Challenges in Determining a Lease’s Incremental Borrowing Rate
Public companies are facing challenges when determining the discount rate to record leases on the balance sheet when applying ASC 842 under the new lease standard. The lease accounting standard requires the use of the rate implicit in the lease when determinable, but this is often not feasible for lessees. As a result, public companies are required to determine their incremental borrowing rate (“IBR”). The process for determining a company’s IBR has been faced with a significant amount of auditor scrutiny, leading many companies to seek outside help with determining an appropriate IBR. The following is a brief summary of the issues and what companies should consider when determining their IBR.
What is ASC 842?
New accounting standards for lease accounting will go into effect for public companies this year. This standard will have a significant impact on most companies’ balance sheets. As part of the new guidance, companies are required to capitalize operating leases and create a lease liability and corresponding “right-of-use” asset for all leases with terms of 12 months or greater. This is a significant change from the legacy guidance, ASC 840, which allowed companies with operating leases to disclose as off-balance sheet financing activities in the “Commitments and Contingencies” note to the financial statements. Beyond changes to the classification of some leases and recording these contracts on the balance sheet at fair value, the Financial Accounting Standards Board (“FASB”) has issued new requirements for how lease liabilities are discounted.
Determining the Right IBR Approach
Determining the appropriate discounting approach will be a two-step process for most public companies. Under the new guidelines, companies are required to use the interest rate implicit in the lease if “readily determinable” to discount to present value. ASC 842-10-20 defines the rate implicit in the lease as the following:
The rate of interest that, at a given date, causes the aggregate present value of (a) the lease payments and (b) the amount that a lessor expects to derive from the underlying asset following the end of the lease term to equal the sum of (1) the fair value of the underlying asset minus any related investment tax credit retained and expected to be realized by the lessor and (2) any deferred initial direct costs of the lessor.
In most cases, this will be difficult for lessees to attain due to factors of the implicit rate being based on the lessors’ estimations and indirect costs. In the more likely event of the implicit rate not being readily determinable to the lessee, ASC 842 requires the use of a company’s IBR. The IBR as defined by FASB in ASC 842-10-20 is as follows:
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.
While no explicit guidance is provided in the new standard as to how companies should determine their IBR, certain factors should be considered and assessed when discounting to present value, such as lease-specific terms, a company’s credit quality, economic environment and 100% collateralization in determining cost of borrowing. Where ASC 842 differs from legacy guidance in ASC 840 is the consideration of collateral and the economic environment the lessee resides when determining costs of borrowing. The lease standard does not dictate the nature of the assets collateralizing the borrowing. Therefore, any collateral may be used to determine the IBR if the lessee has the right to pledge the collateral. Additionally, multinational companies may be required to determine multiple IBRs due to the required economic environment considerations for their leases.
To arrive at an appropriate IBR for each individual lease, companies must consider multiple inputs and exercise judgment. Methodology should be consistently applied and well-documented. For more information regarding lease discounting and incremental borrowing rates, please contact our Opportune professionals.
About the Author:
Thomas Fraser is a Senior Consultant in Opportune’s Complex Financial Reporting practice based in Denver, Colorado. Thomas has almost 10 years of financial and accounting experience encompassing technical accounting research, SEC financial reporting, hedge accounting and derivative valuation. He holds a bachelor’s degree in Accounting and Finance from Oral Roberts University.