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:

• Inaccurate representation of leasing transactions
• No requirement for lessees to recognize assets or liabilities arising from operating leases
• Ability to structure the terms of leases to keep them off balance sheets
• “Many companies, like airlines who lease planes and retail chains who lease real estate for their stores, have large amounts in long-term lease obligations that are effectively the same as debt, but under current rules they aren’t carried on the balance sheet and their impact isn’t readily visible to the average investor who doesn’t delve into the footnotes.”^[1]

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.

The New Lease Accounting Standard (ASC 842)

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.

Finance vs. Operating Leases Under ASC 842

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:

• The lease transfers ownership of the underlying asset to the lessee by the end of the lease term.
• The lease grants the lessee an option to purchase the underlying asset that the lessee is reasonably certain to exercise.
• The lease term is the major part of the remaining economic life of the underlying asset. However, if the commencement date falls at or near the end of the economic life of the underlying asset, this criterion shall not be used for the purpose of classifying the lease.
• The present value of the sum of the lease payments and any residual value guaranteed by the lessee that is not already reflected in the lease payments equals or exceeds substantially all of the fair value of the underlying asset.
• The underlying asset is of such a specialized nature that it is expected to have no alternative use to the lessor at the end of the lease term.

Figure 1 outlines what a lessee will be required to do for both finance and operating leases.

Figure 1. Finance vs. Operating Leases Under ASC 842

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.

Operating Leases: Right-of-Use Assets and Lease Liabilities

A right-of-use asset consists of the following:

• The amount of the initial measurement of the lease liability.
• Any lease payments made to the lessor at or before the commencement date, minus any lease incentives received.
• Any initial direct costs incurred by the lessee. Examples would include commissions, costs related to activities that occur before the lease is obtained, such as costs of obtaining tax or legal advice, negotiating lease terms and conditions, or evaluating a prospective lessee’s financial condition.

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.

IBR Determination – Key Factors

When determining an IBR specific to a lease, there are several factors to consider:

The credit-worthiness of the lessee

• The first step in the process of analyzing credit quality is related to determining the specific legal entity or entities that are deemed to be the lessee under a specific agreement.
• For a business with multiple legal entity lessees, consensus seems to be developing that if (i) the business either consolidates its treasury function or (ii) an explicit or implicit guarantee is deemed to exist by the ultimate parent company, then the business will only need to analyze a single point of credit risk estimation (i.e., we would only analyze credit quality for a consolidated business).
• For cases in which none of the criteria for a single point of credit risk estimation are met, the business will need to consider varying the credit risk among its different legal entity lessees.

The security structure

• The perspective from which the IBR is determined is that of a secured interest, meaning that the credit risk associated with the lessee should be lower than that of an unsecured interest, all else equal.
• Determination of the IBR is unrelated to the specific nature of the assumed collateral assets securing the interest.
• The IBR must reflect a collateralized borrowing for a principal amount that is similar to the total lease payments.

The currency of the lease

• The IBR applicable for each lease should be specific to the currency in which it is denominated.

The term of the lease

• The IBR applicable for each lease should be specific to the remaining term of the lease. For example, given a typical upward sloping yield curve, a longer-term lease would have a higher IBR, all else equal.

IBR Determination – Methodology

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).

Actual Company Borrowing Rates

First, we examine the Company’s actual credit rating and/or cost of borrowing, as shown in Figure 2.

Credit rating

• If the Company has recently been rated by a major rating agency, this would be considered throughout the analysis. In particular, this type of evidence would be used in the “bottom-up” analysis described below.

Outstanding debt

• If the Company has publicly traded debt from which we can extract an implied yield based on current pricing, this would serve as a useful benchmark, as outlined below.
• If the Company does not have public debt but has consummated a recent debt financing, this can also be used as a benchmark.

Adjustments to actual borrowing cost

• When using an actual cost of borrowing as a benchmark, we would need to consider certain adjustments, as outlined below.
• Specifically, these adjustments relate to (i) security interest, (ii) changes in credit risk since a transaction, (iii) underlying risk-free rate differentials, and (vi) term structure of credit risk.

Figure 2. Company's Actual Cost of Borrowing

Bottom-Up Analysis

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.

Credit rating

• If the Company is not rated by a major ratings agency, one would employ a credit estimation model.
• This model calculates certain credit metrics from a universe of public companies with rated debt and then seeks to draw conclusions using the same credit metrics for the Company.
• The public company ratings used in this analysis are “issuer ratings,” and therefore correspond to a senior unsecured rating.

Adjustments to the rating

• In order to arrive at a secured rating, we make an upward adjustment to the senior unsecured rating of either one or two notches.^[2]

Yield analysis

• Last, we map the concluded secured rating into the appropriate yield curve.
• The output of this analysis is a yield curve, with varying rates corresponding to different maturities, as shown in Figure 3.

Figure 3. Yields by Rating

Final Determinations

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).^[3]

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.

Figure 4. Concluded Yield Curves

Co-authored by: 

Robert Wallace, CFA
Vice President, Valuation Advisory
+1.404.369.1118
rwallace@stout.com

1. Michael Rapoport, “New Rule to Shift Leases Onto Corporate Balance Sheets,” The Wall Street Journal, February 25, 2016.
2. We adjust the Company’s senior unsecured issuer rating upward by one or two notches to conclude on the secured credit rating (one if BBB- or better, two if lower). Refer to “Notching Corporate Instrument Ratings Based on Differences in Security and Priority of Claim,” Moody's Investors Service, October 26, 2017.
3. For risk-free rates, it is common to benchmark either to government-issued debt (e.g., U.S. Treasury secured) or a LIBOR rate denominated in the target currency.