NetLease - Determining The Incremental Borrowing Rate
Overview
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 (“ROU”) asset and a corresponding lease liability. The lease liability and right of use asset are measured with an appropriate discount rate to calculate the present value of future lease payments. The following definitions and guidance come directly from ASC 842:
842-20-30-(2-3)
30-2 The discount rate for the lease initially used to determine the present value of the lease payments for a lessee is calculated on the basis of information available at the commencement date.
30-3 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 for all leases.
Rate implicit in the lease
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.
Incremental borrowing rate (IBR)
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.
Ways to determine IBR
1. Utilize existing borrowing rates for the company that have similar lease terms, payment terms, payment amount, economic life, and currency.
2. Compare the borrowing rates in competing entities with similar credit rating in the same industry.
3. Obtain borrowing costs from credible third parties such as lenders.
4. Compare US Treasury Yields from reputable third parties such as Bloomberg.
When to update the IBR:
842-20-35-5 If there is a remeasurement of the lease liability in accordance with paragraph 842-20-35-4, the lessee shall update the discount rate for the lease at the date of remeasurement on the basis of the remaining lease term and the remaining lease payments unless the remeasurement of the lease liability is the result of one of the following:
a. A change in the lease term or the assessment of whether the lessee will exercise an option to purchase the underlying asset and the discount rate for the lease already reflects that the lessee has an option to extend or terminate the lease or to purchase the underlying asset.
b. A change in amounts probable of being owed by the lessee under a residual value guarantee (see paragraph 842-10-35-4(c)(3)).
c. A change in the lease payments resulting from the resolution of a contingency upon which some or all of the variable lease payments that will be paid over the remainder of the lease term are based (see paragraph 842-10-35-4(b)).
Resources
Leases (Topic 842)- Financial Accounting Standards Board
https://www.fasb.org/jsp/FASB/Document_C/DocumentPage?cid=1176167901010&acceptedDisclaimer=true
Lease Accounting Guide (ASC 842)- PWC
https://www.pwc.com/us/en/cfodirect/assets/pdf/accounting-guides/pwc-lease-accounting-guide.pdf
A guide to the new leasing standard "The Deloitte roadmap to applying ASC 842"- Deloitte
Demystifying the new leasing standard "How to determine your discount rate for lease measurement"- Deloitte