In many cases, it makes more sense for a business to lease equipment or property rather than buy it outright. Necessities such as automobiles and computer systems must be replaced or upgraded regularly, making leases an attractive option. But the interest rate is often not specified by the lessor in the lease agreement. Instead, pertinent information like the lease term, payments, and the asset’s fair market value can be used to calculate an implied rate, a figure known as the implicit interest rate on a lease.
Being able to calculate the rate implicit in a lease is a beneficial skill to have in lease accounting. Knowing the rate implied from the terms of a lease leads to a better understanding of the benefits of leasing vs. buying. And under ASC 842, a lessee must calculate a lease liability at each balance sheet date for both operating and finance leases.
In this article, we’ll go over what an implicit interest rate is, how you calculate it for leases, and why this is important for your business.
What Is the Implicit Interest Rate on a Lease?
The implicit interest rate on a lease is the interest rate the lessor charges the lessee. It is called an implicit rate because it’s not explicitly stated in the lease agreement. Instead, the interest rate is implied by the value of the item being leased, compared to the total amount the lessee will pay during the term of the lease.
For a simple real-world example of implicit interest, imagine a scenario where you borrow money and agree to pay back a fixed extra amount on top of what you borrowed.
Let’s say you borrow $500 from a friend and agree to pay back $550. As an interest rate was not explicitly stated, you could use a two-step algebraic formula to determine the implicit rate in this agreement:
- Total amount paid/Amount borrowed = X
- X-1 x 100 = implicit interest rate
Plugging in the numbers from our example into the formula, we first divide the total amount paid by the amount borrowed:
- $550/$500 = 1.1
Now that we know x equals 1.1, we can do the second step of the formula.
- 1.1 – 1 = 0.1
- 0.1 x 100 = 10
So your implicit interest rate on the loan is 10%. This is easy to verify because we know $50 (the extra amount paid) is 10% of $500 (the amount borrowed).
Of course, the calculation is not quite that simple when figuring out the implicit interest rate on a lease. Even though the basic concept is the same, there are more factors to consider in lease accounting, including:
Payment periods: As we are figuring out an annual percentage rate, this will be the number of years of the lease agreement.
Fair value: The value of an asset if it were to be sold, or the price paid to transfer a liability, in the open market at the time of calculation. Also known as fair market value.
Lease payments: The payments agreed upon by the lessee and lessor.
Investment tax credit: Received by the lessor, this credit is deducted from the fair value.
Deferred lessor initial recognition costs: Incremental costs of a lease if the lease had not been created. This is added to the fair value.
Now let’s see how we use these inputs to calculate a lease’s implicit interest rate.
How to Calculate Implicit Interest Rate on a Lease
ASC 842 sets a definition that explains how to calculate the interest rate implicit in a lease:
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.
As a lessee is typically unaware of some of this information, such as the lessor’s initial direct costs and investment tax credits, the lessee can use the information they have. The important part is to arrive at a rate that causes the present value of the lease payments and the expected residual value of the underlying asset (at the end of the lease) to equal the fair market value.
With the information that a lessee has, the calculation can be easily done in spreadsheet apps like Microsoft Excel or Apple Numbers using the IRR (internal rate of return) function.
Using a Spreadsheet to Get the Implicit Interest Rate in a Lease
To see how we do this, let’s create an example lease agreement. Company XYZ is leasing some computer hardware for six years, with payments of $5,000 paid annually at the start of each year. At the commencement of the lease, Company XYZ researches the fair value of this leased hardware and estimates it to be worth $25,000.
In our example, we’ll assume that Company XYZ is unaware of any deferred initial costs on the lessor’s part or any investment tax credits that the lessor has retained. We’ll also assume that the value of this hardware will be $0 at the end of the lease.
In the spreadsheet of your choice, create a table with four columns: Period, Fair Value, Payments, and Net Cash Flow. We start with a period of 0, as the payments are made at the beginning of each period. The Net Cash Flows reflect the receipt of the asset at the beginning of the lease, equal to the asset’s fair value.
The total of the Net Cash Flow column, the sum of the hardware asset’s estimated fair value of $25,000 plus six years of $5,000 annual payments. In this table, the IRR function returns a rate of 7.93%. This is the implied interest rate of the lease.
Why Is Finding the Implicit Rate Important?
With this example, we have seen that with the payment terms of a lease, a little bit of research to determine FV, and an Excel function, a lessee is able to quickly and easily estimate the interest rate implicit in any lease. It’s important to do these calculations for a few reasons.
Making a reasonable estimate of the implicit rate of a lease is an essential step for any company choosing whether to buy or lease an asset. The break-even point is going to be different on leases than on an outright purchase, depending on the nature of the asset. Comparing a lease’s implicit rate and the interest rate on a conventional loan provides key data in a lease vs. buy analysis.
Companies that follow the generally accepted accounting principles (GAAP) reporting standards are required to follow ASC 842. Under ASC 842, lessees must use the implicit rate to calculate a lease liability when they have all the required information from a lessor. But as we’ve seen, most of the information required to make a reasonable estimate will be in place by the time of lease inception.
What If I Can’t Calculate the Implicit Rate?
If the implicit interest rate in a lease cannot be reasonably determined, ASC 842-20-30-3 allows for the lessee to use its incremental borrowing rate (IBR) instead. This is the interest rate a lessee would have to pay to borrow an amount of money equal to future lease payments in a similar economic environment on a collateralized basis over a term similar to the lease’s term.
Similarly, private companies can decide to use a risk-free discount rate for a lease as an accounting policy election. The risk-free discount rate would be based on the borrowing rate for the US Federal Government for a period comparable to the lease term. Going this route locks the company into using a risk-free rate for future leases.
How Occupier Can Help
At both private and public companies, calculating the implicit interest rate on a lease is just one component of their larger lease accounting operations. A full-featured system that manages your entire lease life cycle is needed for businesses that want to spend less time doing the legwork and devote more time to making data-driven decisions.
That’s where Occupier can help. We leverage a modern and innovative tech stack for all your commercial real estate and lease management needs. Whether it’s lease accounting, lease administration, or transaction management, our end-to-end solutions integrate with your ERP system to close the books every month, ensuring you are compliant with ASC 842 in the process.
Occupier’s solutions will free up your stakeholders to make better portfolio decisions for your business. To see how Occupier can help your business take control of your real estate portfolio and unlock opportunities within your business’s lease lifecycle, get in touch today to schedule a demo.