Leasing – Discount rate for the lease liability

Published on March 22, 2021

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The discount rate is used by a lessee to measure liabilities under the new leases standard. As lessees evaluate the appropriate discount rate to use, this video helps cover key factors to consider.

*Transcript text has been reduced for space restrictions. Watch the full video for the complete information.

Continuing our leases video series with the discount rate that a lessee should use in measuring a lease liability under the new leases standard. We’ll cover:

Why the discount rate in a lease matters and how it impacts lease accounting;

How the new standard has changed the definition of the incremental borrowing rate or IBR;

What can be used as collateral in determining the IBR, and

How to determine the term used for the IBR.

The discount rate is used to measure the lease liability for an operating lease at transition and for any new operating or finance lease going forward. The discount rate will directly impact the amounts recognized on the balance sheet for lessees. The discount rate will be important to more companies than before.

The standard requires companies to use the rate implicit in the lease … but only if it’s readily determinable. The rate implicit in the lease is the interest rate that causes the aggregate present value of the lease payments and the unguaranteed residual value of the asset … to equal the current fair value of the leased asset less any investment tax credit plus the lessor’s deferred initial direct costs. Usually a lessee won’t be able to readily determine the unguaranteed residual value nor the lessor’s deferred initial direct costs … so we don’t expect lessees will use the rate implicit in the lease very often.

If the lessee can’t readily determine the rate implicit in the lease, it should use its own incremental borrowing rate, or IBR. Now, that’s the same requirement as the current leasing guidance. But the definition of the incremental borrowing rate is different under the new guidance.

The new leases guidance 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.

Now, that’s different from the current guidance……..which requires companies to use a rate that the lessee would have incurred to borrow the funds over a similar term to purchase the leased asset…. and the rate didn’t have to be a FULLY collateralized or secured rate. The rate was usually a weighted average of secured and unsecured rates. Often this was based on what the lessee would pay on debt with characteristics approximating those of the lease, such as a similar loan-to-value ratio.

We think that any form of collateral can be used to determine the incremental borrowing rate, so long as it’s a fully-secured rate for a loan with similar payment terms.

We don’t think you have to use the leased asset as collateral. And in many cases, you may not be able to use it as collateral.

An observable interest rate for an existing secured line could be an acceptable IBR. It may be challenging for some companies to determine a secured borrowing rate for the length of the lease. A company may have secured borrowing arrangements with maturities of 3 years whereas they may have a 10 year lease. Companies may need to start with an unsecured rate and make adjustments to come to a secured rate. Or they may need to start with the term of payments under a borrowing and make adjustments to get to the specific term of the lease payments.

It’s also important to consider the timing of when principal payments are made on borrowings relative to the timing of payments for leases.

Many borrowings have a bullet payment in which the entire principal is due at maturity. Often, with leases, the portion of the payment that would be allocated to the principal occurs over the life of the lease as it’s an amortizing amount … which makes the weighted average life shorter. A shorter weighted average life typically results in a lower interest rate. Therefore, understanding the payment terms is important in determining the IBR. As an example, a 5 year borrowing with the entire principal payable at year 5 could have a different and usually higher interest rate than a 5 year borrowing where some of the principal is payable in installments at each payment date over the 5 years.

For more information, please refer to the leases section on CFOdirect.com.

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