LEASE Common Denominator
Where did July go? It’s hard to believe that summer is almost over. I have enjoyed the time that we have spent together thinking about leases and summer. Hopefully, you are prepared to tackle ASC 842-Leases head on!
In the fourth installment of our lease series, we discuss discount rate considerations used when calculating the present value of future obligations related to leases.
Discount Rate
Once the term of the lease is determined, the next logical step is to calculate the amount of the right-of-use asset and lease liability by calculating the present value of the lease payments over the expected lease term.
ASC 842 dictates that lessees are required to use the rate implicit in the lease if it can be readily determined, when calculating the lease liability. However, in order to determine the rate implicit in the lease, a lessee needs to know several assumptions used by the lessor in pricing the lease, such as the underlying asset’s fair value, the estimated residual value of the asset, and any initial direct costs deferred by the lessor.
This information may not be readily available to the lessee, so they often need to determine the rate by another method. As they say in the movies, “We can do this the easy way or the hard way.”
Hard Way And Easy Way
Following are some options to consider:
| Hard Way | Considerations |
| Incremental Borrowing Rate (IBR) | ASC 842 defines IBR 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.” |
IBR Approach:
- Start with the interest rates on recent borrowings.
- Consider other observable market rates.
- Adjusting those rates to reflect differences in the amount of collateral and the payment terms of the leases at or near the lease commencement dates.
This approach requires significant professional judgment and documentation to support the estimate. ASC 842 does not prescribe a method for estimating the IBR.
Following are some additional matters to consider:
- A lessee may have borrowed under a debt facility that it can reference when estimating its IBR. The contractual interest rate on an existing debt facility should not simply be used as the IBR without adjusting the contractual rate so that it satisfies the definition of the IBR.
- An acceptable method of considering collateral when determining the IBR is to evaluate the collateral considered for the borrowing as follows:
- The lessee should start with a rate that is obtained for a general, unsecured, recourse borrowing and should adjust that rate for the effects of collateral. This should have the effect of reducing the rate.
- The lessee should assume full collateralization and should not assume under or over collateralization.
- The collateral considered does not have to be the leased asset. It can be the leased asset, but it may also be any form of collateral that a creditor would be expected to accept to secure a borrowing for a similar term (i.e., collateral that is at least as liquid as the leased asset).
| Easier Way | Considerations |
| Risk-Free Discount Rate | The FASB provided a practical expedient for nonpublic business entities to relieve those lessees from having to calculate an IBR which could create unnecessary cost and complexity. Nonpublic business entities are permitted to use a risk-free discount rate (e.g., in the U.S., the rate of a zero-coupon U.S. Treasury instrument) for its leases comparable to corresponding lease terms. The risk-free rate should not be less than zero. |
Link to U.S. Dept of The Treasury Interest Rates
Preferred Method
The risk-free rate involves less judgment and is easier to determine. However, management’s decision of whether to use a lower or higher discount rate can impact other areas of the financial statements, including ratios. For example, using a higher discount rate results in a lower right-of-use asset which generates a higher asset turnover ratio. Conversely, using a lower rate (such as the risk-free rate) results in a higher right-of-use asset which generates a lower asset turnover ratio. The interest rate coverage ratio is also affected based upon the discount rate utilized (i.e., a higher rate generates higher interest expense and therefore lower interest rate coverage ratio). Ratios can also impact various debt covenants so this should be considered.
Thank you to Michael Westervelt and Brittney Fox who contributed to this post. As always, let us know if we can be of any help!
Allyson works for businesses of all sizes, maintaining a primary focus on business tax and consulting. She provides her clients with creative resolutions for technical tax issues and clearly interprets proposed and existing business tax law. Moreover, her thorough experience with trusts and estates allows her to deftly guide clients through the complicated legislation and the intricate processes involved in compliance, maximization of returns, and sustaining business and family wealth. She first gained knowledge and experience working for several years in a national firm, in a small firm environment, and in solo practice. She was also a partner in a regional legacy firm for 15 years prior to joining CLA. Her extensive tax experience bolsters CLA's talented staff and cultivates client relationships and makes her an invaluable member of the professional and civic communities.
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