ASC 842 is the FASB’s (Financial Accounting Standards Board) new lease accounting standards that replace the current guidance, ASC 840, effective December 15, 2018. The new standards introduce changes to how companies are required to account for operating leases on the balance sheet. In the past, companies capitalized their financing leases while operating leases were disclosed in the footnotes. However, to increase transparency into the financial standing of companies, FASB created ASC 842 so that right-of-use assets and lease liabilities for all operating leases longer than 12 months are recorded on the balance sheet at present value discounting using a collateralized incremental borrowing rate.

The incremental borrowing rate is defined in the accounting standards under ASC 842 and IFRS 16 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.” For the most part, all companies performing lease accounting will need to utilize this rate unless they have access to their implicit interest rate for the lease itself. Most organizations do not have that information readily available which makes the alternative a requirement. Furthermore, this update has caused confusion in terms of how to properly calculate this rate, and mistakes in these calculations can incur consequences. The incremental borrowing rate calculation considers the creditworthiness of the lessee as if they were financing the purchase of the leased asset which includes some of the following key considerations:

• Collateralized rate - Financing would presumably be secured by the underlying asset which would decrease the borrowing cost. 
• Term - The length of the lease or financing would increase the borrowing rate with an increase in the term as the likelihood of default increases.
• Currency - the economic environment of the lease would require the lease to be in the home currency where the leased asset is utilized. Despite a central treasury function, the incremental borrowing rate should consider the location of the right of use asset.

Why do I need an incremental borrowing rate?

Under ASC 842, the lease liability is estimated by finding the present value of future lease payments at a discount rate which complies with the new standards. Once the lease liability is determined, it serves as a starting point for determining the right-of-use asset. To record the right-of-use asset, companies will start with the lease liability and adjust for payments made prior to the lease commencement date, lease incentives offered to the lessor, and initial indirect costs to arrive at the asset value. Sourcing accurate inputs, namely the discount rate, will be important for companies to properly perform a present value calculation of their lease liability.

A lessee could ascertain the implied discount rate from the lease contract if the lessee was provided certain information by the lessor. This information includes the fair value of the underlying leased asset, the estimated residual value of the leased asset, and any initial indirect costs incurred by the lessor. These calculation inputs are rarely available to the lessee to determine an implied discount rate. Recognizing this issue, ASC 842 recommends that companies use their incremental borrowing rate.

Incremental Borrowing Rate Calculation

The accounting guidance suggests that the best incremental borrowing rate calculation is to imply the borrowing rate from the lease. This is nearly impossible for an operating lease because you don’t have control of the asset and don’t know how much the asset cost and how many other users the asset will be leased to over its useful life. The next best approach for your incremental borrowing rate calculation is to utilize your consistent secured borrowing program in that location. For most companies, the borrowing program doesn’t happen quarterly nor at the same maturity term as the leases. This method can be used if the company has recently secured financing with a maturity reasonably similar to all of its leases. Most companies don’t have a borrowing program that is frequent enough to utilize this approach.

The next best approach to finding the incremental rate is as follows:

1. Estimate the company’s creditworthiness (likely on an unsecured basis)
2. Research and develop a spread between secured and unsecured lending
3. Use market-based data to build an unsecured borrowing rate curve from bond yields, recovery data, or Credit Default Swaps 
4. Reduce your unsecured borrowing rate curve by the secured vs. unsecured spread
5. Apply any collateral or company-specific adjustments to the market secured borrowing rate curve to calculate your Incremental Borrowing Rate
6. If the lease is in a different country, use the local currency risk-free yield curve as the base to apply your credit spread, secured vs. unsecured spread, and any collateral or company-specific spreads - Note: check that the risk-free yield curve in the foreign currency meets the covered interest parity test (Link to our page that links to my article published on FEI)

Incremental Borrowing Rate Example

Below is an example of the incremental borrowing rate calculation. Market data and an estimated credit rating are the key inputs needed to calculate the incremental borrowing rate.

Most companies can’t imply the rate from the lease, nor have a borrowing program with the frequency and maturities that match their leases, so they will have to calculate their incremental borrowing rate on a collateralized basis considering term and local currency. In order to do this, they will need to estimate their creditworthiness and then gather market data for the risk-free rates, credit spreads, and secured vs. unsecured spreads.

LeaseSCRE uses a machine-learning algorithm to estimate the credit rating using some basic financial statement data and provides the company with a credit rating specific collateralized borrowing rate curve. Companies can apply their company or collateral specific spreads to this curve and easily calculate their incremental borrowing rate curve.

What does LeaseSCRE estimate? 

LeaseSCRE provides lessees with a market-based collateralized incremental borrowing rate estimation under ASC 842 that may require a company-specific or lease/collateral specific adjustment determined by the company.

How does LeaseSCRE estimate a collateralized borrowing rate? 

At a high level, LeaseSCRE performs a 3-step process when estimating a collateralized borrowing rate:

• Estimate the lessee’s credit risk via a machine learning-based calculation of the company’s potential credit rating 
• Derive an unadjusted unsecured borrowing rate using the estimated credit rating by averaging CDS spreads of companies with the same rating 
• Adjust the rate to reflect borrowing on a collateralized basis 

You can read about or process and methodology in further detail here. 

Can I use LeaseSCRE for areas outside of ASC 842? 

LeaseSCRE was developed for the sole purpose of estimating an incremental borrowing rate to present value leases. We do not recommend or support any other use. 

Can I use LeaseSCRE for IFRS16?

The IFRS 16 lease was created by the IASB (International Accounting Standards Board), while the ASC 842 lease was created by the FASB (Financial Accounting Standards Board), which establishes standards solely for US companies and nonprofits. The Machine Learning model that estimates credit ratings was trained with public company financial statement data from US-listed companies only.  We have not tested the accuracy of the credit ratings estimate for non-US Companies.

If LeaseSCRE generates a credit rating associated with my company, is this a credit rating opinion or judgment?

Any credit ratings generated or displayed by LeaseSCRE are estimates based on historical analysis of publicly available S&P credit ratings. Given that the ratings are estimations of what a rating agency may provide as a rating, they do not represent an opinion or judgment of the creditworthiness of a company.

Does the LeaseSCRE output represent an opinion of a company’s collateralized borrowing cost?

LeaseSCRE’s output is an estimate of a rating specific collateralized incremental borrowing cost and does not represent an opinion on the company’s hypothetical collateralized borrowing cost.

Will Alvarez & Marsal support the results of LeaseSCRE with my auditor?

LeaseSCRE was designed to be used by the company and supported by the company using the White Paper found here. If you would like to engage Alvarez & Marsal Valuation Services LLC to assist you with your financial reporting around ASC 842, email us at help-leasescre@alvarezandmarsal.com to discuss.

What is Machine Learning and how can I support this?

Our Machine Learning model is a recursive algorithm that is trained on data to predict the outcome of similar data.  Please see our White Paper found here to support the results.  The accuracy of our model is greater than any other model we have seen.  No other model we have seen is greater than 90%.  The accuracy is what makes our machine learning model supportable.

How are you able to do in minutes what my 3rd party consultants have taken weeks to do?

We have taken out subjectivity and created an automated process using Machine Learning, publicly-traded Credit Default Swap data, and bond yields to estimate a collateralized incremental borrowing rate.  There are a lot of factors that are important, we spent a lot of time building the best machine learning model considering those factors to estimate S&P credit ratings.  We are not recreating the wheel for every company because we created an automated process that results in a better wheel.

What about my leases in foreign currencies?

Your foreign currency-denominated leases require an incremental borrowing rate that accounts for the economic environment and all the risks inherent in borrowing in the lease locale.

The incremental borrowing rate will be based on the local borrowing rate that starts with the government zero coupon borrowing rate adjusted for credit, collateral, lease, and company-specific risks. The rate will begin with the country-specific rate adjusted credit based on the company-specific credit rating and reduced for a collateralized rate. LeaseSCRE estimates that incremental borrowing rate for all lease terms so that you can simply apply any lease or company-specific adjustments as needed to determine your incremental borrowing rate.

LeaseSCRE is capable of estimating the collateralized incremental borrowing rate by company credit rating in 17 different countries that meet the Covered Interest Rate Parity test. Please see our white paper for more information on foreign leases under ASC 842.

What types of companies can use LeaseSCRE for ASC 842 compliance?

Any U.S.-based company outside of the financial sector with existing operations.

What should I do before buying LeaseSCRE?

We recommend that you undergo three steps before purchasing LeaseSCRE: 1) Ensure that your company is included in the scope of LeaseSCRE, namely that it is a US based company outside of the financial sector with existing operations. 2) Examine our White Paper (which can be found here) with your auditors to ensure that both sides are comfortable with the process and methodology followed in developing an incremental borrowing rate 3) Ensure that you have the required data to run the analysis. We require the following data points as part of our calculation:

• Company Sector
• LTM Income Statement info: Revenue, Gross Profit, EBITDA, EBIT, Interest Expense, Net Income
• Balance Sheet info: Long Term Assets, Total Assets, Total Debt, Total Liabilities, Retained Earnings, Shareholders Equity
• LTM Cash Flow Statement Info: Cash Flow From Operations, Dividends Paid, Total Cash Flow

What information do I need to estimate my Incremental Borrowing Rate?

We require the following data points as part of our calculation:

• Company Sector
• LTM Income Statement info: Revenue, Gross Profit, EBITDA, EBIT, Interest Expense, Net Income
• Balance Sheet info: Long Term Assets, Total Assets, Total Debt, Total Liabilities, Retained Earnings, Shareholders Equity
• LTM Cash Flow Statement Info: Cash Flow From Operations, Dividends Paid, Total Cash Flow

If I have received a curve of collateralized incremental borrowing rates from LeaseSCRE, which one do I use?

For each lease that you are discounting select the “t” value (in months) that matches the maturity of your lease and the corresponding rate.  Adjust the rate as you determine appropriate for company specific adjustments or lease/collateral specific adjustments.

Can I make adjustments to the LeaseSCRE output?

There are certain lease specific adjustments that companies may want to make to reflect specific considerations concerning their lease obligation. For example, companies can adjust for the marketability or liquidity of the leased asset. Leased assets that are specialized in nature can make the job difficult for a lender to find a buyer for the asset if the borrower defaults. Consider a situation where a company is taking on a lease to build a custom gas compressor located near a secured military zone and another company is taking on a lease for the same amount and tenor to build a warehousing facility near a large metropolitan area.

A lender would have an easier time finding a buyer for the warehouse than for the gas compressor because the warehouse is more fungible than the gas compressor. Another adjustment example is collectability. Lenders may want to charge a higher rate for assets that are less collectible, such as a wellhead in West Texas, than for assets that are more easily collectible, such as a fleet of vehicles in New York City. Because there are many lease specific factors, such as specialization and collectability, that impact a lender’s required yield, lessees should consider an adjustment to the incremental borrowing rate produced by LeaseSCRE to reflect lease specific factors.

If I purchased a credit but do not want to use LeaseSCRE, can I receive a refund?

Please contact us at help-leasescre@alvarezandmarsal.com to discuss.

The output of LeaseSCRE is not close to my expectations.

Please contact us at help-leasescre@alvarezandmarsal.com to discuss.

David Juneau is a Managing Director at Alvarez & Marsal. He brings over fourteen years of experience providing valuation advisory services for a broad range of purposes and industries. 

FASB Financial Accounting Series, Accounting Standards Update, July 2018

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