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Discount Rate Calculations for Lease Accounting

Aug 23, 2022

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FASB Accounting Standards Codification (ASC) 842, Leases, which became effective in January 2022, dramatically increased the number of leases companies need to report on their balance sheets. With these changes, the importance of accurately estimating lease discount rates became critical, as they can significantly impact a company's overall lease liabilities and right-of-use (ROU) assets.

Options for Using the Appropriate Interest Rate for the New Lease Standard

With the new standard, each lease with a lease term longer than a year must be recorded on the balance sheet as an ROU asset and a corresponding lease liability. This is measured using a discount rate that calculates the present value of future lease payments. With several options available for determining the appropriate interest rate, the overall impact on accounting is a key factor in deciding which option is right for your company. The options available include:

Rate Implicit in the Lease

It is required for lessees to use the rate implicit in the lease (RIIL) whenever it can be readily determined. For the lessor, the implicit rate will be readily available since the lessor is the one drafting the lease terms and is aware of what they will be charging the lessee. For the lessee, however, things can be slightly more complicated. To determine the RIIL, the lessee must 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 at the end of the lease, and any initial direct costs that the lessor deferred. As this information is often unavailable to the lessee, most choose to use a different method when determining the appropriate discount rate.

Incremental Borrowing Rate

In situations where the information required of a RIIL is not readily available to the lessee, FASB ASC 842 requires the lessee to use their incremental borrowing rate (IBR) instead. This is the rate of interest that a lessee would have to pay to borrow on a collateralized basis over a similar term on an amount equal to the lease payments in a similar economic environment. However, this method doesn’t come without its own challenges. For example, suppose a lessee did not incur borrowing at or near the lease  commencement date (for a term similar to the lease term or amounts similar to the lease payments). In that case, the lessee may need to determine its IBR for that lease by referencing the costs of borrowing for other similar entities within the same industry that have a similar credit rating to that of the lessee. Otherwise, they would need to obtain borrowing costs from other lenders. One other item to note when using the IBR is the IBR is not determined for the entity as a whole, but rather for each individual lease or by using a portfolio approach.

Risk-Free Discount Rate

The risk-free discount rate permits a lessee that is not a public business entity to use a risk-free rate (e.g. the rate of a zero-coupon U.S. Treasury instrument) for lease measurement using a period comparable with the lease term. When selecting this route instead of its IBR, a lessee must apply this policy to either all leases, or by applying an accounting policy election by class of underlying assets and disclose the election in their notes within the financial statements. Of note, the risk-free rate is an alternative only to the IBR rate. A lessee must use the rate implicit in the lease if that rate is readily determinable, regardless of whether it has made the risk-free rate election.

Need Help Determining the Right Course of Action for Your Company?

With the changes implemented by FASB ASC 842, determining the appropriate discount rate for your organization can pose a unique challenge. Work with your CRI advisor, who can examine the impact of the discount rate and help you select the right course of action for your company.

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