ASC 842: How Intrinsic Can Help You in Determining an Incremental Borrowing Rate
by Colton Owens, CFA | 23 May 2023
WHAT IS ASC 842
ASC 842 is a lease accounting standard issued by the Financial Accounting Standards Board that requires companies reporting under U.S. GAAP to capitalize their leases to the balance sheet as a liability with a corresponding asset. This standard was established to increase disclosure and transparency into the leasing obligations of both public and private companies. Under ASC 842, the term “lease” is defined as “a contract that conveys the right to control the use of identified property, plant, or equipment (an identified asset) for a period of time in exchange for consideration.”
Implementing ASC 842 is a relatively straightforward exercise of modeling out cash flows in accordance with the terms of a lessee’s existing lease agreements. The complicating factor, however, is that many companies struggle to select an appropriate incremental borrowing rate.
WHAT IS THE INCREMENTAL BORROWING RATE
The incremental borrowing rate is the fully collateralized discount rate a lessee will need to use to discount future lease payments back to a present value, allowing a lessee to capitalize their lease liabilities on their financial statements. FASB’s ASC 842 guidance defines the incremental borrowing rate 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.”
If available, the lessee should use the implied borrowing rate in the lease itself to discount future lease payments back to the present value. However, this approach assumes the lessee knows the fair value of the asset being leased and the rate that causes the aggregate present value of lease payments to equity the fair value of the leased asset. This information is generally not knowable to the lessee, which creates the need to determine its incremental borrowing rate.
HOW IS THE INCREMENTAL BORROWING RATE ESTIMATED
ASC 842 provides limited guidance regarding the calculation of the incremental borrowing rate, but the factors that require consideration can be identified from FASB’s definition of the incremental borrowing rate, including the credit rating of the lessee, consideration of the lessee’s outstanding debt, the secured nature of the borrowing rate, the materiality and term of the lease payments, and sovereign credit risk / foreign currency considerations.
Credit Rating of the Lessee
The creditworthiness of the lessee is a key consideration when determining a lessee’s incremental borrowing rate. The best practice is to consider the lessee’s existing debt that has been rated by one of the major credit-rating agencies. If a credit rating for the lessee does not exist, a shadow credit rating can be estimated. A shadow credit rating is an internal rating approach that utilizes a major credit-rating agency’s rating methodology, which selects and weighs different risk drivers of the business. In most cases, it is most appropriate to utilize an industry-specific rating methodology. The shadow credit rating can be estimated based on qualitative and quantitative measures of the lessee. Shadow credit-rating models can generally be developed using rating methodology guidance provided by major credit rating agencies. Those models consider financial ratios related to liquidity and solvency to map the lessee into a credit-rating category.
After categorizing the lessee into a credit-rating group, a market yield curve can be pulled from the same credit rating as the proxy market risk profile of the lessee based on similarly rated debt issuances. In addition to general yield curves being extracted, industry-specific yield curves should be considered in evaluating the market risk profile of the lessee, where practicable.
Consideration of Existing Debt
The lessee’s existing debt obligations should be considered in conjunction with selecting an incremental borrowing rate. Specifically, determining an implied yield on a lessee’s debt facility will result in a company-specific rate and credit profile that can be compared to the lessee’s selected credit rating group and extracted market yield curves. Once the implied yield is determined at the credit agreement date, the rate will need to be indexed to the date required for determining the incremental borrowing rate and should be adjusted by changes in the base/reference rate in addition to changes in the company-specific credit spread. Lastly, the collateralized nature of the lessee’s outstanding debt must be considered. For instance, if the debt facility is unsecured an adjustment can be made to the implied yield to estimate a collateralized rate.
Collateralization of the Incremental Borrowing Rate
The incremental borrowing rate should be determined on a fully collateralized basis. This is different compared to unsecured debt, which has no recourse when the obligor defaults. The incremental borrowing rate will typically have a lower interest rate than an unsecured issuance with the same credit rating. Therefore, an adjustment should be made to convert unsecured market rates to reflect a secured borrowing rate for the lessee. If available, the secured adjustment should be specific to the company. Otherwise, market studies on secured adjustments can be utilized using the recovery rate approach to convert an unsecured rate to a fully collateralized borrowing rate.
Materiality and Term of Lease Payments
The amount of the lease payments should be considered in determining the credit risk profile of the lessee since the discounted lease payments will impact the lessee’s capital structure. To the extent the lease payments are material to the capital structure, one should consider the increased credit risk profile due to larger debt obligations. If the lease payments are insignificant in relation to the existing debt obligations, a risk adjustment may not be necessary.
In addition to the amount of the lease payments, the term of the lease should be considered when determining the incremental borrowing rate. Risks vary across the term structure of an interest rate curve, and the discount rate will usually be different based on the lease terms. If there are multiple material leases with different terms, separate incremental borrowing rates should be determined to account for differences in risk.
Sovereign Credit Risk and Foreign Currency Considerations
Country risk should be considered in the credit risk of leases outside of the country in which the lessee operates. An additional consideration for foreign currency translations should be included in calculating the incremental borrowing rate of a lease in a different country. Measuring sovereign yield spreads between the country in which the lessee is domiciled and the country where the lease was executed considers the credit risk and currency exchange rate risk between the two countries. These considerations are only necessary if prior steps were performed based on yields and market information for the lessee’s home country.
Determining an incremental borrowing rate is a complex issue, and there is no standardized approach. Intrinsic’s Financial Reporting team has significant experience in determining incremental borrowing rates for leases in accordance with ASC 842.
// ABOUT THE AUTHOR
Colton serves as Vice President within the Financial Reporting practice at Intrinsic and is responsible for relationship management, project management, and execution across the firm’s private equity clients and their portfolio companies. His experience includes performing a variety of valuation tasks, including purchase price allocations, ASC 718 valuations, portfolio company valuations, and goodwill and intangible asset impairments.
Prior to Intrinsic, Colton worked as a Valuation Consultant for WilliamsMarston. His experience included managing and executing an array of valuation engagements, including purchase price allocations, ASC 718 valuations, goodwill and intangible asset impairments, tax reporting matters such as 409a valuations, and intellectual property and complex security analyses. Prior to WilliamsMarston, Colton worked as an Investment Research Analyst at MidFirst Private Wealth Management where he covered stocks in the technology, media, and telecom industries. While at MidFirst Private Wealth Management, Colton constructed financial models of publicly traded companies under his coverage in addition to monitoring performance and leading strategic initiatives of the firm’s large-cap core-growth strategy.