The discount rate definition can vary depending on the situation at hand as it is utilized in accounting for all kinds of industries. In the case of lease accounting, the lease discount rate refers to the interest rate used when analyzing discounted cash flows to calculate the present value of future cash flows. The discount rate helps to determine the lease liability for operating leases in transition and for any new leases in the future. As such, this amount will affect what appears on the balance sheet for lessees. Discount rates are a crucial part of accurate lease accounting and the importance of these rates should not be overlooked. Read on to learn how to determine the appropriate discount rate according to the new ASC 842 standards.
Why Is the Lease Discount Rate Important?
Under ASC 842: Leases, operating leases longer than 12 months must be recorded on the balance sheet at present value. Companies must present value those future lease payments and record them as liabilities on the balance sheet using a lease discount rate. The lease discount rate is important to comply with the accounting standards and allow for readers of the financial statements to understand the future obligations the company has undertaken. Using a lease discount rate that complies with the new Lease Accounting standards under ASC 842: Leases, allows comparability and consistency between companies obligations and the present value of those obligations.
How To Determine Lease Discount Rate
The guidance allows for 3 ways to estimate the lease discount rate.
1. Imply the discount rate from the lease contract
It is rare that a company has visibility into the cost, other contracts for the leased asset, and current fair value in order to imply a discount rate. This approach is rare in practice. This is possible in Finance leases where the company is essentially financing the purchase of the asset through a lease. For Operating leases the company has less transparency into the underlying asset and other contracts that may be in place for use of the asset.
2. Estimate your borrowing costs based on your current borrowing program
Some companies have an active borrowing program that is active enough to use this approach to estimate a borrowing rate if they are borrowing frequently at various tenors on a secured basis. Most companies don’t have many secured loans and might use a recent term loan as a starting point for estimating an incremental borrowing rate. It is uncommon to have current borrowing data for all the various tenors of leases.
3. Estimate your incremental borrowing rate
Most companies need to estimate their incremental borrowing rate because the first two approaches aren’t viable for the entirety of their lease portfolio. ASC 842 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.” This often requires estimating a credit rating. The credit rating will provide insight into market based borrowing rates for similarly rated companies. Companies can apply a discount to the market based borrowing rates for collateralization. Premiums or discounts may also be applied for company specific factors. LeaseSCRE is a compliant, convenient, and cost effective application to estimate your incremental borrowing rate.
Lease Discount Rate & Incremental Borrowing Rate
The term lease discount rate and incremental borrowing rate are interchangeable since ASC 842 defined the appropriate discount rate to present value leases is the collateralized incremental borrowing rate.
About The Author
Chandu Chilakapati is a Managing Director at Alvarez & Marsal. He is Head of Innovation for Valuation Services and has 20 years of experience providing fair value solutions. He is a frequent speaker at National Accounting and Valuation Conferences. Mr. Chilakapati is the national lead for complex financial instrument valuation at Alvarez & Marsal.