Yup, you guessed what it is: discount rate.
At this stage, it has become clear that determining the discount rate to measure the net investment in the lease will be no easy feat. But before you throw your hands up in exasperation, let's explore how you can navigate this challenging route.
The implicit interest rate
Although the implicit interest rate is not in itself a new concept, it still presents a challenge—namely, how to apply it in the new world of lease accounting. As a reminder, the standard defines the interest rate implicit in the lease as the discount rate at which the sum of the present value of (i) the lease payments and (ii) the unguaranteed residual value equals the sum of (iii) the fair value of the underlying asset and (iv) any initial direct costs (of the lessor).
If this implicit interest rate can be readily determined, then the lessee should discount the lease payments using it. If it can't, then the lessee should use the incremental borrowing rate, which is specific to:
- the lessee, specifically his/her company
- the terms of the arrangement, which is typically the lease duration unless the lease payments are paid up front
- the amount of the funding that is "borrowed"
- the "security" granted to the lessor, i.e. the nature and quality of the underlying asset
- the economic environment, or the jurisdiction and the time at which the lease is entered into as well as the currency in which the lease payments are denominated
Despite this guidance, figuring out the incremental borrowing rate is still much harder than it seems.
So many questions, so little time
The burning question on everyone's lips: do I need to determine a discount rate for every lease? The answer is yes: the lessee needs a discount rate for each lease to which it applies the new lessee accounting model. But, you've been thrown a few ropes—there are three exceptions to the rule:
- A fully prepaid lease: no future lease payments means nothing to discount (most likely relevant to some real estate leases where the lessee obtains the right to use the real estate for a single up-front payment).
- Variable payments to the lessor based on sales or usage: the lessee should recognise the variable lease payments as expenses as they are incurred (for example, electricity-generating assets such as wind farms where lease payments are linked to the amount of electricity generated).
- Leases to which the recognition exemptions have been applied, i.e. short term leases or leases with low-value underlying assets.
Now at this point you may be whispering to yourself, "She forgot the fourth one! What about the portfolio approach where you're allowed to apply a single discount rate for a portfolio of leases with similar characteristics?"
Well, research shows that the most effective blogs are around 500 words, and I'm already at 498, so we'll need to park it for another post. Until next time...
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.