Rates, rates and more rates. Well, maybe just one more rate. Did you know that lessors may need to use up to three different discount rates to account for leases under ASC 842? As a preparer or auditor dealing with lessor accounting, this is important to be aware of.
Under the guidance of ASC 842, lessors utilize the rate implicit in the lease when accounting for leases. ASC 842 defines the rate implicit in the lease as: “the rate of interest that, at a given date, causes the aggregate present value of (a) the lease payments and (b) the amount that a lessor expects to derive from the underlying asset following the end of the lease term to equal the sum of (1) the fair value of the underlying asset minus any related investment tax credit retained and expected to be realized by the lessor and (2) any deferred initial direct costs of the lessor.” The following graphic illustrates this definition.
That’s all fine and good, but there may actually be three variations of this rate when a lessor is accounting for a lease. It depends first on where you are in the process and then on what type of lease you are accounting for. Before we explore these rates, let’s briefly review the different types of leases a lessor can have and how they are initially recognized and measured.
With that review, let’s start looking at the rates used throughout the process. When a lessor is first examining a lease, classification as sales-type, direct financing or operating must be determined. Lessors first apply the following test:
Here’s where the first rate comes in. The discount rate used in determining whether the present value of future lease payments is substantially all of the fair value is the rate implicit in the lease that assumes no initial direct costs will be deferred, regardless of whether there are initial direct costs. Why? Because ASC 842 says so! However, the way to remember this is that we don’t yet know how the initial direct costs will be accounted for, meaning whether or not they will be deferred. Also, there is a caveat to be aware of. We assume no initial direct costs will be deferred so long as the fair value of the underlying asset is different from its carrying amount (which is most often the case). If it is the same, then the rate used includes initial direct costs.
Now, if the outcome of this classification test is a sales-type lease, then the same rate is used in the accounting for the lease. So, for a sales-type lease you can hit the easy button, there is only one rate. If the outcome of the classification test is that the lease is not a sales-type lease, then a second classification test must be used to determine whether the lease is direct-financing or operating.
The second test states that if both of the following criteria are met, the lease is a direct financing lease. If one or both of the criteria are not met, then it is an operating lease.
- The present value of the sum of the lease payments and any residual value guaranteed by the lessee that is not already reflected in the lease payments and/or any other third party unrelated to the lessor equals or exceeds substantially all of the fair value of the underlying asset.
- It is probable that the lessor will collect the lease payments plus any amount necessary to satisfy a residual value guarantee.
Applying the second test requires a second rate to determine the present value. This discount rate is the rate implicit in the lease that includes the initial direct costs, regardless of whether the fair value and the carrying amount of the underlying asset are different or the same. Because we know the outcome of this test will be a direct financing or an operating lease, and initial direct costs are deferred and amortized in the accounting for both of those types of leases, it only makes sense to include the impact of the initial direct costs in the rate.
Here’s where the third rate might, or might not, come in. If the result of the second classification test is a direct financing lease, the rate used to account for the lease depends on whether the lease gives rise to a selling profit. If it does not give rise to selling profit, then the rate used in the second classification test is used to account for the lease. If the lease gives rise to selling profit, a third rate must be used to account for the lease. This is due to the fact that any selling profit is deferred and included as a reduction to the net investment in the lease in a direct financing lease. This third rate is calculated as the rate at lease commencement that would have resulted in the sum of the lease receivable and the unguaranteed residual asset equaling the fair value of the underlying asset less the selling profit. Said another way, it is the rate that is needed to properly accrete the net investment in the lease, which now includes the deferral of selling profit.
Rates, rates, and maybe one more rate. Just remember that accounting for lessor leases can involve up to three different discount rates. All variations of the same theme which is defined in ASC 842.
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