One of the key changes under the new leasing standard, Accounting Standards Codification Topic 842 (Topic or ASC 842), is that a lessee must calculate a lease liability at each balance sheet date for both its operating and finance (formerly ‘capital’) leases. The only exception is for certain leases with an original term at lease commencement of 12 months or less – known as ‘short term leases.’ The good news is that although the lease liability is recalculated at lease inception and each subsequent reporting date, the discount rate used to calculate the lease liability is determined only once – at lease inception – unless the lease is subsequently modified. The question arises as to what requirements are placed on, or options are available to, a lessee in determining the lease liability discount rate under ASC 842.
The general rule under Topic 842 is that a lessee should use the discount rate implicit in the lease. However, in the case that rate cannot be readily determined, the lessee must use its incremental borrowing rate (IBR). Since a lessor is expected to always be able to determine the interest rate implicit in its lease, a lessor must always use such rate.
The rate implicit in the lease is the interest rate that, at a given date, results in:
- The aggregate present value (PV) of a) the lease payments plus b) the amount a lessor expects to derive from the underlying asset at the end of the lease term (e.g. through the sale of the asset(s) to the lessee or another party, or the value to lessor from the asset(s) being returned); equaling
- The fair value of the underlying asset(s) net of any related tax credits retained and able to be realized by the lessor, plus any deferred initial direct costs (IDCs) of the lessor.
The IBR is the interest rate the lessee would have to pay to borrow funds, equal to the future lease payments, on a collateralized basis over a similar term, in a similar economic environment. The discount rate for the lease used to determine the PV of future lease payments at lease inception is calculated based on information available at the lease commencement date.
The problem in determining the rate implicit in the lease is that the lessee usually will not know or be able to reliably estimate the values for all of the four inputs. In particular, the lessee will usually not know what IDCs were incurred by the lessor to enter into the lease, or what amounts the lessor expects to derive from the leased asset(s) at the end of the lease term, not least as this is based on the lessor’s future plans and assumptions. As a result, in most cases, a lessee will not be able to determine the interest rate implicit in the lease.
Private company option:
A lessee that is not a public business entity is permitted to make an accounting policy election to use a risk-free discount rate for the lease, rather than the interest rate implicit in the lease. The risk-free discount rate would be based on the borrowing rate for the US Federal Government or a similar entity, for a period comparable to the lease term. Usually, the rate of a zero coupon US Treasury instrument for the commensurate term will provide a good risk-free rate to use. Once a lessee makes this accounting election, it must use the risk-free rate, which may not be negative, for all of its leases going forward.
Although making the ‘private company’ election can significantly simplify the discount rate calculation, doing so is not without possible drawbacks; in particular:
- The lessee is locked into using a risk-free rate for future leases
- The resulting lease liability and ROU assets will likely have higher values at inception than if the lessee’s IBR were to be used, as the risk-free discount rate used will generally be lower.
- This in turn may make it more likely that the lease is classified as a finance lease (as the fair value (FV) of future lease payments is more likely to equal or exceed substantially all of the FV of the underlying asset).
Reassessing the discount rate:
Lessees are required to reassess the lease liability discount rate when, subsequent to lease inception, there is a change to the lease terms or scope and the changes are not accounted for as a separate lease or contract. In addition, if after the lease commences, there is a change in the assessment as to whether the lessee is reasonably likely to exercise an option to buy the leased asset(s) at the end of the lease term, then the discount rate may need to be reassessed.
When the discount rate changes, the lessee is required to remeasure the lease liability using the new discount rate, and adjust the associated ROU asset. In some cases these remeasurements can result in a profit or loss.
For additional resources on lease accounting, visit our Lease Accounting Hub.