Lease Accounting for Treasurers: 5 Lessons Learned
Challenges due to new lease accounting standard
On Wednesday 20 May, Zanders and the Association for Finance Professionals (AFP) held a webinar titled ‘Don’t get left behind: understand the incremental borrowing rate (IBR)’. The audience was updated on implementation and operational challenges that treasurers face due to the new lease accounting standard. We summarize the five lessons learned from the webinar.
1. How does the new lease accounting standard impact key financial ratios?
Over the last years, new lease accounting standards (IFRS 16 and ASC 842) have been introduced aiming to create more transparency on entities’ leasing activities. These new standards require all leases to be capitalized on the balance sheet to obtain this transparency. It creates a right-of-use asset as well as a lease liability on the balance sheet of the lessee. The balance sheet extension corresponds with the net present value of future lease payments.
The impact of both IFRS 16 and ASC 842 on the balance sheet of the lessee is similar due to an equal shift towards the balance sheet. As a result, certain balance sheet ratios will be impacted. The current ratio, for example, will deteriorate due to the increase in current lease liabilities. The gearing ratio will increase because of the increase in liabilities. However, the impact on the income statement is different between IFRS 16 and ASC 842. Operational lease payments remain operating expenses under ASC 842, but under IFRS 16 those payments move from operating expenses to depreciation. Therefore, the EBITDA under IFRS 16 will be higher due to the new lease accounting standard, while ASC 842 does not impact EBITDA.
2. Which method to use when determining the IBR: the granular vs. conservative approach?
Corporates are encouraged to select a calculation method as a first step towards a compliant IBR. Their geographical footprint and lease portfolio complexity will drive the analysis. Some corporates might find the conservative approach most suitable. This approach is relatively straightforward as it groups leases with similar characteristics. It could also group leases across lessees, for example by relying on a parental guarantee. However, in many cases the conservative approach would result in more balance sheet extension. This could impact the credit rating and overall funding cost. Therefore, this approach is considered costly.
The second method to determine the IBR is the granular approach, which will enable corporates to manage the balance sheet impact by calculating the IBR on a lessee and lease specific basis. This approach will be easier to substantiate as it follows a strict interpretation of the IBR. The downside of this approach is the increased need for market data and time investment. An efficient IBR process is key for a successful adoption of the granular approach.
3. How to calculate the IBR given your approach?
ASC 842 defines the IBR 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 can thus be seen as the result of these five different building blocks. Regardless of the selected method, a corporate should assess each IBR on these five building blocks.
The first building block (lessee) requires a creditworthiness assessment of the lessee. This often results into a lessee-specific credit rating. The second building block (collateral) will incorporate the recovery value of different asset types. This leads to different IBRs for leases with different asset types. The third building block (amount) assesses the balance sheet impact of the lease, which might be material for substantial leases such as aircraft leases. The tenor of the lease is often grouped in different time buckets in order to comply with the fourth building block (term) of the definition. The last building block (economic environment) is assessed by analyzing the jurisdiction, currency and pricing date.
The conservative approach will group as much leases as justifiable. The granular approach will calculate an IBR for each unique combination of the building blocks that is present in the lease portfolio.
4. What are best practices in documenting your IBR processes?
The calculation of the IBR for large lease portfolios requires good market data and treasury processes. The more granular the selected method is, the higher the need for an efficient and less error-prone process. The IBR is often displayed as a build-up rate that adds a risk premium on top of a risk-free rate. In order to calculate both elements accurately, market data should be up-to-date, and the model should allow for flexibility in the calculation of the risk premium. This flexibility is needed as the lease portfolio might change substantially over time and new lessees might be added.
Under the granular approach, adding a lessee would lead to an additional credit rating assessment. Hence, it is recommended to have an automated credit scoring solution in place. Ideally, the IBR pricing process should also allow for different types of lease assets, terms and currencies to be added to the lease portfolio. This flexibility can be achieved in a time-efficient manner by an adequate degree of automation. Hence, we recommend to design your processes before running the (initial) IBR calculation. A more efficient and standardized methodology and process will be easier to document and will increase the reproducibility of the IBRs.
5. What is the impact of the COVID-19 pandemic on lease accounting?
The COVID-19 pandemic impacts lease accounting, but the magnitude depends highly on the industry. In general, three different impact areas can be identified. First, the FASB and IASB have given additional guidance on whether some lease concessions, such as payment deferrals, can lead to a lease modification under the respective lease accounting standard. Should a lease be modified, then the fair value should be reassessed by a new discounted cash flow calculation. Not only the lease payments will have changed, but also the IBR. This is the second impact area. The COVID-19 pandemic has caused increased volatility in the financial markets. Therefore, an increased risk premium will lead to higher IBRs. Lastly, an impairment test on the right-of-use asset may arise. The impact of the crisis on lease accounting is thus broader than ASC 842 or IFRS 16.
In conclusion, Zanders recommends corporates to make a detailed analysis on which method to adopt before the calculating the IBRs, as each methodology has its own advantages and pitfalls. Consequently, it is important to have a standardized and automated workflow in place. Lastly, the impact of the current crisis on lease accounting cannot be overlooked. Corporates should aim to leverage on lean processes to accurately analyze the impact and react in a timely manner.
Please read more about how to calcalute the incremental borrowing rate on our innovative Zanders Inside platform. If you have any questions or remarks on the calculation of the incremental borrowing rate, please contact Casimir Leuridan.