Establishing a Lease Borrowing Rate: ASC 842 Approaches
Adopting the latest lease accounting standard (ASC 842) can be a complex process for private companies. One of the most common challenges a company faces is determining an appropriate discount rate to be used when identifying the appropriate lease classification and when measuring the right-of-use (ROU) asset and lease liability.
Where to start? ASC 842 requires both operating and finance leases to be discounted using the rate implicit in the lease. This is the interest rate that causes the present value of the lease payments and any residual amount the lessor can derive from the asset after the lease term to equal the fair value of the leased asset minus certain other items. If the implicit rate cannot be determined, which is often the case, the company can use an incremental borrowing rate (IBR). An IBR is the interest rate a company would have to pay to borrow funds equal to the lease payments over the lease term, assuming the loan was collateralized by the underlying assets.
Regulators also permit private companies to elect an accounting policy and use a risk-free discount rate in lieu of an IBR for each individual asset class. While it may seem enticing for companies without a treasury department to use a risk-free rate, there are trade-offs when compared to developing an IBR. The risk-free rate is based on the borrowing rate for the US Federal Government or a similar entity for a comparable period to the lease term, such as a zero-coupon US Treasury rate.
Advantages of using the risk-free rate: One of the biggest benefits of using the risk-free rate is that it simplifies the calculation for a private company. Due to the complexities of calculating IBRs, many private companies will rely on a third party to provide the initial calculation as well as any subsequent updates to the rate. As the risk-free rate is publicly available, accounting teams are able to reduce both the time and cost of calculating an IBR when accounting for leases under ASC 842.
Disadvantages of using the risk-free rate: Given the possible benefits, a private company might consider using the risk-free rate, although it is important to consider the drawbacks. The risk-free rate is typically low compared with the expected incremental borrowing rate for most private companies. As a result, using the risk-free rate election will likely increase a company’s lease liabilities and right-of-use assets. This impact is magnified for leases that are longer in nature, such as real estate. Additionally, using the risk-free rate might alter the classification of the lease from operating to finance as it will increase the present value of the lease payments as compared to the asset’s fair market value. Finally, if a private company is considering a public offering in the future (on its own or through an acquisition by a public company), then it will need to revert to using an IBR for its lease portfolio because the practical expedient only applies to private companies. Therefore, before making the decision to utilize the risk-free rate policy election, the company will need to analyze the applicable advantages and disadvantages.
Complexities of establishing an IBR: Private companies electing to use an IBR may find it difficult to establish a process for calculating their borrowing rates due without in-house treasury specialists or similarly structured borrowings (e.g., commencement date, term, collateralization) that align with their lease portfolios. If such information is not available, the company can develop an approximate IBR by considering internal and external debt factors or by engaging a third party to develop a synthetic debt rating and yield curve.
If a company elects to develop its own IBR, there are several items to consider as part of this calculation, including the following:
- Credit risk rating
- Debt and liquidity ratios
- Industry benchmarks
- Subsidiary guarantor relationship with parent company
- Subsidiary operating country
- Collateralized versus uncollateralized debt
Regardless of the discount rate used, the company should ensure the process to develop and apply that rate is substantiated by reasonable inputs and a well-documented process. This includes establishing a cadence for recalculating the discount rate on a periodic basis (monthly, quarterly, or annually) that aligns with the company’s reporting requirements. Choosing the appropriate discount rate upfront can reduce future rework and limit unintended lease classifications (e.g., failed sale-leaseback).