As you are no doubt aware, ASC 842 Leases is effective for public business entities this year, and, as we discuss in this post, fundamentally changes the accounting for leases. Many of these changes are “google-able,” but when you search for questions about discount rates you might hit a dead end. And it’s a complicated topic! In a previous post, we discussed that lessors may need to use up to three different discount rates to account for leases under ASC 842. Luckily for lessees there are only two possibilities! In this post, we’ll focus on the discount rates used by lessees. Specifically, whether they should use the rate implicit in the lease or their incremental borrowing and what that means in practice.
Before we start, we want to point out that it is important that lessees use the correct discount rate at the commencement date of the lease. Why? Because it directly impacts amounts recorded on the balance sheet. 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.
You might be thinking, “Let’s just keep it easy and use the rate that is stated in the lease agreement.” Stop right there! Rates explicitly stated in lease agreements are rarely meaningful and should not be used be 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).
The rate implicit in the lease causes the following:
Of course, lessors would know this information, and therefore should use the rate implicit in the lease when accounting for leases under ASC 842. However, lessees likely would not know this information. Why? Lessees would likely not know the assumptions used by the lessor to determine the residual value of the leased asset. Furthermore, the lessee would not know the initial direct costs of the lessor.
As a result, it is highly likely that lessees would use their incremental borrowing rate to discount the future minimum lease payments.
Incremental Borrowing Rate
ASC 842 defines the incremental borrowing rate as follows:
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 would need to consider:
- Term of lease
- Current economic environment
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 is permitted to use a risk-free discount rate for the 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!
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 842-20-55-18 sets out a portfolio approach that lessees could use to establishing 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.
Note that ASC 842 is silent with respect to HOW lessees should calculate the incremental borrowing rates on their leases. We understand that companies and their auditors are still wrangling with methodologies, so expect a future post on that topic!
This post is published to spread the love of GAAP and provided for informational purposes only. Although we are CPAs and have made every effort to ensure the factual accuracy of the post as of the date it was published, we are not responsible for your ultimate compliance with accounting or auditing standards and you agree not to hold us responsible for such. In addition, we take no responsibility for updating old posts, but may do so from time to time.