This article was written by Yon Valtchev, Markets Specialist at Bloomberg.
Determining the appropriate discount rate under ASC 842 and IFRS 16 has proven to be more challenging than originally thought. While conceptually the accounting guidelines are straightforward, once market participants begin to search for data to substantiate the analysis, it quickly becomes evident that the data is not readily available and, in some cases, is missing altogether.
The evolution of the accounting standards
In moving towards global accounting standards, the Financial Accounting Standards Board (FASB) in the U.S. and the International Accounting Standards Board (IASB) have been working together since 2006 on replacing old lease accounting standards, ASC 840 (previously FAS 13) and IAS 17. The project was completed in early 2016 with FASB and IASB issuing separate standards – ASC 842 and IFRS 16.
The project’s primary objective was to require companies worldwide to capitalize operating leases and include them on their balance sheets as assets and liabilities. Under the previous accounting rules, operating leases were accounted as off-balance-sheet items and a table of future operating lease obligations was disclosed in the footnotes of the company’s financial statements.
Since most users of financial statements estimate lease assets and obligations to adjust their financial ratios and measures, the boards believed that users of financial statements, such as analysts and investors, would gain more useful information when operating leases were capitalized in a global and uniform way. The discussion surrounding implementation, however, was not straightforward. Between 2013 and 2016, FASB and IASB made significant changes to the original approach presented in the Re-Exposure Draft (RED) issued in May 2013. This resulted in two standards that differ in some key areas. One area of overlap was the determination of the incremental borrowing rate (IBR).
What is an IBR?
The lessee’s incremental borrowing rate is a defined term in the new standards. Under the accounting rules, the lessee will calculate the present value (PV) of the estimated lease payments using the implicit rate in the lease, if known to the lessee, or the company’s incremental borrowing rate. The IBR is defined as the interest rate the lessee would incur to borrow under a secured loan with terms similar to those of the lease. It’s the rate of interest that a lessee would have to pay to borrow over a similar term, and with a similar security, the funds necessary to obtain an asset of value similar to the right-of-use asset in a similar economic environment.
Thus, to determine the IBR rate the following information should be taken into account: the lessee company-specific borrowing rate, the term of lease arrangement; the amount and currency in which the borrowing is taking place, the “security” granted to the lessor and the nature, the quality of the underlying assets and the economic environment, as well as the jurisdiction along with its political risk where the borrowing is taking place. A lessee may operate in multiple jurisdictions and the economic environment in those jurisdictions can also influence its incremental borrowing rate. These factors vary from lease to lease, resulting in different incremental borrowing rates for every lease. As a result, the lessee, in theory, would need to determine a specific IBR for each individual lease, unless the lessee is taking a portfolio approach, in which case the lessee would fund all leases centrally.
The process surrounding the determination of the appropriate IBR rate plays a role both in determining the present value of the leases and also impacts the financial and leverage ratios of the lessee.
Depending on the materiality of the leases, choosing a higher discount rate will reduce reported liabilities. It will also reduce the gearing or leverage ratios because of these lower liabilities. It will increase asset turnover because the right-of-use asset’s impact on total assets reduces them. It also increases the current ratio as the current portion of the lease liability will be lower; it increases the operating profit/earnings before interest, and tax will be higher because depreciation will be lower. On the other hand, the earnings before interest, tax, depreciation and amortization (EBITDA) will be unchanged since depreciation and interest are both excluded in calculating EBITDA — meaning that the interest cover will be lower because the interest expense will be higher.
For a single lease, a higher discount rate will accentuate the impact of the front-loading of total lease expense since a higher discount rate reduces total depreciation expense (typically recognized on a straight-line basis) and increases total interest expense (recognized on a front-loaded basis).
Portfolio approach and synthetic IBR/funding through cross-currency swaps
A lessee may use a portfolio approach and determine a single discount rate for a portfolio of leases with similar characteristics across jurisdictions. This is permitted if the company expects the results of this approach would not differ materially from applying the standard to individual leases. It is particularly helpful when the issuer is looking for an IBR in a jurisdiction where they have no direct borrowing capacity or ability to determine direct local IBR, or they fund the leases centrally. In such cases, a cross-currency analytics is needed to obtain foreign currency equivalent rates for known parent USD or EUR IBRs may be applied. The cross-currency swap applies inputs such as FX forwards and local interest rate curves, thus accounting for the implied economic risk associated with the foreign jurisdiction.
Can a lessee use its Weighted-Average Cost of Capital rate as its incremental borrowing rate?
Weighted-average cost of capital (WACC) is a rate that incorporates the market’s view of how a company would structure its financing using both debt and equity optimally over the long term, with each having a different rate of return. WACC encompasses all sources of finance, including equity, whereas the IBR is a rate that considers only borrowings – the corporate debt. Furthermore, a company’s WACC is not specific to a lease contract and does not take into account the term, security and value of the underlying asset in a lease. As such, the WACC does not meet the new standard’s definition of a lessee’s incremental borrowing rate.
In some cases, a company’s WACC may be a useful input when determining the incremental borrowing rate. However, in practical terms, a company may often find that it’s more effective to use an unsecured borrowing rate as an input since fewer adjustments would be necessary.
What is the relationship between “secured” and “unsecured borrowing rate”?
The large majority of corporations borrow on an “unsecured” basis. But what is the appropriate adjustment to the “unsecured” debt in order to approximate it to a “secured” borrowing rate? In a paper published by Moody’s in 2017, the agency argued for a global and consistent approach to measure the rating impact of structural subordination between related debt claims of a single issuer or group of issuers that are part of consolidated legal structure. The “notching” process is expressed relative to the issuer’s baseline rating, typically the senior unsecured rating. Under this approach, the secured debt for issuers rated Baa3 (BBB-) or higher will be assumed to be +1 notch higher, whereas for issuers rated Ba1 (BB+) or lower either +1 or +2 notches higher. One approach from Bloomberg (+1 for Ba3/BB- or higher and +2 for B1/B+ or lower) is very similar and largely in line with Moody’s notching methodology. Applying the “notching” is a viable workaround to determine a borrowing “proxy” for a secured rate in cases where observable data is scarce. The reality is that the latter is the case for most jurisdictions outside the U.S. and EU, which explains the wide adoption of the “notching” by lessees around the world.
How should a lessee determine its IBR for a lease in a currency different from its functional currency?
The lessee must first determine the rate at which it would borrow in the currency in which the lease is denominated. In some cases, the lease contract is denominated in a currency different from the company’s functional currency (the currency of the primary economic environment in which the company operates) – e.g. a heavy machinery lease is denominated in US dollars, but the company’s functional currency is CADs. In this case, the incremental borrowing rate is determined by using the currency in which the lessee would have to borrow the funds necessary to obtain an asset of a similar value to the right-of-use asset. Based on the example presented above, the incremental borrowing rate would be US dollars.
There are some situations where locally determined IBR is not available or difficult to determine. In these cases, a local currency equivalent IBR translated from the parent lessee USD or EUR observable IBR may be applied.
This article is reproduced from the Bloomberg’s Professional Services blog, and is licensed by The Association of Corporate Treasurers.
