7.1 General

ASC 842-10 — Glossary

Discount Rate for the Lease

For a lessee, the discount rate for the lease is the rate implicit in the lease unless that rate cannot be readily determined. In that case, the lessee is required to use its incremental borrowing rate.

For a lessor, the discount rate for the lease is the rate implicit in the lease.

Incremental Borrowing Rate

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.

Initial Direct Costs

Incremental costs of a lease that would not have been incurred if the lease had not been obtained.

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. However, if the rate determined in accordance with the preceding sentence is less than zero, a rate implicit in the lease of zero shall be used.

An entity uses discount rates to calculate the present value of lease payments when (1) determining lease classification (see Section 8.3 for the lessee’s determination and Section 9.2 for the lessor’s determination), (2) measuring a lessee’s lease liability (see Section 8.4), and (3) measuring a lessor’s net investment in a lease for sales-type and direct financing leases (see Section 9.3). Under ASC 842, the discount rate used by a lessee and a lessor is determined on the basis of information as of the lease commencement date. A lessor will always use the rate implicit in the lease. A lessee will typically use its incremental borrowing rate for the reasons discussed in Section 7.2.

Connecting the Dots

Discount Rate for Lessors Rarely the Same as That for Lessees

As described above, the lessor is required to use the rate implicit in the lease when calculating the present value of lease payments. In contrast, a lessee will generally use its incremental borrowing rate, since many of the inputs used to calculate the rate implicit in the lease are not readily determinable from the lessee’s perspective (e.g., initial direct costs of the lessor and the lessor’s estimate of the residual value of the underlying asset). Therefore, the lessor discount rate and the lessee discount rate would rarely be the same.

Bridging the GAAP

Differences Between Discount-Rate Terminology Under U.S. GAAP and That Under IFRS Accounting Standards

While the principles in ASC 842 behind the definitions of the rate implicit in the lease and the incremental borrowing rate are generally consistent with those in IFRS 16, the wording in the definitions varies.

Specifically, ASC 842 defines the rate implicit in the lease as follows:

In contrast, IFRS 16 defines the interest rate implicit in the lease as:

The rate of interest that causes the present value of (a) the lease payments and (b) the unguaranteed residual value to equal the sum of (i) the fair value of the underlying asset and (ii) any initial direct costs of the lessor.

Further, ASC 842 defines the incremental borrowing rate 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.

On the other hand, IFRS 16 defines the lessee’s incremental borrowing rate as:

The rate of interest that a lessee would have to pay to borrow over a similar term, and with a similar security, the funds necessary to obtain an asset of a similar value to the right-of-use asset in a similar economic environment.

As a result of these wording differences, the accounting outcome for an entity that applies the above definitions under U.S. GAAP could slightly differ from that under IFRS Accounting Standards. For more information about the differences between ASC 842 and IFRS 16, see Appendix B.

7.1.1 Rate Implicit in the Lease

The “rate implicit in the lease” is the interest 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 . . . by the lessor and (2) any deferred initial direct costs of the lessor” (emphasis added).1

Changing Lanes

Impact of Initial Direct Costs on the Rate Implicit in the Lease

During redeliberations, the FASB and IASB evaluated whether it would be appropriate to include initial direct costs in the determination of the lease’s implicit rate (in a manner similar to IAS 17’s requirement) or whether they should be excluded (in a manner similar to ASC 840’s requirement). Ultimately, the boards concluded that it would be more appropriate for an entity to include initial direct costs when determining the rate implicit in the lease because a lessor would generally price the lease to obtain a specific return by considering all costs associated with entering into the lease, including initial direct costs. Therefore, the inclusion of initial direct costs in the calculation of the lease’s implicit rate under ASC 842 differs from the calculation of the lease’s implicit rate under ASC 840 and will result in a lower interest rate.

7.1.2 Incremental Borrowing Rate

The incremental borrowing rate is 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.”

Connecting the Dots

Appropriate Forms of Collateral

On the basis of discussions with the FASB and SEC staffs, we think that in determining the incremental borrowing rate, a lessee should evaluate the collateral considered for the borrowing as follows:

The lessee should start with a rate that is obtained for a general, unsecured, recourse borrowing and should adjust that rate for the effects of collateral. This should have the effect of reducing the rate.
The lessee should assume full collateralization and should not assume undercollateralization or overcollateralization.
The collateral considered does not have to be the leased asset. It can be the leased asset, but it may also be any form of collateral that a creditor would be expected to accept to secure a borrowing for a similar term (i.e., collateral that is at least as liquid as the leased asset).

Connecting the Dots

Incremental Borrowing Rate for Leases Denominated in a Foreign Currency

In determining an incremental borrowing rate for a lease denominated in a foreign currency, a lessee, rather than using its functional currency, should calculate its incremental borrowing rate by using assumptions that would be consistent with a rate that it would obtain to borrow — on a collateralized basis and in the same currency in which the lease is denominated — an amount equal to the lease payments in that currency over the lease term.

Changing Lanes

Changes in the Definition of Incremental Borrowing Rate

The incremental borrowing rate under ASC 842 differs from the incremental borrowing rate under ASC 840. For example, under ASC 842, the incremental borrowing rate is the rate that the lessee would pay to borrow an amount equal to the lease payments on a collateralized basis over a similar term. Under ASC 840, however, the incremental borrowing rate was the rate the lessee could obtain to borrow the funds necessary to purchase the underlying asset.

In addition, under ASC 842, the incremental borrowing rate is the rate of interest that a lessee would have to pay to borrow on a collateralized basis (i.e., a secured borrowing). In contrast, under ASC 840, a lessee was not required to use a rate that takes collateral into account but should use a rate that is “determinable, reasonable, and consistent with the financing that would have been used in the particular circumstances,” regardless of whether the rate is secured.

Footnotes

ASC 842-10-25-4 states, in part, that “a lessor shall assume that no initial direct costs will be deferred if, at the commencement date, the fair value of the underlying asset is different from its carrying amount.” Therefore, in a sales-type lease, initial direct costs will be recognized as an expense at lease commencement unless no selling profit or loss is recognized upon the derecognition of the leased asset.

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This publication provides comprehensive guidance; however, it does not address all possible fact patterns, and the guidance is subject to change. Consult a Deloitte & Touche LLP professional regarding your specific issues and questions.