Determining the appropriate discount rate to use under FASB 842 and IFRS 16 is a little bit like being between a rock and a hard place.
According to the new lease accounting standards, which private companies have until the end of the year to implement in order to be in compliance, lessees need to recognize a lease liability on the balance sheet using either the rate implicit in the lease or their incremental borrowing rate (IBR).
At first glance, this choice appears straightforward enough. But actually this aspect of the new guidance is causing more than just a little confusion and frustration. So much so, that the topic is open for discussion in FASB’s next roundtable meeting scheduled for mid-May. (The meeting was originally slated for early April, but with concerns related to the coronavirus crisis, it was pushed back.)
Before getting into the specifics about what makes this discount rate determination so perplexing, private companies reporting under FASB 842 should be aware that the board offers an alternative in the form of a practical expedient.
Private companies can elect to use a risk-free rate instead of their IBR. Because the risk-free rate is usually going to be lower than the IBR, choosing this discount rate often results in a higher lease liability, so some companies may not want to go that route. You should carefully weigh the advantages and disadvantages before deciding on this option.
Moreover, if there are plans to take the company public, then the calculations would have to be redone as the risk-free ASC 842 discount rate is not valid for public companies.
How to know which rate to use:
Both FASB 842 and IFRS 16 are clear that if you know the rate implicit in the lease, that’s the one to use.
If the lease is for an asset like a vehicle or piece of equipment, the rate can be figured out without too much trouble. It should be relatively easy to know the fair value of the asset at the commencement of the lease and at the end of the lease and what your payments are. These amounts are all you need to calculate the present value of future lease payments. Then based on your known payments, you can determine what rate will take you from the initial fair value to the ending fair value.
But what about other leases?
The problem (the rock from the opening analogy) is that most of the time, lessees won’t know the rate or don’t have enough information to recalculate it.
First, you’re not usually going to see the rate written out in black and white in a lease because it’s an internal measure based on lessor data such as deferred initial direct costs and estimations that the lessor uses specifically for a particular lessee. Typically, lessors will not be amenable to disclosing the interest rate implicit in the lease as that information would allow lessees to know their profit margin.
Secondly, accounting experts believe determining the rate implicit in the lease will be challenging due to a slight change in the language in the new lease accounting standards regarding implicit rate. Although FASB 842 carries over “rate implicit in the lease” and “incremental borrowing rate” from the legacy guidance, the terms are interpreted a bit differently in the newer guidance.
Under the new standard, lessees must discount their remaining unpaid lease payments using the rate implicit in the lease when it can be “readily determined.” That qualifier is not actually defined in FASB 842.
But a meaning can be inferred by examining other parts of US GAAP where “readily determined” appears. The phrase is used in the context of deciding upon fair market value by using published market quotes or published determined prices--which makes determining that value an easier task than estimating it. So the new guidance seems to require a higher degree of certainty.
As mentioned before, the rate a lessor uses is rarely published, so it’s not expected that it can be readily determined in most instances.
That leaves the lessee with having to use its own incremental borrowing rate (the hard place mentioned in the opening.) It’s expected that most companies will use the IBR most of the time--even though it’s not a simple solution.
Incremental borrowing rate:
The boards explain the IBR as the interest rate a lessee would have to pay to borrow the value of the asset over a similar term length and with a similar security. In other words, it’s the rate a bank would charge you for a collateralized loan with the amount and terms being much like the lease in question. IBR is not based on fair value.
And this definition from the new standard is different from IBR under the legacy guidance. ASC 840 requires that a company use a rate that it would have incurred to borrow the funds needed to buy the leased asset over a similar term. The rate wasn’t required to be collateralized or secured. It was typically a weighted average of secured and unsecured rates and was often based on a similar loan-to-value ratio.
Companies that already have multiple debt agreements that are collateralized will have a less complicated process for calculating IBR. By taking data points from their other securitized debts with similar terms, they can estimate what the rate should be.
For companies without a portfolio of examples to access, calculating IBR will be a process of gathering information from multiple sources and making carefully thought out judgements.
Key components of IBR:
It’s important to remember that the incremental borrowing rate varies from lease to lease. Companies may choose a portfolio approach to determine a single IBR for a group of leases that have similar characteristics. The portfolio approach is allowed if you expect little material difference from accounting for each lease separately.
Whether you choose the portfolio approach or apply the standard to your leases individually, you should consider these components when you determine your IBR. Make sure to provide both quantitative and qualitative support in the documentation of your conclusions.
Lessee-specific credit risk:
Because the IBR is lessee-specific, a lessee’s creditworthiness, or its ability to repay its debt obligations, is the foundational basis for determining IBR.
If you can obtain a credit rating from one of the major credit-rating agencies, use it along with other data points to figure out your base credit-risk profile. If you don’t have a credit rating, you can develop a hypothetical one by using qualitative and quantitative measures. For example, one model for doing this considers liquidity and solvency financial ratios to assign a lessee into a credit-rating category. Another way to come up with a synthetic credit-risk profile is to perform a regression analysis of your financial metrics against a peer group of public debt issuers, giving you a credit rating on a ranked basis.
Whichever method you use to determine your credit rating, that information is the starting point for this first component of your IBR.
In addition, you need to take a big picture look at all the leases in a company that will require an IBR calculation. For example, if you are a subsidiary, it will likely be appropriate to use your corporate parent’s credit-risk profile if there exists a guarantor relationship between you. If your corporate parent guarantees your leases, then you only need to consider its credit-risk profile when you’re determining it for IBR.
Amount of the lease payments:
Now that discounted lease payments are included on the balance sheet as a lease liability, there is an impact on your overall debt obligations. If the lease payments are insignificant compared to your other debt obligations, the adjustment to your credit-risk may be minimal. However, if there is a significant impact, you will need to adjust accordingly.
Collateralized nature of the lease:
Always keep in mind that the IBR is determined on a secured basis. Therefore, it typically will be at a lower rate of return than on an unsecured basis because collateralized debts should have less risk.
Quality of the lessee’s collateral:
This component doesn’t necessarily need to focus on the specific leased asset, but the quality of your collateral as a whole. There may need to be an adjustment if it’s believed that you don’t have sufficient collateral in total to pledge to meet your lease payments. Also, if you or your parent company has high creditworthiness, making default an unlikely outcome, that fact will have a positive effect on any adjustment.
Borrowing term and lease term
Because the risks are different, a lease with a shorter term should have a different IBR than one with a longer term.
Economic environment of the lease and foreign-currency
The economic environment applies to the period in time and the place. A lease entered into in a foreign country that is highly developed has a different risk profile than one in an undeveloped nation. And of course, currencies different from US dollars have to be taken under consideration.
The need for reassessment
If any of the components change after the initial IBR determination, then generally you will need to reassess the IBR for that lease liability. This includes if there are any modifications to the lease contract terms.
And because market rates fluctuate and the new guidance requires periodic updates that reflect those changes, you will also need to establish how you will determine IBR for any new leases after your implementation date.
Conclusion: Let a software solution take some of the sting
No doubt about it, compliance to the new lease accounting standards will have many challenges. One of the more complicated aspects will be determining the appropriate discount rate. Lessees should use the rate implicit in the lease, but as obtaining that information is frequently difficult, companies will need to use their IBR.
IBRs are lease and lessee-specific and several components need to be considered in their determination. Alternatively, lessees can apply a portfolio approach or may elect a practical expedient to use a risk-free rate but should be aware of that rate’s impact on critical ratios.
Finally, lessees need to meticulously document which discount rate was used and how it was calculated.
One of the ways to ease the complexity of the implementation process is by using the right lease accounting software solution. At AMTdirect we have a team of accounting and software experts with over 20 years of experience to answer your questions and alleviate the confusion and stress of compliance. We are here to help.