Determining the reduction in value of collateral using real estate leases as an example
Many companies are currently intensely studying the effects of IFRS 16 on the accounting treatment of their leases. One of the greatest challenges in this regard is determining an appropriate incremental borrowing rate (IBR), as the interest rate implicit in the lease is usually not disclosed by the leasing firm (lessor) and therefore the IBR must be determined by the lessee.
The IBR is used to discount the cash flows resulting from the lease to the reporting date to determine the carrying amount of the lease liability. This requires first determining the contracts to be considered as well as their terms and conditions. The IBR is not only a company-specific WACC, but also a WACC specific to the individual lease. It is defined as 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 a similar value to the right-of-use asset in a similar economic environment. The main determinants are:
It is therefore essential to establish robust assumptions for the above determinants. In particular, the implications of using a right-of-use asset as security/collateral should be chosen transparently and non-arbitrarily on the basis of good arguments and convincing evidence and also be documented. In the following, we will therefore explore the implications of such collateralisation using real estate located in Germany as an example.
The presented argument is based on the fundamental idea of transferring the observable effect of using real estate as collateral, on the basis of available market data for mortgage bonds, to one's own leased asset.
Let us therefore assume a real estate lease for a property in Germany with a loan-to-value of 60%, in line with the relative lending limit for refinancing using a mortgage bond.
To 40% of the lease volume, an interest rate is applied that reflects unsecured borrowing. This rate usually consists of a risk-free rate, such as the Euribor, and the company's credit spread. Both components are determined with matching maturities and as of the relevant closing date. To the collateralised 60% of the lease volume an additional reduction in collateral value is applied as the third component.
A mortgage bond is issued by a bank in each case and fully collateralised by real estate assets. The collateralisation effect on an individual mortgage bond can be observed by comparing the refinancing rate of the issuing bank and the effective interest rate of the mortgage bond as of the relevant closing date. The difference can be determined for example by means of the zero spread of the benchmark of the issuer's ratings category and the zero spread of the mortgage bond. By repeating this procedure for several mortgage bonds of various issuers and different residual maturities, a curve can be determined for the reductions in collateral value. The interest rate for the collateralised 60% of the lease volume is thereby completely determined. 60/40 weighting completes determination of the collateralisation effect on the IBR in our example.
Experience has shown that when drawing up the documentation of assumptions made and automating the calculations numerous detailed questions arise. These primarily concern:
As the level of the lease-specific IBR has a major quantitative effect on accounting and financial reporting for many companies, it is indispensable to unequivocally derive and reliably determine the discount rates. In order to increase your planning and audit security it is therefore worthwhile to clarify these open issues as soon as possible.
Source: KPMG Corporate Treasury News, Edition 94, September 2019
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