We serve privately held and family businesses, angel and venture-backed companies, public companies, foundations, not-for-profit and public sector organizations, and high net worth individuals and their families.
Originally published 10/6/2023 and updated 2/17/2023 to include a current example of risk-free rate.
Your discount rate, which impacts both lease liability and lease classification, is a key item to understand and determine as you begin implementation of Accounting Standards Update No. 2016-02 and subsequent updates (Topic 842).
Why is the Discount Rate Important?
In determining the lease liability, the discount rate is applied to all future lease payments to calculate the present value of those lease payments. Since the right-of-use asset is based on the lease liability, the discount rate will, in turn, also impact the initial value of the right-of-use asset.
In determining the appropriate classification of a lease, as either a finance lease or an operating lease, one factor to consider is whether the present value (calculated using the discount rate) of lease payments is equal to substantially all of the fair value of the asset. Therefore, the discount rate can impact the balance sheet and the income statement, based on determination of lease classification as either an operating or finance lease. We’ll discuss calculating the lease liability and lease classification further in future articles.
Determining Your Discount Rate
For lessees, the discount rate for the lease is the rate implicit in the lease unless that rate cannot be readily determined, in which case the incremental borrowing rate or risk-free rate is used. The discount rate is established at the later of:
a) the beginning of the earliest period the lease is presented in the financial statements, or
b) the lease commencement date.
In the case where subsequent remeasurement of the lease is required, a new discount rate would be established at remeasurement. The implicit rate and incremental borrowing rate are as follows:
The rate implicit in the lease is the rate of interest that, at a given date, causes the aggregate present value of (a) the lease payments, and (b) the amount that a lessor expects to derive from the underlying asset following the end of the lease term to equal the sum of (1) the fair value of the underlying asset minus any related investment tax credit retained and expected to be realized by the lessor, and (2) any deferred initial direct costs of the lessor.
Essentially, this is the rate of return provided to the lessor under the lease. While this information is readily available to the lessor, the lessee may not have sufficient information to determine the rate implicit in the lease. If the rate is provided, the lessee must use this rate as the discount rate.
While the majority of leases will not include a readily determinable rate, using the rate implicit in the lease will likely result in a lower lease liability as the lessor’s rate of return will likely exceed the company’s borrowing rate.
Incremental Borrowing Rate (IBR)
Under Topic 842, the incremental borrowing rate is defined 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.”
The incremental borrowing rate will vary depending on factors such as the size of the loan, loan term, and economic environment at that time of lease commencement. Determining the appropriate IBR to use as a discount rate may be difficult to determine, depending on the size and expertise of your organization, as well as borrowing history, and will require organizations to develop a process to estimate this rate. For this reason, a practical expedient policy election has been provided under the new standard to ease implementation.
Policy Election – Risk-free Rate
Through various updates to ease the burden of implementation for private companies and not-for-profit organizations, entities that are not public business entities can make an accounting policy election to utilize a risk-free discount rate as their discount rate in place of their incremental borrowing rate. The risk-free rate applied should be determined using a comparable term to the lease term, determined as of the later of the beginning of the earliest period the lease is presented in the financial statements, or the lease commencement date. The election is made by class of underlying assets, with disclosure required to inform users of the financial statements of the rate applied to each class of assets. This rate can only be used when the rate implicit in the lease is not readily determinable. If the rate implicit in the lease is readily determinable, that rate must be used as it best reflects the economics of the transaction and can be easily determined.
In cases where this accounting policy has been elected for a class of assets, but one lease within the asset class includes a readily determinable implicit rate, the rate implicit in the lease must be utilized for that specific lease, while the risk-free rate can be applied to the remaining leases within the asset class.
Using the risk-free rate in place of the incremental borrowing rate will likely result in a higher lease liability, based on discounting the lease payments at a lower rate. For this reason, companies may elect the accounting policy election for one class of assets (higher volume and/or lower dollar value leases – e.g., equipment leases) while applying the incremental borrowing rate to another class of assets (less frequent transactions and/or higher dollar value leases – e.g., real estate leases).
To demonstrate an example, ABC Company entered into an agreement to lease equipment for a five-year term, commencing July 1, 2019. The Company adopted ASC 842 on January 1, 2022, and elected to use the risk-free rate as the discount rate for the lease liability.
The risk-free rate is determined the latest of the lease commencement dates or the date the Company adopted the new lease standard (January 1, 2022). The risk-free rate should be determined using a period comparable with the lease term. The guidance does not specify whether, at adoption of ASC 842, that calls for the initial term of the lease or the term remaining on the lease at adoption.
While the initial lease term is five years, as of January 1, 2022, the Company has two and a half years remaining on the lease at adoption. Based on the treasury rates on January 3, 2022 (closest to date of adoption), the Company could elect a rate between the two and three-year term (.78% – 1.04%) or the five-year term (1.37%). The Company’s policy should be applied consistently and disclosed in the financial statements.
This article or blog contains general information only and should not be construed as accounting, business, financial, investment, legal, tax, or other professional advice or services. Before making any decision or taking any action, you should engage a qualified professional advisor.