Under the new guidance in ASC 842, Leases, lease liabilities reported on the balance sheet represent a lessee’s obligation to make lease payments, measured on a discounted basis. Determining the appropriate discount rate for the lease is now a critical component of calculating lease liability.
The discount rate is always the rate implicit in the lease for lessors. For lessees, the discount rate is also the rate implicit in the lease, unless it cannot be determined. In the event that the rate implicit in the lease cannot be readily determined, lessees should use their incremental borrowing rate. Lessees that are non-public businesses may alternatively use a risk-free rate that reflects a time period comparable to the lease term as an accounting policy election by class of underlying asset.
Rate Implicit in the Lease
ASC 842 defines the rate implicit in the lease as follows:
The sum of the present value of lease payments + The present value of the amount that the lessor expects to derive from the underlying asset following the end of the lease term = The fair value of underlying asset, less any related investment tax credit retained and expected to be realized by the lessor + Any deferred initial direct costs of the lessor
Lessees are required to use the rate implicit in the lease if it is readily determinable, which would mean a lessee has access to or knowledge of the above inputs. In most cases, lessees will not have access to all of the required information. When the implicit rate is not readily determinable, the lessee should use its incremental borrowing rate as the discount rate for the lease.
Incremental Borrowing Rate
ASC 842 defines the incremental borrowing rate in its glossary 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.” A lessee would take into account their credit risk, the lease term, the economic environment (location and date in which the lease is entered) and other collateral assets. In determining the incremental borrowing rate, a lessee should assume a lender could seek recourse from other assets of an entity, not just the asset leased.
As a starting point, a lessee can use their general credit rating based on the effective interest rate of any debt obligations. An entity, from that rate, would need to adjust based on any new economic factors (e.g., general economic downturn), term of the lease as compared to the term of the loan and any entity specific characteristics (e.g., increases in revenue or profitability).
ASC 842 allows for a company to take a “portfolio approach” to discount rates, whereby a lessee would group together leases with similar characteristics and apply one discount rate (e.g., one incremental borrowing rate) to the portfolio of leases. Entities would be required to use judgment to determine the size and composition of the portfolio.
Non-public Business Entity Accounting Policy Election
ASC 842 allows non-public business entities to use a risk-free discount rate for leases, determined using a period comparable with that of the lease term, as an accounting policy election by class of underlying asset. For a U.S. based company, this would typically mean the rate of Treasury yields comparable to the lease term. If a company makes this accounting policy election, it must be disclosed in the notes of any financial statements.
It is important to note, however, that when the rate implicit in the lease is readily determinable for any lease, the lessee should use that implicit rate rather than its incremental borrowing rate or a risk-free rate, regardless of whether the entity made the risk-free rate policy election.
Typically, the risk-free rate would be less than an incremental borrowing rate for an entity. This means that when utilizing the risk-free rate, any initially measured right-of-use assets and lease liabilities will be larger than if an entity calculated their incremental borrowing rate. Further, as the right-of-use asset is valued higher at inception, there is greater likelihood that the present value of the lease payments plus any guaranteed residual value would equal or exceed substantially all of the fair value of the underlying asset, requiring companies to classify more leases as finance leases.
Lessees and lessors are required to reassess the discount rate upon a modification of a lease. A modification to a lease is defined as a change to the terms and conditions of a contract that result in the change in the scope of or the consideration for a lease. Examples of modification provided by the standards could include a change to the terms and conditions of the contract that adds or terminates the right to use one or more underlying assets or extends or shortens the contractual lease term.
Lessees will also reassess the discount rate if there is a change in the lease term or the assessment by the entity as to whether they are reasonably certain to exercise an option to purchase the underlying asset. If the lessee determines that there is a change in the discount rate, a lessee should remeasure the lease liability using the new discount rate and adjust the corresponding right-of-use asset.
Determining the discount rate is a critical step in accounting for leases under ASC 842. The discount rate drives the lease asset and liability amounts and contributes to the decision regarding the classification of operating and finance leases. If you have questions about determining the discount rate or the new guidance under ASC 842, please contact our team.