Last Updated on May 5, 2022 by Andrew Flint
One of the key differentiators when Comparing ASC 840 to ASC 842 is that now all leases, both finance (previously capital under ASC 840) and operating must be on the balance sheet. Meaning that their lease liabilities must be calculated at the lease commencement date. Luckily, the discount rate used to calculate the lease liability is only determined once, at the lease inception date. The only exception to this rule is if the lease is subsequently modified.
So, under ASC 842, the lease liability is measured by determining the appropriate discount rate needed to then calculate the present value of future payments. If the rate implicit in the lease is readily ascertainable then the lessee should use that rate which is implicit. Although, if the rate implicit in the lease is not readily determinable, then the lessee uses its incremental borrowing rate.
The Rate Implicit in the Lease
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.
However, if the rate determined in accordance with the preceding sentence is less than zero, a rate implicit in the lease of zero shall be used.
If a lessee can ascertain the following points, then they can calculate the lessor’s implicit rate:
- The fair value of the underlying asset
- The residual value estimated by the lessor
- The initial direct costs incurred by the lessor
The catch 22 is that this information is rarely available to the lessee considering the sensitive nature of the above data points to the lessor and the potential impact it could have on existing or future lease negotiations.To that end, the lessees and lessors will often use a different discount rate for the same lease, called the incremental borrowing rate.
The Incremental Borrowing Rate
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.”
A lessee that is not a public business entity is permitted to use a risk-free discount rate for the lease, determined using a period comparable with that of the lease term, as an accounting policy election for all leases. While a lessee’s use of a risk-free discount rate may reduce some of the complexities related to measuring its lease liabilities and ROU assets, there may be some unintended consequences.
For example, using a risk-free discount rate would result in a lease liability and ROU Asset that are larger than those that would have been calculated by using the lessee’s incremental borrowing rate. In addition, using the risk-free rate could result in a present value calculation that may equal or exceed all of the fair value of the underlying leased asset substantially, causing the lease to be classified as a finance lease rather than an operating lease.
Steps to Determining the Incremental Borrowing Rate
In determining the incremental borrowing rate, a lessee should evaluate the collateral considered for the borrowing as follows:
- The lessee should start with a rate that is obtained for a general, unsecured recourse borrowing and should adjust that rate for the effects of collateral. This should have the effect of reducing the rate.
- The lessee should assume full collateralization and should not assume under- or over-collateralization.
- The collateral considered does not have to be the leased asset. It can be the leased asset, but it may also be any form of collateral that a creditor would be expected to accept to secure a borrowing for a similar term (i.e., collateral that is at least as liquid as the leased asset).
- For leases denominated in a foreign currency, a lessee should calculate its incremental borrowing rate by using assumptions that would be consistent with a rate that it would obtain to borrow on a collateralized basis and in the same currency in which the lease is denominated.
A determination of the lessee’s incremental borrowing rate at the lease commencement date of a lease may be difficult. If a lessee did not incur borrowings at or near the commencement date of a lease that was for a term similar to the lease term, the lessee may need to determine its incremental borrowing rate through discussions with bankers or other lenders or by reference to obligations of a similar term issued by others with a credit rating similar to that of the lessee. The incremental borrowing rate should be an effective borrowing rate that takes into account any compensating balance or other requirements affecting the stated interest rate. When the lessee obtains a third-party guarantee of its lease payments, it should adjust its incremental borrowing rate to reflect the impact of that guarantee if obtaining a third-party guarantee for a similar borrowing that could have been used to purchase the leased asset would have affected the lessee’s borrowing rate for that debt.
If a lessee is not able to obtain financing from a third party because of its overall financial condition and creditworthiness, the incremental borrowing rate may not be readily available. In such circumstances, the lessee should use, as its incremental borrowing rate, the interest rate available for the lowest-grade debt in the marketplace, adjusted for the effects of collateral.
If a lease is modified or the terms amended in any way then the lessee will need to reassess the lease liability discount rate as well as adjust the associated ROU Asset.
Accounting Guidance Referenced:
- ASC 842-10 — Glossary
- ASC 842-20-30-2
- ASC 842-20-30-3
- PwC Leases October 2020 220.127.116.11
- Deloitte A Roadmap to Applying the New Leasing Standard (2020) 7.2.3, 7,1,2, Q-A 7-2, Q&A 7-4
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