Discount rates are one of the new data points that need to be captured when implementing the new lease accounting standard. The guidance for non-public companies is more lenient than that for public companies, but it will require significant consideration as the adoption date quickly approaches.
Background of the lease accounting standard
The Financial Accounting Standards Board issued Accounting Standards Update 2016-02 Leases (“ASU 2016-02”) which will require companies to capitalize all operating lease obligations that exceed 12 months. Historically, operating lease obligations have been off-balance sheet and only addressed in the notes to the financial statements, with limited descriptions and explanations surrounding the contracts and arrangements that give rise to the obligation. In calculating the amounts to capitalize, the right-of-use asset and related lease liability, the company will take the rent payments and compute a present value using a discount rate.
Why is the discount rate so important?
Consider a ten-year real estate lease with monthly payments of $10,000. Below are the present values of those cash flow payments using Excel’s PV function (present value) along with a few example interest rates:
The range of the resulting present values is significant, so scrutiny is imperative when applying the discount rate.
Start with the calculation of the rate implicit in a lease
The guidance suggests the discount rate should be the rate implicit in the lease. Rates explicit in lease agreements are rarely accurate or meaningful. If the fair market value of the leased asset is easily determined, you can back into the rate using some Excel wizardry. If you are leasing a piece of equipment, ask the lessor what they would sell it for today – or use eBay and search completed sales. Also, consider searching other aftermarket equipment resellers (including the manufacturer).
In Excel, use the IRR function (internal rate of return): schedule out the payments as positive values with the fair market value amount being the first payment in the series (this amount should be entered as a negative). This effectively reflects the lessor’s transaction, purchasing an asset (outflow) and leasing it for payments (inflows). The result is the rate of return implicit in the lease.
Private companies: risk-free rate or incremental borrowing rate
The guidance permits private companies to elect an accounting policy to use a risk-free rate (i.e. Treasury Bill) of a similar term. This is good news, but keep in mind risk-free rates are generally lower than a company's incremental borrowing rate. Lower rates yield higher present value computations. If your goal is to minimize the lease liability, be mindful of the math. Additionally, the higher present value could throw the lease into the finance category (capital lease).
If you can’t back into the rate and you don’t elect the aforementioned accounting policy, your next option is to use the incremental borrowing rate. The guidance suggests this rate should be “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.” Breaking this down, if you borrowed the money from a bank and pledged collateral, what rate would they give you. This can get extremely complicated by employing credit ratings, yield curves, inflation, etc.
An option to consider for assessing the IBR is the rate on a revolving line of credit already maintained by your Company. If you have a line of credit with capacity – that could be the rate. You could purchase the asset by drawing down funds from the line of credit. Alternatively, you might use that line of credit to make the lease payments. The cost of drawing down on that line is, effectively, the rate explicit on the line. What if you don’t have a line of credit? Ask your bank to quote you a rate given the facts and circumstances of the lease in consideration.
Adoption date is quickly approaching
When transitioning at adoption date (January 1, 2019, for public companies and January 1, 2020, for non-public companies), companies will be required to apply the effective discount rates at that date. It is not the rate at the commencement date of the lease. So, get with your auditors and hash out a game plan. Finalize your rates in the fourth quarter of the fiscal year to help expedite the math at year end.
After the transition date, discount rates should be determined as of the commencement date of the lease. For larger companies with significant leasing portfolios, consider a portfolio approach to help simplify the process. Under this approach, companies could periodically (semi-annually) determine discount rates at various term intervals. The company should evaluate, perhaps using a sensitivity analysis, the impacts (i.e. materiality) of using the portfolio approach. This will keep the auditors at bey when it comes time for evidence.