By Colin Hannifin, Business Assurance & Advisory Services Manager
What Discount Rate is Appropriate When Calculating the Initial Value of a Lease?
Issued in February 2016, Accounting Standards Update (ASU) 2016-02 Leases (Topic 842) requires all long-term leases to be recorded on balance sheets. As entities grapple with the impact of this change, many are left wondering how to calculate the initial value of the lease. Though it sounds simple enough – the initial value of the lease is the future cash flows discounted back to present value – deeper consideration reveals a number of questions, including what discount rate is appropriate?
The ASU, which established Accounting Standards Codification (ASC) 842, allows for three potential appropriate discount rates:
- The rate implicit in the lease;
- The lessee’s incremental borrowing rate; or
- If the lessee is a non-public entity, a risk-free discount rate.
The Rate Implicit In The Lease
It isn’t always clear which of these options may be the most ideal for a lessee. ASC 842-10-65-1 states that a lessee “should use the rate implicit in the lease” whenever readily determinable. Starting with this preferred option, then, ASC 842-20-20 defines “rate implicit in the lease” as:
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.
In essence, the rate implicit in the lease is that which, when used, results in a present value of the lease and residual value that is equal to the fair value of the underlying asset and any initial direct costs deferred (that is, capitalized) by the lessor. This method relies on the lessee to understand the lessor’s anticipated residual value of the underlying asset and what costs the lessor has capitalized. As a result, many lessees will find this number difficult to calculate.
Incremental Borrowing Rate
The second option allows for a lessee to use its incremental borrowing rate. The standard, at ASC 842-20-20, defines the “incremental borrowing rate” as:
The rate that, at lease inception, the lessee would have incurred to borrow over a similar term the funds necessary to purchase the leased asset.
To apply this option, a lessee has to consider the nature of the lease, including the term of the lease, the payments required under the lease, the nature of the underlying asset, and the economic environment. After all, short term loans have different interest rates than a long term one and real estate loans carry different risks – and rates – than a loan secured by office equipment. The incremental borrowing rate should reflect these differences.
Many lessees may be tempted to use their weighted-average cost of capital as a short cut to determining the incremental borrowing rate. However, this is not permitted under the standard as the weighted average cost of capital also considers the cost of equity and is not specific to the lease contract.
The standard does allow the lessee to determine a single discount rate for a portfolio of leases with similar characteristics. However, regardless whether being applied to one lease or a portfolio of similar leases, determining the incremental borrowing rate can be difficult and time consuming for a lessee to calculate.
Risk Free Discount Rate
The final option is only available to nonpublic entities and allows entities to make an accounting policy election to use a risk-free discount rate when valuing its leases. This election can only be made for all leases – that is, either all leases are valued using a risk-free discount rate or no leases are valued using the risk-free discount rate. This election still requires lease-specific considerations: when applying the election, the risk-free discount rate is to be determined using a period comparable with that of the lease term.
Generally, the risk-free discount rate is the simplest rate for lessees to calculate. However, it is often lower than the rate implicit in the lease or the incremental borrowing rate. As a result, the right-of-use asset and lease liability will generally be higher when using the risk-free discount rate. Entities should be mindful of this trade-off of balance sheet bloat for ease of calculation. It may warrant reconsideration of the chosen option – or at least additional discussion with users of the financial statements.
The discount rate is an important element in the calculation of the initial value of a lease liability and right-of-use asset. The new lease standard offers three discount rate options from which non-public entities can choose (public entities are limited to just the first two options). Each have benefits and drawbacks, including the difficulty in calculation and the impact to a lessee’s balance sheet. Entities with significant leases should begin evaluating their leases, and their discount rates, now to be prepared when the standard goes into effect.
Additional Resources on ASC 842:
What Construction Companies Should Consider When Implementing ASC 842
ASC 842: Financial Statement Presentation and Disclosure Requirements of the Lessee
The information contained within this article is provided for informational purposes only and is current as of the date published. Online readers are advised not to act upon this information without seeking the service of a professional accountant, as this article is not a substitute for obtaining accounting, tax, or financial advice from a professional accountant.