In February 2016, the Financial Accounting Standards Board (FASB) issued new lease rules effectively eliminating the use of lease-based off-balance-sheet accounting for long-term leases. The new standard, Accounting Standards Update No. 2016-02, Leases (Topic 842), was the result of a joint effort between the FASB and the International Accounting Standards Board (IASB) to improve the financial reporting of leasing transactions with the stated goal of increasing transparency and comparability among organizations. Public companies with calendar year-ends are to have complied with the new standards by January 1, 2019, whereas private companies must comply by January 1, 2020.
Prior accounting models for leases have been criticized for a variety of reasons, including:
One of the provisions of the new standard that many companies have wrestled with as they began to adopt the new rules is the requirement, in many cases, for them to estimate incremental borrowing rates (IBRs). However, as the first of the new rule adoptions have begun working their way through the audit process, a consensus on appropriate methodologies has emerged, and we are able to provide a general framework for that analysis.
Under ASC 842, at the inception of a contract, an entity should determine whether that contract is or contains a lease. The core principle of ASC 842 is that a lessee should recognize the assets and liabilities that arise from all leases. This recognition includes operating leases, which, under the previous accounting standard, were given “off-balance-sheet” treatment.
The lease liability reflects the obligation to make lease payments, and the right-of-use asset represents the right to use the underlying asset for the lease term. Leases will need to be classified as either finance or operating (current capital leases will maintain the same accounting treatment but will be renamed as finance leases).
Short-term leases (less than 12 months) are exempt from the new rule. If a lessee elects not to recognize lease assets and liabilities for a short-term lease, they should recognize the lease expense generally on a straight-line basis over the lease term.
The criteria for determining whether an arrangement meets the definition of a lease under ASC 842 are similar to prior generally accepted accounting principles (GAAP). However, an important difference is whether a lessee has the right to control the identified asset. The arrangement may not qualify as a lease if the lessee does not have the right to control the use of the asset.
The accounting applied by a lessor is largely unchanged. Additionally, the recognition, measurement, and presentation of expenses and cash flows arising from a lease by a lessee have not significantly changed.
As mentioned previously, balance sheet leases will be classified as either finance or operating (again, current capital leases will maintain the same accounting treatment but will be renamed as finance leases), and the classification will impact the pattern of expense recognition in the income statement.
A lessee shall classify a lease as a finance lease when the lease meets any of the following five criteria at its commencement:
Figure 1 outlines what a lessee will be required to do for both finance and operating leases.
Because interest expenses decrease as liability decreases, finance leases will reflect greater expenses than operating leases in the early years and lesser expenses in the later years. This could potentially lead to a significant timing difference in expense recognition, depending on the number and sizes of the leases.
A right-of-use asset consists of the following:
The lease liability is equal to the present value of the remaining lease payments discounted using the rate implicit in the lease or, when the rate cannot be readily determined, the lessee’s IBR. The lease payments should exclude any payments that a lessee has made before the commencement of the lease. As leases often do not contain implicit rates, estimating the IBR is frequently critical to establishing lease-related balances under the new rules.
When determining an IBR specific to a lease, there are several factors to consider:
The credit-worthiness of the lessee
The security structure
The currency of the lease
The term of the lease
When determining an IBR specific to a lessee under the new guidance, there are generally two well-accepted approaches: (i) analysis of the lessee’s actual cost of borrowing and/or credit rating and (ii) a “bottom-up” analysis of the credit risk of the lessee and required rates of return on instruments of comparable risk. In this case, we will consider the publicly traded parent of a multinational corporation (the “Company”) with leases denominated in both euro (EUR) and U.S. dollars (USD).
First, we examine the Company’s actual credit rating and/or cost of borrowing, as shown in Figure 2.
Adjustments to actual borrowing cost
If we are unable to draw reliable conclusions from the Company’s actual cost of borrowing, we move on to a “bottom-up” analysis in which we determine a credit rating for the Company, make certain adjustments to arrive at a secured rating, and map that rating into an appropriate yield curve.
Adjustments to the rating
Since the Company has both USD and EUR leases, we require two separate yield curves. Accordingly, we first calculate the credit spread applicable to the USD-based yield curve (i.e., the premium over a USD risk-free rate). Next, we apply that credit spread to the EUR risk-free rates to determine the EUR-based curve (note that as of this time period, EUR-based risk-free rates were less than USD rates).
Last, the IBR specific to an individual lease of the Company would be determined based on the remaining term and currency of the lease, where the term is interpolated into the relevant curve to derive an appropriate yield, as shown in Figure 4.
Robert Wallace, CFA
Vice President, Valuation Advisory