LEASE Common Denominator

In our fourth installment of our lease series, we discuss discount rate considerations used when present valuing future obligations related to leases.   

Discount Rate  

Once the term of the lease is determined, the next logical step is to calculate the amount of the right-of-use asset and lease liability by present valuing the lease payments over the expected lease term.  

 ASC 842 dictates that lessees are required to use the rate implicit in the lease if it can be readily determined when calculating the lease liability. However, in order to determine the rate implicit in the lease, a lessee needs to know several assumptions used by the lessor in pricing the lease, such as the underlying asset’s fair value, the estimated residual value of the asset, and any initial direct costs deferred by the lessor.  

 This information may not be readily available to the entity, so they often need to determine the rate by another method. As often suggested by the villain to the protagonist in movies, “we can do this the easy way or the hard way.”   

 Now you may ask, “what is the hard way?”  

 It is not always apparently clear, but it is likely harder than the easy way.   

 Following are some options to consider:  

IBR Approach:  

1. Start with the interest rates on recent borrowings.  

2. Consider other observable market rates.   

3. Adjusting those rates to reflect differences in the amount of collateral and the payment terms of the leases at or near the lease commencement dates.   

 This approach requires significant professional judgment and documentation to support the estimate. ASC 842 does not prescribe a method for estimating the IBR.   

 Following are some matters to consider:  

 A lessee may have borrowed under a debt facility that it can reference when estimating its IBR. You shouldn’t simply use the contractual interest rate on an existing debt facility as your IBR without adjusting the contractual rate so that it satisfies the definition of the IBR, including collateral considerations and timing of the debt facility’s origination compared to the lease commencement date.  

• An acceptable method to consider collateral when determine the IBR is to evaluate the collateral considered for the borrowing as follows:  

1. 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.  
2. The lessee should assume full collateralization and should not assume under or over collateralization.  
3. 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).  

Link to U.S. Dept of The Treasury Interest Rates    

Which method is preferred?  

The risk-free rate involves less judgment and is easier to determine. However, management’s decision of whether to use a lower or higher discount rate can impact other areas of the financial statements, including ratios. For example, using a higher discount rate results in a lower right-of-use asset which generates a higher asset turnover ratio. Conversely, using a lower rate (such as the risk-free rate) results in a higher right-of-use asset which generates a lower asset turnover ratio. The interest rate coverage ratio is also affected based upon the discount rate utilized (i.e., a higher rate generates higher interest expense and therefore lower interest rate coverage ratio). Ratios can also impact various debt covenants so this should be considered.   

In our next blog of this series, we cover accounting alternatives and policies. As always, let us know if we can be of any help!