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Perspectives

Why do lease discount rates matter?

How to estimate an incremental borrowing rate (IBR)

The new leasing standard, ASC 842, dramatically increases the number of leases that companies may need to record on their balance sheets. Under some circumstances, lessees are instructed to use their incremental borrowing rate, which presents its own unique challenges. This paper offers guidance for solving the IBR problem—and examines why lease discount rates matter.

The importance of lease discount rates

Accurately estimating lease discount rates can have a significant impact on your company’s lease liabilities and right-of-use (ROU) assets.

Under the new standard, every lease with a lease term of more than a year must be recorded on the balance sheet as a right-of-use asset and a corresponding lease liability. The lease liability is measured by using an appropriate discount rate to calculate the present value of future lease payments.

Lessees are required to use the rate implicit in the lease (RIIL) if it can be readily determined. Absent the ability to determine the RIIL, lessees are instructed to use their incremental borrowing rate, which ASC 842 defines 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.

Choosing an appropriate lease discount rate

If a lessee did not incur borrowings at or near a lease’s commencement date for a term similar to the lease term—or for amounts similar to the lease payments—the lessee may need to determine its IBR by referencing the costs of borrowing for competing entities within the same industry with credit ratings similar to that of the lessee (for a similar term and seniority), or by obtaining borrowing costs from other credible sources such as lenders. The IBR should be representative of the interest rate that would be charged to borrow an amount equal to the lease payments. Also, the IBR should be an effective borrowing rate that takes into account any compensating balance or other requirements affecting the stated interest rate (e.g., leases that have guarantees by a third party should be based on an IBR with similar guarantees in place).

For many companies, one of the biggest challenges in determining an appropriate IBR is establishing an efficient and effective process for estimating the rates that would be applicable for borrowings on a fully collateralized basis.

The process for determining IBRs should be:

  • Repeatable
  • Well-documented
  • Consistent
  • Well-controlled
  • Efficient

These attributes are especially important because a variety of IBRs may be needed for different types of leases and lease terms. In addition, a company’s IBR can change over time and therefore needs to be updated periodically. Public companies will likely review their IBR determinations at least quarterly, given their quarterly reporting requirements.

Numbers on the board

Solving the incremental borrowing rate challenge

The good news is there are reasonable approximations, processes, and proxies that can be used to determine a collateralized IBR. Although a company’s IBR is typically expressed as a single-point estimate, it should be developed using a number of different data sources with appropriate adjustments to establish a rate that is meaningful for its intended purpose. It is also important for a company to develop its IBR in accordance with the ASC 842 definition and document the process with a reasonable rationale for the key inputs used and judgments made.

The credit quality of the entity should be analyzed to form a basis to develop appropriate borrowing rates. In addition, consideration should be given to the requirements within the guidance that the rates used to reflect a secured, or collateralized, cost of borrowing. For most entities, a curve reflecting secured borrowing rates for varying tenors will need to be developed so that suitable rates can be applied to leases with different remaining lease terms. In many cases, this may take the form of selecting or developing a rate curve based upon the credit quality of the entity, with an adjustment made for security.

The determination of an appropriate IBR involves multiple inputs and judgments. Some will start with a base rate that reflects general factors such as overall economic conditions, currency volatility, and the broad interest rate environment for various types of securities and terms and then will adjust for entity-specific factors such as credit risk. Others may start with bond rates that already incorporate a credit factor. In all cases, things like lease term/tenor, level of indebtedness, payment structure and timing, and parent/subsidiary structure should be considered. Finally, entities need to apply an adjustment for full collateralization that reflects the liquidity of the collateral chosen (e.g., the more liquid the collateral, the larger the potential adjustment to the rate).

Solving problem

Solving the IBR challenge

In practice, the model’s underlying details can be quite complex and vary significantly from one business to the next. However, the bottom line is that the IBR problem—although complex and challenging—is one that can be solved both effectively and efficiently with the right tools, data, and experience.

Download "How to determine your discount rate for lease measurement" to learn more.

Solving challenge
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