Lease accounting changes bring new attention to lease liability calculations. Accounting Standards Codification Topic 842, Leases (ASC Topic 842), modifies accounting for leases that had been previously considered operating leases. These leases will now require lessee companies to recognize an asset for the right to use the underlying property and a corresponding liability.
Measurement of the lease asset is based on the present value of the lease payments, including payments to be made in optional renewal periods. The present value should be calculated using the discount rate implicit in the lease, if determinable, or the lessee’s incremental borrowing rate (IBR) if it is not. Most often, lessee companies will need to use an IBR.
There are a couple of ways to derive the present value of the lease payments, which we touched on in our earlier article, Selecting the Right Lease Discount Rate for You. For many lessee companies, however, the only option is to estimate an IBR, which requires careful analysis. Several factors should be part of the evaluation.
Some Context for a Lessee’s IBR
In some ways, accounting for lease liabilities is not so different from accounting for interest-bearing debt. ASC Topic 470, Debt requires companies to disclose the fair value of the debt they hold, which involves estimating the present value of its contractual payments.
Lessees under the updated guidance in ASC Topic 842 will follow a parallel process to debt accounting in that they will measure the lease liability at fair value based on the present value of the contractual payments. The present value measurement requires a lease-specific discount rate based on information which may or may not be readily available. Some leases, for example, may indicate their implicit interest rate. These situations are rare, however, and the implicit interest rate will normally depend on lessor-based information that the lessee is unlikely to know. Accordingly, lessees in most cases will need to develop an IBR to serve as their lease discount rate.
The challenge with the IBR, however, is that ASC Topic 842 provides very broad parameters for how lessees may calculate it. Broad guidance opens the door to subjectivity in the analysis and calculation process.
Acronyms aside, the IBR in real life (IRL) is often based on the creditworthiness of the lessee and an analysis of certain risk-defining considerations, including:
- Size of the lease payments
- Collateral provided by the leased asset or supplied by the lessee
- Lease term
- Economic and geographic environment where the lease is deployed
- Lessee’s preexisting obligations
If the lessee already has an established credit rating from one of the major agencies (e.g., Moody’s or Standard & Poors), that credit rating will be the starting point of the IBR analysis. It is important to note that the changes under ASC Topic 842 may affect a lessee’s financial position. To the extent that the lessee holds a significant number of leases, it will record more balance sheet liabilities, possibly affecting the debt service coverage ratios used to determine its credit ratings.
Lessees that do not have an established credit rating will need to develop a synthetic one. The synthetic credit rating will be based on the same ratios and criteria used by the major credit rating agencies. Once developed, the synthetic credit rating can be translated into an IBR by considering the Corporate Composite Yield Curve (generally sourced from entities such as Bloomberg or S&P Capital IQ). Guidance in ASC Topic 842 does not define the IBR methodology or specific data sources to use, however, which adds several levels of subjectivity to the analysis.
Considerations for the Corporate Composite Yield Curve & IBR Estimation
The Corporate Composite Yield Curve is not a one-size-fits-all tool. Lessees and their valuation providers will need the correct variation in order to get to an accurate IBR.
First, the Corporate Composite Yield Curve uses geography-specific information, so it is important to match geographies. Consider, for instance, the interest term structure in Germany or Japan where short term rates are negative, compared to the United States where all rates are positive.
A lessee’s funding sources also matter when it comes to this analysis. The Corporate Composite Yield Curve reflects the yields-to-maturity prevailing in the public debt market across a spectrum of geographies and maturities. Many companies, however, cannot access the public debt market and must rely on bank debt, private equity, or other funding sources. Each funding source will have its own set of rates to consider in the IBR analysis. Some of these rates are summarized in market sources such as SPP Capital Partners.
On a more micro level, large companies with high borrowing demands often find efficiencies in the public debt market, with lower borrowing rates more than offsetting the initial underwriting and professional fees. Smaller and medium-sized companies often rely on bank debt, which tends to have lower professional and legal fees but generally comes at a higher interest rate. Early stage companies may use private equity, which also comes at a high cost. The point is that companies use a variety of funding sources with different borrowing rates, which must be considered in estimating their IBRs.
Estimating the IBR When the Entity Isn’t Creditworthy
Analysis may determine that the lessee company would not merit a credit rating. Such situations will require consideration of the funding sources that might be available, and the corresponding borrowing rates. These situations often involve greater subjectivity.
What the IBR Process Means for Lessees
ASC Topic 842 allows significant latitude in estimating a lessee’s IBR. This latitude, combined with the broad variety of input sources described above, heightens the importance of a structured IBR estimation process. Lessee companies that need to estimate their own synthetic credit ratings will need a provider who can bring the right level of scientific analysis to what can be a subjective process.
For more information about the valuation work require for lessee accounting, please contact the author, Carl Schulze, in the CBIZ Valuation Group. Carl can be reached at firstname.lastname@example.org or 972.406.6901.
Published on August 20, 2019