasury security is used as a starting point to derive the IBR, the balloon payment upon maturity will not match lease payments that are due monthly or quarterly.  In that case, the referenced Treasury rate would need to be adjusted for the difference in payment pattern in addition to other adjustments for collateral and credit rating of the lessee.
  8. If a subsidiary issues separate financial statements and wants to use its parent company’s IBR, there must be evidence that the lessor relied on a guarantee from the parent in pricing the lease.
  9. In many cases, the IBR will need to be a hypothetical rate derived from observable information rather than a rate from an actual borrowing.
  10. Auditors are likely to pay close attention to the IBR, especially if the ROU assets and/or lease liabilities have a significant impact on the company’s financial statements.

Suggested Actions

  • Determine whether you have internal resources with enough knowledge to develop an IBR to apply at the commencement date of each operating lease.
  • If you do not have suitable internal resources, consider engaging an external valuation expert for assistance in developing the IBR. In selecting one, ensure that the expert has experience supporting valuations with external auditors.
  • Design an operational (repeatable) process with adequate internal controls to determine the IBR for each new operating lease at the commencement date of the lease. At a minimum, that process should consider the following:
    • Personnel or external resources responsible for developing the IBR.
    • Personnel responsible for review and approval of the IBR to be applied.
    • The sources of data to be used to develop the IBR.
    • The adjustments to be applied and how those adjustments will be determined.
  • Document your approach to determining the IBR for external auditors and/or regulators.
  • Preview your approach to determining the IBR early with your external auditors for comments and suggestions.

The new leasing standard is complex and will require a company to focus on its provisions and requirements. It is imperative that companies start assessing the standard now and develop a solid strategy and plan to accomplish absolute compliance.

There are many resources available to assist companies in all aspects of compliance with the new standard.

CNM LLP has extensive experience in assisting companies with the adoption of new accounting standards, including ASC 842, as well as the effect on internal controls and financial reporting requirements.

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