Which rate should you use?
The first thing you need to know is that you should use the rate implicit in the lease. If you know that rate, or if you can recalculate that rate, that’s what you use. If you’re thinking, “But I don’t know what that is! That’s why I clicked on this blog,” then you’re not alone. Most leases don’t clearly spell out the discount rate, so lessees don’t know it. Typically, you’ll be able to calculate that rate when you’re leasing vehicles or certain types of equipment, such as computers. In those cases, you know the fair value of the asset at the beginning and end of the lease, and how much your payments are. You can use that data to do a present value calculation to determine the rate you would need to get from the initial fair value of the asset to the ending fair value based on your payments.
What to do when you don’t know the fair value of the asset
The calculation above isn’t useful when you don’t know the fair value of the asset. After all, you’re not in the business of leasing out buildings or servers in data centers. In these cases, the boards say you should use your incremental borrowing rate (IBR). Here’s how the boards define IBR: if you went to a bank to obtain a collateralized loan with the amount and terms being similar to your lease, the rate the bank would charge you is your IBR. That rate should be based on lease payments over a similar term, not the fair value. If you work for a publicly traded corporation, you can get this information from your treasury department. Your treasury department will need very specific information to provide the right calculation. You can’t just ask them for a borrowing rate with no specifics. That’s why the definition we outlined above is so important. Here’s what you need to tell your treasury department to enable them to give you the correct IBR:
- Lease term – The rate for a 3-year lease will be very different from the rate for a 20-year lease.
- Subsidiary – The rate you use has to be the rate for that particular subsidiary. If it’s an individual subsidiary with its own cash flow, then you need to use the rate for that subsidiary.
- Note: If the lease is guaranteed by the parent, that may change which rate you use. The key determinant here is where the cash flow comes from.
- Currency – The rate for a lease using Japanese yen will be different from that of a lease using USD.
- Purchase vs. lease – Under 840, you would use the rate a bank would give you to purchase an asset. Under 842, you need to use the rate a bank would give you to satisfy your lease obligation.
- Commencement date vs. earliest comparative period – Use the rate of the earliest comparative period presented or the commencement date, whichever is later. For example, if a lease started on 1/1/16, a public company would use the borrowing rate as of 1/1/17. If the lease started in 3/1/17, then the pubic company would use the borrowing rate as of 3/1/17.
- Note: this may change with the new practical expedient, which is expected to be released soon.
What not to do
A common mistake when calculating discount rates is using your weighted average cost of capital (WACC) to determine your discount rate. This is the wrong approach because WACC includes an equity component. Another potential pitfall is forgetting to document how you arrived at the discount rate. Remember, you’re making some judgement calls, and your auditors will be paying close attention to how you approach this calculation. Document your work and you’ll save yourself from questions from your auditors in the long run.
How current GAAP differs from the new standards
Under current GAAP, when you calculate your present value of minimum lease payments, you have to compare it to the fair value of the asset. Current GAAP precludes you from recording an asset on your books that is greater than the fair value. Therefore, if the present value exceeds the fair value, you increase your interest rate, which reduces your liability. Let’s take a closer look at how that works using our present value calculator, which is a free tool that you can download to use yourself.
As you can see, increasing your interest rate lowers the present value, which enables you to get the present value to equal the fair value. Then, you would record that amount to be in compliance with current GAAP. Under the new standards, this approach is no longer allowed. You record the asset at the higher value, and then you immediately impair it. This means you’ll take an immediate hit on your books. So, if the present value of your lease payments is $100,000, but the fair value of the asset is $80,000, you would immediately write off $20,000 on the asset to comply with the new standards. Because of this change, your auditors will be paying more attention to ensure that you don’t attempt to lower the interest rate to get your asset to fair value. The silver lining here is it gives you an opportunity to do a thorough lease vs. buy analysis.
Choose the right solution
The right lease accounting solution – in terms of both software and expertise – will make this process go much more smoothly. If you tell regulators and auditors that the solution you chose didn’t prompt you to gather this information or that you received the wrong advice, that won’t suffice as an explanation for your non-compliance. Ask any potential software vendor or consultant to show you how their solution will enable you to address this challenging issue with confidence.
LeaseQuery enables you to fully comply with FASB ASC 842 and IFRS 16. Schedule a free consultation and demo to see how.
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