Lease Standard Education Series for Nonprofits – Discount Rates
Another foundational piece to understand when it comes to the new lease standard are the various discount rate options available. Discount rates include the rate implicit in the lease, the incremental borrowing rate, or the risk-free discount rate. ASC 842 requires the lessee to use the rate implicit in the lease whenever that rate is readily determinable. If that rate is not readily determinable, the lessee uses the incremental borrowing rate (IBR). A not-for-profit entity (and any lessee that is not a public business entity) is permitted to use a risk-free discount for the lease as a policy election for all leases.
Rate Implicit in the Lease
The rate implicit in the lease is not always easy for the lessee to determine since there are several assumptions used by the lessor in pricing the lease. Those assumptions include the underlying asset’s fair value, the estimated residual value of the asset, and any initial direct costs deferred by the lessor. A lessee can work with their lessor to obtain this information. When negotiating future leases, consider including this as part of those discussions. When this information is not readily available to the entity, the IBR should be used.
Incremental Borrowing Rate
ASC 842 defines the IBR as “the rate of interest that a lessee would have to pay to the borrow on a collateralized basis over a similar term an amount equal to the lease payments in a similar economic environment”. When determining IBR, an entity would look at its recent borrowings and other observable market rates and adjust those rates to reflect the difference in payment terms at or near the lease commencement date and amount of collateral. Significant professional judgment is needed to determine the IBR and requires supporting documentation to support the estimate used. ASC 842 does not prescribe a method for estimating the IBR, but there are methodologies in practice that a lessee can use. As an example, if you have other debt you can start with the rate for that debt and adjust based on the effects of collateral. This should result in reducing the rate. You should assume full collateralization. When considering collateral, it can be the leased asset or any form of collateral a creditor would be expected to accept to secure when borrowing for a similar term.
Risk-Free Discount Rate
If the implicit rate is not available and IBR cannot be calculated, the practical expedient provided by the FASB to use the risk-free discount rate can be used. The FASB recognized that having to calculate an IBR creates unnecessary cost and complexity for nonpublic business entities. Nonprofits are allowed 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 for all leases. The risk-free discount rate includes the rate of zero-coupon U. S. Treasury Instrument. It should be noted that risk-free discount rates create higher lease liabilities due to the current economic environment.
Incremental Borrowing Rate or Risk-Free Discount Rate?
When trying to decide between using the IBR or to elect the practical expedient and use the risk-free rate, the risk-free rate involves less judgment and is easier to determine. Management should be aware that the decision to use the higher or lower discount rate can impact other areas of the financial statements, including ratios. When you do not have a material amount of leasing activity, the risk-free rate may make sense since it is less complex. If leases are material, the IBR may make sense, but this is a decision that must be made by each entity, taking debt covenants and other financial considerations into account. The discount rate is a sensitive estimate requiring discretion.
How CLA can help?
The new lease standard is here. Be proactive to understand its impact on your nonprofit. CLA has the lease resources to help assess its impacts beyond general accounting and financial reporting, and walk you through readiness assessment, software selection and analysis, and implementation.
A turnkey lease accounting option can include:
- Assistance to identify and analyze leases that are subject to the standard
- Delivery of leased asset schedules, journal entries, and comprehensive footnote disclosures
- Updated and revised information at future interim or annual periods based on your needs
Lease Education Series
Stay tuned! In our next post we are taking a dive deeper into this new standard, looking at lease identification and lease terms.
In case you missed or would like to recall upon any prior content, below is a running list of the educational series:
This content was created by CLA’s Ann-Marie WalshLaRocca, Nonprofit Director.
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