FASB ASC Topic 842 Lease Accounting: Discount Rate

The new lease accounting rules retain the two-classification concept that existed under previous lease accounting rules.  Leases are classified as operating leases or finance leases.  Finance leases are the same as the former capital leases under FASB ASC Topic 840.  The most striking difference in the new accounting standard is that operating leases are recognized on the balance sheet. 

At the commencement date of a lease or at the date of transition to FASB ASC Topic 842, a lessee will recognize the assets and liabilities arising from leases with the lease liability measured at the present value of the lease payments not yet paid, discounted using the discount rate for the lease.  The right-of-use asset is measured at the value of the lease liability, adjusted for certain items such as initial direct costs and deferred rent liabilities under legacy lease accounting guidance. 

Lessees with capital leases are familiar with the concept of discounting the present value of minimum lease payments and the importance of selecting an appropriate discount rate, but lessees that have traditionally only had operating leases could be faced with the challenge of identifying and sourcing an appropriate discount rate.  We will explore the definitions of the discount rate under FASB ASC Topic 842 and provide some tips and tricks to evaluate this crucial component of lease accounting.

As stated directly in the text of FASB ASC Topic 842, the discount rate for the lease initially used to determine the present value of the lease payments for a lessee is calculated on the basis of information available at the commencement date.  A lessee should use the rate implicit in the lease contract whenever that rate is readily determinable. If the rate implicit in the lease contract is not readily determinable, a lessee uses its incremental borrowing rate.

Many lessees find themselves unable to determine the implicit interest rate in a lease contract.  The definition of implicit interest rate within the FASB ASC Topic 842 Glossary is the rate that the lessor is charging the lessee or the rate that causes the aggregate present value of (a) the lease payments and (b) the amount that the lessor expects to derive from the underlying asset at the end of the lease term to equal the sum of (1) the fair value of the underlying asset minus any related investment tax credits retained and expected to be realized by the lessor and (2) any deferred initial direct costs of the lessor.  Many components of the implicit interest rate definition may be proprietary to the lessor and therefore unknown by the lessee.  If the implicit rate cannot be readily determined, the lessee may use its incremental borrowing rate.

The FASB ASC Topic 842 Glossary defines the incremental borrowing rate 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.

FASB ASC Topic 840 contained a similar definition of the incremental borrowing rate to the FASB ASC Topic 842 definition; however, there is a key difference between the definitions.  The previous definition of the incremental borrowing rate is the rate, at lease inception, that the lessee would have incurred to borrow, over a similar term, the funds necessary to purchase the leased asset.  The new definition is based upon an aggregate lease payment input, whereas the previous definition is based upon a fair value input.  In most circumstances, the aggregate of the lease payments would be less than the fair value of the underlying asset.

A lessee could reference its other collateralized borrowings in the determination of the incremental borrowing rate and ensure appropriate adjustments to achieve a similar term in an amount equal to the lease payments.  It might be the case that a lessee only has unsecured financing sources and no recent history of secured financing or quoted secured interest rates.  In these cases, it would be appropriate for the lessee to formulate an incremental borrowing rate starting from unsecured base rate and adjusting for the various definitional attributes of the incremental borrowing rate in order to achieve a collateralized rate, similar payment structure, prepayment terms, lease term and economic environment.

In the Basis for Conclusions to FASB ASC Topic 842, the board noted that it may be appropriate in some circumstances for a lessee to establish a single discount rate and apply it to all leases in a portfolio because using that discount rate would not result in a materially different measurement than using a discount rate determined for each individual lease.

Depending on the sophistication and resources of an entity’s treasury management function, it may be appropriate and necessary to select an incremental borrowing rate(s) from published sources, seek rate quotes from lenders, and perform sensitivity analyses over the rate(s).

The new lease guidance includes a practical expedient that is only available to lessees that are not public business entities that permits an accounting policy election for the initial and subsequent measurement of lease liabilities to be discounted using a risk-free rate.  This accounting policy election must be elected for all leases.  Risk-free rates are generally lower than interest rates meeting the definition of the incremental borrowing rate.  As such, the measurement of the initial lease liability and the right-of-use asset would be higher using a risk-free rate than using the incremental borrowing rate.  This could potentially cause a day-one impairment of the right-of-use asset if the amount recognized at the transition date or lease commencement date exceeds the fair value of the underlying asset.

Organizations need to find a suitable solution for calculating the FASB ASC Topic 842 right-of-use assets and lease liabilities at the transition date and the subsequent lease accounting.  Generally, an Excel-based solution would be appropriate for a noncomplex portfolio of 10 or fewer leases.  If the lease profile is more complex or greater than 10 individual leases, management is better served by a lease software solution, such as simpLEASE. In addition to offering our clients simpLEASE, Schneider Downs provides advisory services for the technical aspects of lease accounting. For more information concerning lease accounting and the impact on your organization, please visit the Schneider Downs Our Thoughts On blog or email us at [email protected].