NetLease - Discount Rate
Use Case: This article will give a background and then explain 3 different options for determining a discount rate.
Background
At the commencement date of a lease, the lessee should measure both the lease liability and the ROU asset. As it states in ASC 842-20-30-1, the lease liability is measured as "the present value of the lease payments not yet paid, discounted using the discount rate for the lease at lease commencement."
Discount rates follow a hierarchy set by the FASB. ASC 842-20-30-3 outlines these three rates: "A lessee should use the rate implicit in the lease whenever that rate is readily determinable. If the rate implicit in the lease is not readily determinable, a lessee uses its incremental borrowing rate. A lessee that is not a public business entity is permitted to use a risk-free discount rate for the lease, determined using a period comparable with that of the lease term, as an accounting policy election made by class of underlying asset." So the order should be 1) rate implicit in the lease 2) incremental borrowing rate (IBR) 3) risk-free rate (for most private companies).
Discount Rate Options
1) Rate Implicit in the Lease
Although the rate implicit in the lease is the first rate that should be used for discounting, it's worth noting that this rate is rarely accessible. The FASB even alludes to this in the standard quoted above, saying that the rate should be used "whenever that rate is readily determinable." The guidance defines the rate implicit in the lease as the rate that 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 more plain English, the rate implicit in the lease is essentially the profit margin that the lessor will make on the lease. Because of this, the lessor is highly unlikely to include this rate in the lease agreement or even disclose to the lessee the necessary inputs to calculate the rate. The NetLease tool does provide a calculator if the inputs are known, but chances are that the lessee will need to use one of the other two rates. It's worth noting that the rate implicit in the lease is likely the highest of the three allowable rates, which would result in a lower lease liability on the balance sheet.
2) Incremental Borrowing Rate
This rate is defined by the FASB as "The rate that, at lease inception, the lessee would have incurred to borrow over a similar term the funds necessary to purchase the leased asset." Think of this as the rate a borrower would have received from a bank had they gotten a collateralized loan on the leased asset for the lease payments (note this could be different than a rate to purchase the asset.) While this rate is much more realistic to obtain than the rate implicit in the lease, some caveats do still exist. Netgain recommends working with auditors to ensure the IBR is within their expectations.
The benefit of this rate versus the risk-free rate is similar to the benefits of using the rate implicit in the lease. The IBR will likely result in a lower liability than the risk-free rate, but will be more difficult to obtain than the risk-free rate.
3) Risk-Free Rate
As stated above, non-public companies are permitted to use a risk-free discount rate for leases using a period comparable with that of the lease term. Of the three, this will be the simplest rate to obtain. The risk-free rate on the later of lease commencement and transition to ASC 842 date should be used. For example, for a lease commencing on 7/1/2022, use rates for 7/1/2022. For a lease commencing on 9/1/2019, use the rate at the transition date (1/1/2022) if that lease is still active at transition. Follow these steps to obtain an appropriate risk-free rate.
1. Segment your lease portfolio into general buckets based on term (e.g., 2, 5, 10 years).
2. Align the risk-free rates found here (Treasury.gov or Bloomberg.com) with terms outlined above.
3. Document (including screenshots of the rates) and discuss with your auditors as early as possible during the transition process to ensure alignment.
A couple of options exist if the lease term does not exactly align with a stated treasury term. If a lease term is between two quoted treasury rates, an average rate may be used. An Excel tool that extrapolates a rate for dates between quoted treasuries is also linked below. This file can be used and uploaded in the "Documents" tab of NetLease as support for rate decisions. Work with auditors to ensure the rate selected is within reason based on their expectations.
It's important to note that this practical expedient must be applied to all leases in a portfolio, and will likely result in a lease liability and ROU asset that is greater than if the incremental borrowing rates were calculated separately.
Accounting Policy Memo Example - Application of risk free rate as lease discount rate