Understanding and Avoiding Discount Rate Myths in Lease Accounting
As companies adopt ASC 842, selecting and estimating the discount rates embedded within their various leases will play an important role in their implementation as well as their accounting going forward.
These decisions can be complicated by common misunderstandings about the different types of discount rates available, as well as the potential implications to the organization’s balance sheet.
The Discount Rate Options for Lessees Include:
- Implicit Rate (IR): 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.
- Incremental Borrowing Rate (IBR): 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.
- Risk-Free Rate (RFR): The rate of a zero-coupon U.S. Treasury instrument using a period comparable with the lease term.
Myths and Misunderstandings Associated with Each Election
Common Implicit Rate Myth:
- Myth: The implicit rate on financing leases (formerly known as capital leases) will be easy to obtain, whether stated explicitly in the lease agreement or readily available from the lessor.
- Fact: It’s unlikely the lessor will be willing to share the implicit rate, since the data underlying the rate is related to the lessor’s profit on the agreement. The lessee will need to calculate the implicit rate based on information including the fair market value of the leased asset, the estimated residual value of the underlying asset at the end of the lease, and any initial direct costs deferred by the lessor.
Common Incremental Borrowing Rate Myths
- Myth: The IBR is the interest rate on an easily accessible line of credit.
- Fact: This approach was allowable under ASC 840, but lessees must use a collateralized rate under ASC842.
- Myth: The IBR is the weighted average interest rate that a lessee pays on its other debt.
- Fact: Lease terms and other economic characteristics will vary, precluding the use of a blended rate.
- Myth: A lessee can use the same IBR for all of its leases.
- Fact: ASC 842 requires applying discount rates to each individual lease, therefore IBR needs to be determined for each lease. A lessee may elect the “portfolio approach” practical expedient and apply the calculated IBR across a similar group of assets such as a vehicle fleet.
Common Risk-Free Rate Myth:
- Myth: Lessees can elect to use the risk-free rate on certain leased assets, and the incremental borrowing rate and/or the implicit rate on other leases as they see fit.
- Fact: If a lessee elects to adopt the risk-free rate practical expedient under ASC 842, they must apply the risk-free rate to all leased assets —even if a lease was classified previously as a capital lease with a known implicit rate.
Note: The FASB released a proposed update in September 2021 allowing a lessee that is not a public entity to make the risk-free rate accounting policy election by class of underlying asset, rather than for all assets under lease. Under this proposal, a lessee will be required to use the implicit rate when it is readily determinable (instead of the risk-free rate), regardless of whether the lessee applies the risk-free rate election.
Questions? Contact us to discuss the best approach to determining an appropriate discount rate for your leases, or for other ASC 842 implementation questions.
