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Accounting

Estimating Incremental Borrowing Rate: Added Challenge for Leases in Foreign Currencies


by Chandu Chilakapati

Despite years to adopt the new lease reporting standard, large budgets, advisers, and toying with countless software packages, companies are limping to the starting line of a marathon.

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Companies have spent years and allocated significant resources in money and human capital to adopt ASC 842, the new lease accounting standard. For calendar year end public filers, the first quarter for adoption under US GAAP is March 31, 2019, the starting line for ASC 842 adoption.

Many companies have gone through this long process to start the marathon of accounting for leases but their current struggle is with one critical input: the incremental borrowing rate (IBR), which is needed to present value all the leases. As a result, many companies are finding that they are not prepared for the adoption of the new rule because their software tools require this as an input. Critically these tools failed to offer a means to obtain or estimate IBR and the challenge of estimating the IBR has taken many companies by surprise, despite the years of preparation.

Fundamentally, ASC 842 has created significant challenges since its introduction. The three categories of challenges are: accounting change, system implementation/process change, and estimating the IBR. However, the bulk of these problems and solutions are being tested in real time right now.

The key change to the lease accounting standard is the requirement to present value operating leases. The lease accounting requirement under the prior standard allowed for operating leases to remain off- balance-sheet. There was also no material difference in accounting for a contract as a lease or an accrual contract that is expenses as incurred. This allowed many companies to disregard whether certain contracts met the definition of an operating lease. However, the new requirements under ASC 842 has caused companies to go through a painstaking process that includes gathering, reviewing, and potentially preparing a present value for right of use assets that are not owned outright and are under contract for longer than 12 months.

This list of what should be included in balance sheets comprises: office equipment, laptops, office space, rolling stock, tools, manufacturing equipment, and many other contracts. Aggregating these contracts and then spending time and resources assessing these contracts has proven difficult for various reasons, but the two plus years of lead time allowed most companies to overcome these challenges. However, implementation of software and updating processes have created unforeseen trials: after having gone through a long process of accounting for the multitude of leases, companies are now struggling as companies did not prepare for estimating their IBR to present value the leases, principally because their software is not able to obtain or estimate IBR.

What is IBR? The FASB in ASC 842 defines it as “the rate of interest that a lessee would have to pay to borrow on a collateralized bases over a similar term an amount equal to the lease payments in a similar economic environment.”

The key attributes that must be considered in estimating your IBR are:

  • Term
  • Collateral
  • Creditworthiness
  • Economic Environment

The difficulties with estimating your IBR in your domicile include:

  • the inability to imply a rate from your lease because of lack of a fair value for the underlying asset
  • your treasury department and corporate borrowing program are infrequent, don’t always include secured and unsecured instruments, and the term to maturity is generally limited
  • your company may not have coverage from a rating agency

I understand that most companies have encountered these difficulties.

What I have found is that many public companies have at least determined an approach that they will test against their auditors’ views on the requirements this quarter. Many companies are using a flat rate that is loosely based on peers’ or their own most recent borrowing rates. However, this may not fully take into account the term, collateral, or creditworthiness, and may not be materially accurate. I believe the best approach is to:

  1. estimate your credit rating
  2. apply a rating based borrowing rate or yield curve
  3. adjust for collateral
  4. extrapolate or check for an upward sloping curve based on the term to maturity that aligns with the changes in debt yields based on maturity
  5. adjust the IBR for company, collateral, or specific economic environment differences

The lease management software tools do not solve these challenges. The challenge of estimating the IBR is exacerbated with foreign leases and considering economic environment differences.

There are two approaches that a company can consider in adjusting their local domicile based IBR for foreign leases:

  1. Covered interest rate parity
  2. Relative Forward Risk-Free Rate Curves

Covered interest rate parity is the condition that describes the relationship between spot and forward foreign currency exchange rates and forward interest rates in the two countries. The idea is that you can’t borrow domestic dollars, invest in a risk-free foreign instrument, and make risk-free money.  The forward exchange rate accounts for the differences in the interest rates of the two countries. The formula is:

 

This would allow you to imply from market-based forward and spot rates the forward interest rate of the foreign country. The difference between the forward foreign interest rate and the forward domestic interest rate is the adjustment to your IBR for the difference in economic environment. This requires market data and applying this across the various terms of your foreign leases.

The second method is the relative risk-free rate curves, which would result in the same outcome but must also hold with the principle of covered interest rate parity. You could bootstrap forward risk-free rate curves using market traded government deposits, futures, swaps, or forward rate agreements to construct your own zero-coupon foreign risk-free rate curve. The difference between those curves at each tenor would be the adjustment to your IBR that accounts for the difference in economic environment.

Both methods described are difficult and require market data.  In our experience, much of the market data on instruments in foreign markets is sometimes limited and does not cover long term instruments.  It is likely that an extrapolation method will be required to match the terms of longer-term leases. It is recommended that both methodologies are used to confirm the adjustment is appropriate as this can be a material adjustment.

Two years was enough time to struggle to overcome the accounting change and implementation of new software and/or internal processes, but the IBR remains a challenge that keeps companies from implementing and starting the marathon that is financial reporting for leases. A key question remains: Will audit firms accept some of the shortcuts being used to estimate an IBR or send companies back to the starting line? Foreign leases present some additional challenges that may keep some companies from even getting to the starting line.

Chandu Chilakapati is a Managing Director with Alvarez & Marsal Valuation Services.