Clarification of Lessee Discount Rates under ASC 842
Discount rates are important in applying ASC 842. Why? Because discount rates are used to:
- Determine the lease classification;
- Determine the present value of lease payments; and
- Measure a lessor’s net investment in the lease (for sales-type and direct financing leases).
The higher the discount rate, all other things being equal, the lower the present value of future lease payments. This results in a lower lease liability and right-of-use asset recorded in the balance sheet.
This post will discuss the discount rate requirements for the lessee under ASC 842 (but will include a brief reminder for the lessor as well!). Check out this post for a high-level overview on ASC 842.
Keep it simple
You might be thinking, let’s just keep it easy and use the rate that is stated in the lease agreement. But stop right there! Rates explicitly stated in lease agreements are rarely meaningful and should not be used by either the lessor or lessee. C’mon, this is U.S. GAAP. You should know by now—it’s never that easy!
ASC 842 explicitly states:
“For a lessee, the discount rate for the lease is the rate implicit in the lease unless that rate cannot be readily determined. In that case, the lessee is required to use its incremental borrowing rate.”
Rate implicit in the lease
The rate implicit in the lease must be used by the lessee if it is known or is readily determinable. This is the interest rate that, at a given date, causes the present value of the net investment in the lease to equal the sum of the fair value of the asset (including capitalized indirect costs of the lessor).
Why might a lessee not be able to readily determine the rate implicit in the lease?
The rate implicit in the lease would be considered readily determinable when all the inputs used to calculate the rate are readily determinable. One such input that the lessee most likely will not know is the amount of the lessor’s initial direct costs. Another is the lessor’s estimate of the residual value of the underlying asset.
As a result, the discount rates used by the lessor and lessee will RARELY be the same.
Lessors are required to use the rate implicit in the lease. However, lessee’s most likely will use their incremental borrowing rate as the rate implicit in the lease will not be able to be readily determined. In other words, “readily determinable” is a fairly high hurdle.
Incremental borrowing rate
ASC 842 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.”
In other words, under ASC 842, a lessee must use the rate of interest it would likely have to pay if it borrowed money from a bank and pledged similar collateral in the current economic environment. Therefore, lessees need to consider:
- Term of the lease
- Collateral
- Current economic environment
The incremental borrowing rate should be representative of the interest rate that would be charged to borrow an amount equal to the lease payments. Furthermore, the incremental borrowing rate should be an effective borrowing rate that takes into account any compensating balance or other requirements affecting the stated interest rate (e.g., leases that have guarantees by a third party should be based on an incremental borrowing rate with similar guarantees in place).
It is important to note that the lessee needs to determine the incremental borrowing rate for the right-of-use asset, not the underlying physical asset. In addition, the lessee should estimate an incremental borrowing rate for each lease. That means lessees with a lot of leases would have not just one, but many incremental borrowing rates!
Keep in mind that the incremental borrowing rate should never be less than zero.
Accounting policy election
ASC 842 permits a lessee that is not a public business entity to use a risk-free discount rate for a lease, determined using a period comparable with that of the lease term, as an accounting policy election for all leases. For example, say a lessee had two leases (a 3-year lease and a 10-year lease) and wanted to use this election. They would use a 3-year risk-free discount rate for the 3-year lease and a 10-year risk-free discount rate for the 10-year lease.
Before you get too excited about this election, remember that the risk-free rate will likely be a lot lower than the incremental borrowing rate. This would lead to a higher lease liability and right-of-use asset reported on the balance sheet!
Portfolio approach
What if a lessee has thousands of leases? Do they really need to determine the incremental borrowing rate for each and every lease? Not necessarily! ASC 842 sets out a portfolio approach that lessees could use to establish the discount rate for their leases. One of the keys to this portfolio approach is that the portfolio has similar characteristics (e.g., size and composition) and that the application of the portfolio approach will not differ materially from the application of ASC 842 to the individual leases in that portfolio.
Final thoughts
If you’re looking for additional reminders on lessee accounting requirements under ASC 842, check out our lessee accounting course. Also check out our Leases technical topic page where we discuss other accounting considerations, compare ASC 842 to IFRS 16, and provide links to all of our lease courses and other helpful resources!
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Disclaimer
This post is for informational purposes only and should not be relied upon as official accounting guidance. While we’ve ensured accuracy as of the publishing date, standards evolve. Please consult a professional for specific advice.
