By LeaseCrunch® on June 29, 2023 at 7:01 AM
Navigating the complexities of lease accounting can be a daunting task, especially with the introduction of lease accounting standards like ASC 842, IFRS 16, and GASB 87. As an essential component of lease accounting, understanding and accurately calculating the lease discount rate is critical for lessees. Let’s take a look at the lease discount rate under these new lease accounting standards, the factors that impact it, and the steps you can take to calculate it with confidence.
What Is the Lease Discount Rate?
The lease discount rate is a rate used to determine the present value of future lease payments and further, the lease liability on a lease. The lease discount rate is determined by identifying the rate implicit in the lease. The implicit rate is the rate charged by the lessor and is usually stated in the contract.
To determine the lease discount rate, lessees should use the rate implicit in the lease. To ascertain the implicit rate, lessees need to know four things: the lease payments, the fair market value of the leased asset, the unguaranteed residual value of the asset at the end of a lease term, and the lessor’s initial direct costs. If the lessee cannot determine these factors, they should use the Incremental Borrowing Rate (IBR) instead of the rate implicit in the lease. Under ASC 842, non-public lessees also have the option of making a policy election to use the risk-free rate based on classes of assets if the implicit rate is not available.
Why Is the Lease Discount Rate Important?
As discussed earlier, the lease discount rate is important because it is used to measure the lease liability and right-of-use (ROU) asset. The lease discount rate has an inverse correlation to lease liability and ROU assets, meaning the higher the rate, the lower the lease liability and ROU asset.
How Do You Calculate the Lease Discount Rate?
To reiterate, calculating the lease discount rate implicit in the lease starts with knowing four things:
- The lessee’s contracted lease payments
- The fair market value of the leased asset
- The unguaranteed residual value of the asset at the end of the lease term
- The lessor’s initial direct costs
Mathematically, the equation for calculating the implicit rate is this:
PV (Lease or Subscription Payments) + PV (Lessor’s Residual Value) = Fair Value of Asset (less investment tax credits) + Lessor’s Initial Direct Costs
Once the implicit rate is determined, a lessee will use it to determine the present value of the payments throughout the lease. Again, if this rate can’t be determined then they should use the Incremental Borrowing Rate as their lease discount rate. Under ASC 842, non-public organizations also have the option to use the risk-free rate as the discount rate.
How Does the Choice of Lease Discount Rate Affect the Present Value of Payments and the Liability on the Balance Sheet?
The lease discount rate a lessee uses has a significant impact on the present value of lease payments and further, the lease liability. Here is an example: With a higher lease discount rate the lease liability will be lower. Inversely, with a lower lease discount rate the lease liability will be higher.
What Are the Implications of a High or Low Lease Discount Rate?
As stated earlier, having too high of a lease discount rate lowers the liability on a balance sheet. This will result in a lower right-of-use asset recorded on the balance sheet at the inception of a lease. This will then cause the lease expense and amortization of the right-of-use asset to be lower. This also makes it possible for financial statements to be misstated, which may affect the users of the financial statements such as bondholders, taxpayers, and other stakeholders. The same could be said for lease discount rates that are too low. These principles can also be applied to discount rates about SBITAs and GASB 96.
Can You Use The Borrowing Rate as the Lease Discount Rate?
Yes, for lessees under ASC 842, IFRS 16, and GASB 87, the Incremental Borrowing Rate can be used as the lease discount rate, but only if they are unable to determine the implicit rate.
How Often Should the Lease Discount Rate Be Reassessed?
Unless specific circumstances arise, the lease discount rate determined at the commencement of a lease term does not change. Reassessing these rates may be necessary if the arrangement requires modifications, remeasurement, impairment, or early termination.
Simplify Your Lease Discount Rate Calculations with LeaseCrunch
Understanding and accurately calculating the lease discount rate under ASC 842, IFRS 16, and GASB 87 is essential for achieving compliance under the new lease and accounting standards. However, navigating the complexities of these discount rates can be challenging without the right tools and expertise.
LeaseCrunch is an easy-to-use lease accounting software built to help you comply with the new lease accounting standards while streamlining your processes, including calculating your lease discount rate. It’s time to get rid of your spreadsheets. Contact us or schedule a demo to see how LeaseCrunch can save you time and money while accounting for your leases with precision.