The discount rate is used by a lessee to measure lease liabilities under the new leases standard. As lessees evaluate the appropriate discount rate to use, this video helps to cover key factors to consider including, (1) why the discount rate matters, (2) how the definition of the incremental borrowing rate or IBR has changed, (3) what can be used as collateral in determining the IBR, and (4) how to determine the term used for the IBR. As the application date of the new leases standard nears, it will be important for lessees to have answers to these questions to accurately measure their lease liabilities.
| Duration: 5:31
Hello, I’m Shannon Detling, a director in PwC’s national office.
Today we’re continuing our leases video series with a discussion on the discount rate that a lessee should use in measuring a lease liability under the new leases standard. In this video 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.
So, let’s start with why the discount rate matters. 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. In other words, the discount rate will directly impact the amounts recognized on the balance sheet for lessees. So, as a result, 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.
So, to summarize, under the new guidance, the lessee has to use a rate that it would’ve incurred to borrow an amount equal to the lease payments completely on a secured basis. It’s no longer the rate to purchase the entire asset.
So, what can be used as collateral in determining the IBR?
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. For example, if a company is leasing a building, we don’t think the lessee can use the entire building as collateral because the lessee doesn’t own the building. It doesn’t have the right to pledge the entire building.
An observable interest rate for an existing secured line could be an acceptable IBR. However it may be challenging for some companies to determine a secured borrowing rate for the length of the lease. For instance, a company may have secured borrowing arrangements with maturities of 3 years whereas they may have a 10 year lease. And others may not borrow on a secured basis at all. So 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.
There are some other things to think about regarding the term when determining the incremental borrowing rate.
For example, when there is renewal option in a lease that is not reasonably certain of exercise, we believe a lessee can make an accounting policy election to either use the accounting lease term (which would exclude the renewal option) ... or a rate that also reflects the existence of the renewal option.
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.
So let’s wrap up. With the effective date of the new leases standard quickly approaching, companies will make a lot of judgments including determining the incremental borrowing rate. But the good news is there are many resources available to help. For more information, please refer to the Leases page on CFOdirect.com. Thank you.