- Beginning in December 2020, private companies will have to adapt to a new accounting rule that governs how they report leases in their financial statements.
- Under the new rule, called ASC 842, firms must report lease obligations longer than 12 months as liabilities on their balance sheets.
- This change has important repercussions for any company that leases property or equipment. The implications, and the decisions about how to address them, can be especially nuanced for companies with leases in international markets.
The right partners can help support you, so you can make sure your firm is prepared. Will your company be ready?
Back in 2011, IHS Global Insight estimated that requiring companies to report lease obligations as liabilities would force public companies to recognize an additional $2 trillion in liabilities on their balance sheets.1 The number may be much greater today, given the rise in commercial real estate prices since then.
Companies that use shared workspace arrangements have a degree of flexibility. These agreements can be structured around durations shorter than 12 months, so the accounting change may not apply.
But while the change may not have a major impact on workshare lessees with short-term leases, it could have huge repercussions for companies like The We Company, aka WeWork. In 2018 pre-IPO filings, The We Company reported long-term lease obligations of $2.9 billion. By 2019, the company’s lease liability ballooned to $17.9 billion, largely because of accounting changes. The spike in lease obligations on the balance sheet may have contributed to investors’ skepticism about the IPO, which the company famously scrapped.2
1 IHS Global Insight is an independent third party, and is not affiliated with SVB Financial Group. Cited analysis derived from the Wall Street Journal article dated November 10, 2015 (Michael Rapoport) ‘Coming to a Balance Sheet Near You: $2 Trillion in Leases’
2 Analysis derived from Fortune.com article dated August 15, 2019 (Anne Sraders) – ‘WeWork IPO: This Accounting Rule Change is ‘Crushing’ the Company’s Financials’. Fortune.com and Anne Sraders, along with The We Company/WeWork are independent third parties and are not affiliated with SVB Financial Group.
The ASC 842 backstory
Companies historically have reported outstanding lease commitments in the footnotes of their financial statements. This procedure came under fire in recent years due to concerns that it provided too little clarity about companies’ leasing activities. Those criticisms had merit: For very large companies, the old arrangement may have effectively under-reported liabilities by billions of dollars.
The groups that set accounting standards, the Financial Accounting Standards Board (FASB) and the International Accounting Standards Board (IASB), worked together to consider changes that could improve the transparency of companies’ leasing arrangements. They developed rule ASC 842, which requires lessees to recognize a right-of-use asset and a lease liability on their balance sheets for any lease with a term longer than 12 months. ASC 842 also changed the definition of a leased item; the new standard applies to leases on a wide range of items, from office buildings to software.
ASC 842 went live for publicly traded companies after December 2018. The new lease standard is expected to be effective for private companies for annual reporting periods beginning after December 15, 2020 (2021 calendar year).
What the new rule could mean for your companyASC 842 has some important implications for your firm’s capital structure and covenants. Some of the impacts are rooted in the method for discounting lease payments. Ideally, you’d discount the value of lease payments using the rate implicit in the lease. But you can determine that rate only if you know the fair value of the asset you’re leasing—and you’re not likely to have that information. (The exception: a sale/lease-back, in which you sell the property at fair value and then lease it from the buyer.)
If fair-value information isn’t available, you need to use an incremental borrowing rate (IBR) to discount cash flows related to each lease. IBR is defined 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.”
The IBR calculation should take into account several factors, including:
- Time period of the lease
- Your company’s credit rating
- Risks related to the leased property
- Currency risks (for leases outside the United States)
Foreign currency considerations
Companies with international operations will be required to record foreign liabilities, including obligations on leases longer than 12 months, on their financial statements. Foreign lease obligations introduce two additional considerations:
The incremental borrowing rate used. Each foreign subsidiary needs to apply a rate that is appropriate for its currency. We recommend first determining the parent company’s appropriate rate in US dollars, then using forward curve pricing (the price at which contract for future delivery or payment can be concluded today) to convert it for the foreign currency. Silicon Valley Bank can help with this calculation.
The currency of the obligation as it relates to the company’s functional currency. If the lease liability is denominated in a non-functional currency (a currency other than the currency of the primary environment in which the entity operates; normally, the currency of the environment in which an entity primarily generates and expends cash), this accounting change will create a new foreign exchange exposure on the company’s financial statements. The new exposure injects re-measurement risk: the possibility that fluctuations in exchange rates may periodically increase (or decrease) the reported value of the company’s obligations.
The silver lining is that the new, foreign-denominated liability may act as a natural hedge for foreign monetary assets such as cash and receivables. Say the local currency were to decline relative to the functional currency: The change would reduce the value of lease obligations in the country, helping offset the negative impact on the value of foreign assets. That said, some entities won’t be able to offset the new balance sheet liability naturally and may need to find other ways to hedge re-measurement risk—especially if they are public or considering an IPO.
How Silicon Valley Bank may helpManaging a potential currency issue related to the adoption of ASC 842 starts with discovering and quantifying risk.
Risk discovery explores:
- Whether the reporting of new foreign lease obligations affects your company
- Where the impact falls within your company’s financial statements
- What currencies are involved
Silicon Valley Bank’s FX Remeasurement Risk Model (FRRM) can quantify the potential impact carrying unhedged liabilities on your books may have on your income statement. The Model will compute your net impact across currencies and offer a probability-based framework to help you make informed decisions. We can help you analyze the impacts from the new foreign leases in isolation as well as in the context of your firm’s overall FX exposure.
If your company does not currently employ a balance sheet-hedging program, this exercise will help you determine if ASC 842 makes your overall exposure large enough to merit hedging. If your company already operates a balance sheet-hedging program, we can work with you to determine whether the new exposure adds risk, and thus warrants more hedging, or offers diversification benefits.
Your company has until December 2020 to prepare for rule ASC 842 - now is the time to start. You can learn from the experience of public companies, which had to comply with the rule after 2018; many were surprised how challenging and time-consuming the process proved to be. We can help you as you plan ahead, so your firm will be fully ready when the new lease-reporting standard kicks in.
Read our other FX Risk Advisory papers.