One of the many determinations companies need to make as they implement ASC 842, the new lease accounting standard, is calculating the appropriate discount rate for their leases.
For lessees, selecting and estimating the discount rate will have an impact on the lease liability and right of use asset (ROU) on the organization’s balance sheet. There are several options, each with potentially different outcomes, so making the most appropriate choice for your organization is a critical step in the process. Generally speaking, a lower discount rate results in a larger liability as there is less of an interest component to the calculation.
Lessees’ Discount Rate Options Include:
Implicit Rate (IR)
This is defined as the interest rate on a given date that generates the aggregate present value of the lease payments, and the amount a lessor expects to derive from the underlying asset following the end of the lease term.
To determine the implicit rate, the lessee needs to know some of the assumptions used by the lessor in pricing the lease. This includes the underlying fair market value of the asset under lease, the estimated residual value of the underlying assets at the end of the lease, and any direct costs that may have been deferred by the lessor. In many cases, this choice may be impractical because much of the information needed to calculate the implicit rate is not readily available to the lessee.
Incremental Borrowing Rate (IBR)
This is defined as the interest rate a lessee would have to pay to borrow, on a collateralized basis, an amount equal to the lease payments over a similar term and in a comparable economic environment. Among the ways to calculate an IBR are using your rate on existing debt or recent loan; the borrowing rate of similar entities with comparable credit risk; or an interest rate quoted by your lender if you were to borrow funds to purchase a similar asset.
Risk-Free Rate (RFR)
The RFR is the rate of a zero-coupon U.S. Treasury instrument using a period comparable with the lease term. This provides a practical expedient alternative for private companies.
New Discount Rate Options
Making this decision became a little bit easier in mid-September as the Financial Accounting Standards Board (FASB) gave private companies and nonprofit organizations flexibility in choosing the discount rate used in calculating the value of their operating leases.
Under FASB’s revised guidance, an entity can choose between a discount rate such as an IBR and a risk-free rate for its leased assets.
The FASB also gave entities the option of selecting different discount rates for various classes of leases, instead of applying the same discount rate to all operating leases. This gives organizations the flexibility of calculating an IBR for high-value leases, such as real estate, and applying an easy-to-determine risk-free rate for low-value leases such as office equipment.
Discount Rate Disclosures
Lessees are required to disclose information about any significant assumptions or judgments to apply ASC 842, and this may include how they determined the discount rate for their leases. In addition, if a lessee elects the accounting policy to use the RFR, they should disclose this policy, assuming it is considered to be a significant accounting policy.
To learn more about choosing a discount rate or other aspects of your lease accounting implementation, reach out to our experts for help.