Fair Value Assessment of Lease Contracts

Points to Consider When Conducting Fair Value Assessment of Lease Contracts

Points to Consider When Conducting Fair Value Assessment of Lease Contracts Fair value assessment of lease contracts, often required due to accounting standards (it is anticipated that fair value assessment of right-of-use assets, required for entities applying current IFRS, will also be necessary under the new domestic lease accounting standards), is usually performed without detailed data being publicly available. In this article, we will discuss the situations and methodologies requiring fair value assessment related to lease contracts from a standard industry perspective.

Instances Requiring Fair Value Assessment of Lease Contracts

Fair value assessment of lease contracts entails determining the degree of advantage or disadvantage of the subject lease contract compared to standard lease contract conditions as of the evaluation date. It involves analyzing advantages and disadvantages across various contract conditions, including not only rent but also rent adjustment clauses and cost-sharing ratios between lessors and lessees. In accounting practice, there are primarily two scenarios where such evaluation is deemed necessary: when conducting fair value assessment of right-of-use assets and when performing market value assessment of lease contracts' advantages and disadvantages in Purchase Price Allocation (PPA).

Application Methodologies

When conducting fair value assessment of lease contracts, it is common to apply the Profit Differential Method and then proceed with value assessment. The Profit Differential Method (With and Without Method) involves assessing the disparity in cash flows between scenarios with and without the contract (in this case, real estate lease contracts) and then discounting these to present value for value assessment.

Cash Flow Estimation

For the Profit Differential Method, assumed cash flows typically consider both market rent and current rent set at a stable rate. If predictions for market rent in the real estate market are reliable, future fluctuations can be incorporated into the assumptions. As for current rent, adjustments reflecting current contract terms (such as CPI adjustments) and rent revisions based on evaluator judgment can be considered. It's essential to thoroughly consider factors such as circumstances at the time of contract conclusion and other relevant aspects when assessing rent revisions. The assessment period is determined based on considerations of the contract duration, with calculations made according to the period in which advantageous or disadvantageous situations are expected to persist.

Discount Rate Assessment

In applying the Profit Differential Method, the discount rate must reflect the nature of assumed cash flows. Since assumed cash flows for fair value assessment of lease contracts (lease contracts) typically consist solely of real estate rent, it is desirable to apply yields related to the real estate market as the corresponding rate. Real estate yields vary depending on factors such as the location, use, age of the property, and factors related to the lease contract terms. Therefore, it is crucial to assess an appropriate discount rate reflecting these factors. Detailed analysis is particularly necessary in cases of significant rent disparities or when there is high risk associated with assumed cash flows.

Conclusion

Fair value assessment of lease contracts is often demanded due to accounting standards, and detailed data on evaluation cases is usually not publicly available, making it a relatively challenging evaluation subject. Especially for fair value assessment of right-of-use assets, similar to entities applying IFRS, it is anticipated that situations requiring assessment, such as impairment considerations, will arise for domestic companies with the application of the new lease accounting standards. Given the accumulated evaluation practices in the industry concerning accounting treatments by entities applying IFRS and PPA, it is advisable to collaborate with experienced consultants when such assessment is necessary to ensure comprehensive advice. The Deloitte Tohmatsu Group has experts in accounting, auditing, real estate, and other fields, enabling us to provide comprehensive advice, so please feel free to consult us if you have any questions or uncertainties.