7.2 Determination of the Discount Rate for Lessees

ASC 842-20

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 instead of its incremental borrowing rate, determined using a period comparable with that of the lease term, as an accounting policy election made by class of underlying asset.

30-4 See Example 2 (paragraphs 842-20-55-17 through 55-20) for an illustration of the requirements on the discount rate.

7.2.1 Initial Determination of the Discount Rate

At lease commencement, a lessee must develop a discount rate to calculate the present value of the lease payments so that it can determine lease classification and measure the lease liability. When determining the discount rate to be used at lease commencement, a lessee must use the rate implicit in the lease unless that rate cannot be readily determined. When the rate implicit in the lease cannot be readily determined (which we expect to generally be the case), the lessee should use its incremental borrowing rate.

Changing Lanes

Required Use of Rate Implicit in the Lease (When Readily Determinable)

Under ASC 842, when the rate implicit in the lease is readily determinable, the lessee must use this rate regardless of whether it is greater than the lessee’s incremental borrowing rate. This requirement differs from that under ASC 840, which indicated that a lessee can only use the rate implicit in a lease when that rate does not exceed the lessee’s incremental borrowing rate and is readily determinable.

The example and discussion below further explain the considerations related to the initial determination of the discount rate. In addition, Example 2 in ASC 842-20-55-17 through 55-20 (reproduced in Section 7.2.5) also illustrates this determination.

Example 7-1

Determination of the Discount Rate for Lessees

Company A enters into an arrangement to lease a crane from Supplier for five years, beginning on January 1, 20Y1. Assume the following facts:

The estimated fair value of the crane is $195,000.
Company A must pay Supplier $37,500 annually, with the payment due at the end of each year.
The estimated residual value of the crane at the end of the lease term is $60,000.
Company A does not know the total initial direct costs deferred by Supplier.
Company A cannot readily determine Supplier’s estimate of the residual value of the crane at lease commencement.
There are no separate nonlease components in the contract.
Company A has an unsecured line of credit with a lending institution that bears an interest rate of 7.75 percent.
Company A receives an interest rate quote of 6.50 percent from its lender for a five-year loan of $187,500 that is secured by commercial equipment.

Evaluation of the Rate Implicit in the Lease

A lessee must use the rate implicit in the lease as its discount rate unless that rate is not readily determinable. In this example, while certain components of the rate implicit in the lease are readily determinable (e.g., estimated fair value and the lease payments), A does not know the initial direct costs that Supplier deferred or Supplier’s estimate of the crane’s expected residual value. Therefore, A would be required to use its incremental borrowing rate.

Evaluation of the Incremental Borrowing Rate

As indicated in Section 7.1.2, the incremental borrowing rate is the rate that reflects the interest a lessee would have to pay to borrow funds on a collateralized basis over a similar term and in a similar economic environment. As a result, when determining its incremental borrowing rate, the lessee is not limited to a rate that is collateralized by the leased asset; rather, the lessee can use any interest rate as long as the rate reflects a term similar to the lease term and the borrowing is fully collateralized.

In this example, A cannot use the rate on its unsecured line of credit because the borrowing is not collateralized. Instead, A would use as its discount rate the interest rate quoted on its five-year loan secured by commercial equipment because that interest rate is fully collateralized and is based on a term similar to the lease term (i.e., five years).

7.2.1.1 Lessee’s Consideration of Whether the Rate Implicit in the Lease Is Readily Determinable

ASC 842-20-30-3 states, in part, “A lessee should use the rate implicit in the lease whenever that rate is readily determinable” (emphasis added).

Generally, the rate implicit in the lease would be considered readily determinable when all of the material inputs used to calculate the rate are readily determinable (i.e., the lessee can readily determine the fair value of the underlying asset, the amount the lessor expects to derive from the underlying asset at the end of the lease term, and the lessor’s initial direct costs, provided that each of these has a material effect on the rate — see Section 7.1 for the definition of “rate implicit in the lease”). In contrast, the rate implicit in the lease would not be considered readily determinable when any of the material inputs are not readily determinable.

In scenarios in which material inputs are deemed readily determinable but immaterial inputs are not, it may be reasonable for a lessee to estimate those inputs when determining the rate implicit in the lease if such inputs are not expected to materially affect the resulting calculations (e.g., when the lessee does not know the lessor’s initial direct costs but the lack of precision in an estimate of a reasonable amount of initial direct costs would not have a meaningful impact on the calculated rate).

Connecting the Dots

“Readily Determinable” Is a High Hurdle

We believe that the phrase “readily determinable” is indicative of a high hurdle. That is, the information a lessee needs to determine the rate implicit in the lease would generally not be considered readily determinable from the lessee’s perspective because of its limited visibility into the actual inputs needed to calculate the precise rate (e.g., the lessee will generally not know the amount that the lessor expects to derive from the underlying asset at the end of the lease term). At the same time, lessees should not ignore available information about the inputs to the rate implicit in the lease.

Some may believe that a lessee can never readily determine the rate implicit in the lease unless all of the lessor’s inputs are fully transparent to the lessee. As discussed above, we believe that there may be limited exceptions to this view. Specifically, when a lessee is able to reasonably estimate the immaterial inputs used to calculate the rate implicit in the lease, we would not object to the use of an estimated implicit rate. However, a lessee is not required to attempt to estimate such inputs if they are not readily determinable in these circumstances and, therefore, may use its incremental borrowing rate when discounting its lease payments.

In January 2019, the FASB received an agenda request to include additional or amended guidance in ASC 842 regarding when a lessee should apply the rate implicit in a lease as its discount rate. This topic was further discussed at the September 2020 public roundtable (see discussion in Section 17.3.3.1). On the basis of the feedback received at the roundtable and other venues, the FASB elected not to further evaluate or change these provisions. As a result, we do not believe that there will be any subsequent changes and the FASB currently has no items related to ASC 842 on its technical agenda.

7.2.1.2 Factors to Consider in Determining the Lessee’s Incremental Borrowing Rate

A determination of the lessee’s incremental borrowing rate at the commencement date of a lease may be difficult. If a lessee did not incur borrowings at or near the commencement date of a lease that were for a term similar to the lease term, the lessee may need to determine its incremental borrowing rate through discussions with bankers, or other lenders, or by reference to obligations of a similar term issued by others with a credit rating similar to that of the lessee. The incremental borrowing rate should be an effective borrowing rate that takes into account any compensating balance or other requirements affecting the stated interest rate. When the lessee obtains a third-party guarantee of its lease payments, it should adjust its incremental borrowing rate to reflect the impact of that guarantee if obtaining a third-party guarantee for a similar borrowing that could have been used to purchase the leased asset would have affected the lessee’s borrowing rate for that debt.

7.2.1.3 Collateralization-Related Factors to Consider

An entity’s collateralized rate cannot be higher than its general unsecured borrowing rate. The starting point for determining a collateralized incremental borrowing rate is an entity’s general unsecured borrowing rate, given the term of the lease and the amount of the lease payments. That base rate is then adjusted to reflect the effect of collateral. Since adding collateral only improves the lender’s level of security, this should lower the applicable borrowing rate.

When estimating an incremental borrowing rate, it would generally be acceptable for an entity to use the leased asset itself as the assumed collateral. This view is consistent with most collateralized borrowings in which the lender can foreclose on the asset that was purchased with the proceeds of the loan. However, on the basis of discussions with the FASB and SEC staffs, we understand that other forms of collateral can also be used if they are likely to be accepted by a lender. For example, a lender that requires collateral would most likely accept U.S. Treasury securities instead of a fixed asset (e.g., building, equipment) because the Treasury securities are more liquid and therefore offer more security to the lender. In general, lender acceptance would most likely depend on the proposed collateral’s level of liquidity in relation to the leased asset. Assets that are more liquid than the leased asset would most likely be accepted as collateral, while assets that are less liquid would not. In addition, the more liquid the collateral, the greater the effect we would expect on the incremental borrowing rate.

On the basis of discussions with the FASB and SEC staffs, we understand that an entity should generally assume full collateralization (not undercollateralization or overcollateralization) and that it is not expected or required to establish levels of collateralization that would typically be required by lenders in similar circumstances (i.e., collateralization based on traditional loan-to-value requirements for loans related to different asset types).

Connecting the Dots

A Lessee’s Consideration of Its Credit Rating When Determining Its Incremental Borrowing Rate

As described in the discussion above, the determination of an incremental borrowing rate depends on a number of factors, including the amount of the borrowing, a lessee’s credit rating, and the lease term. Therefore, irrespective of whether the lessee has an excellent credit rating, it would generally be inappropriate for the lessee to use the same incremental borrowing rate for all of its leases, since it will need to consider all relevant factors in determining this rate.

As noted in Section 7.2.1, the incremental borrowing rate used by a lessee should reflect the interest rate that the lessee would have to pay to borrow funds from a third party on a collateralized basis. In certain instances, a lessee may not be able to obtain financing from a third party because of its overall financial condition and creditworthiness.

In such circumstances, the incremental borrowing rate may not be readily available and the lessee should instead use the interest rate available for the lowest-grade debt in the marketplace, adjusted for the effects of collateral.

The “rate” used as the incremental borrowing rate should be consistent with the lessee’s cost of borrowing for the specific purpose. That cost should be the effective cost of borrowing, including fees paid to originate the loan. Accordingly, the lessee should consider reasonable loan origination fees in computing its incremental borrowing rate.

7.2.2 Reassessment of the Discount Rate

A lessee must update the discount rate when the lease liability is remeasured (see Section 8.5 for a detailed discussion of lessee remeasurement), unless the remeasurement results from changes in one of the following:

The lease term or the assessment of whether a purchase option will be exercised, and the discount rate already reflects the lessee’s option to extend or terminate the lease or purchase the asset.
Amounts that it is probable the lessee will owe under a residual value guarantee.
Lease payments resulting from the resolution of a contingency upon which some or all of the variable lease payments are based.

In addition, a lessee would be required to reassess the discount rate when the contract is modified and that modification does not result in a separate contract. See Section 8.6 for more information.

7.2.3 Use of a Risk-Free Rate by Lessees That Are Not PBEs

In November 2021, the FASB issued ASU 2021-09, which allows lessees that are not PBEs to make an accounting policy election by class of underlying asset, rather than on an entity-wide basis, to use a risk-free rate as the discount rate when measuring and classifying leases.

As indicated below, ASU 2021-09 amends the current guidance in ASC 842-20-30-3 to allow a non-PBE lessee to make an accounting policy election, by class of underlying assets, to use a risk-free rate as the discount rate when the rate implicit in the lease is not readily determinable.

ASC 842-20

In addition to allowing lessees to elect to use the risk-free rate as an accounting policy by asset class rather than on an entity-wide level, the ASU requires lessees to:

Disclose their election, including the asset class(es) for which they have elected the accounting policy.
Use the rate implicit in the lease instead of the risk-free rate when the former is readily determinable, regardless of whether the practical expedient has been elected.

See Section 17.3.1.9 for a detailed discussion of ASU 2021-09, including the transition requirements.

As clarified by ASU 2021-09, the risk-free rate can only be applied by a lessee for leases when the rate implicit in the lease is not readily determinable. Before the issuance of this ASU, non-PBE lessees that had adopted ASC 842 were required to use the risk-free rate as the discount rate to measure all of their leases if they had elected this practical expedient. Upon adopting the ASU, lessees that previously applied this requirement may choose to discontinue using the risk-free rate as the discount rate for any class of underlying asset. Conversely, lessees that did not elect to apply the risk-free rate to all their leases upon adopting ASC 842 may now choose to apply the risk-free rate as the discount rate for any class of underlying asset. A lessee’s policy election regarding the classes of underlying asset to which it will apply the risk-free rate should be consistently applied.

Connecting the Dots

Underlying Asset Class

ASC 842 does not address or further define the phrase “class of underlying asset.” Before ASU 2021-09, entities were allowed to make other accounting policy elections by class of underlying asset, so entities may already have policies in place for how they define asset class. See Section 4.3.3.1 for information about applying this concept in ASC 842.

Connecting the Dots

Use of a Risk-Free Rate May Have Unintended Consequences

While a lessee’s use of a risk-free discount rate may reduce some of the complexities related to measuring its lease liabilities and ROU assets, there may be some unintended consequences. For example, using a risk-free discount rate would result in a lease liability and ROU asset that are larger than those that would have been calculated by using the lessee’s incremental borrowing rate. In addition, using the risk-free rate could result in a present value calculation that may equal or exceed substantially all of the fair value of the underlying leased asset, causing the lease to be classified as a finance lease rather than an operating lease. An entity should exercise caution in using the alternative accounting policies applicable to private companies (non-PBEs) if the entity expects that it may undergo an IPO or that its financial statements or other financial information may be included in another company’s SEC filings. See Section 18.8 for further discussion of an entity’s use of private-company (non-PBE) elections.

7.2.4 Incremental Borrowing Rate Used at a Subsidiary Level

In paragraph BC201 of ASU 2016-02, the FASB acknowledges that it may sometimes be appropriate for a subsidiary to use an incremental borrowing rate other than its own. That is, depending on the nature of the lease negotiations and the resulting terms and conditions of the agreement, it may be more appropriate to use a parent entity’s or consolidated group’s incremental borrowing rate if the borrowing power of these entities is factored into the lease negotiations.

7.2.4.1 Determining a Subsidiary’s Incremental Borrowing Rate When the Lease Terms Are Influenced by Parent or Group Credit

In some cases, a parent negotiates leases on behalf of its subsidiary so that the subsidiary can benefit from the parent’s superior credit. In other cases, a consolidated group might have a centralized treasury function that negotiates on behalf of all of its subsidiaries for the same reason. The negotiations often include guarantees or other payment mechanisms that allow the lessor to look beyond just the subsidiary for payment. This raises the question of whether it would be appropriate for an entity to use a rate other than the subsidiary’s incremental borrowing rate when accounting for a lease at the subsidiary level (if it is assumed that the implicit rate cannot be readily determined).

The appropriate incremental borrowing rate for measuring the lease liability would generally be based on the terms and conditions negotiated between the lessee and the lessor. Often, the pricing of the lease will solely depend on the credit standing of the subsidiary itself (i.e., the lessee in the arrangement). In other cases, the pricing may be significantly influenced by the credit risk evaluated at another level in an organization (e.g., the parent or consolidated group) on the basis of guarantees or other payment mechanisms that allow the lessor to look beyond just the subsidiary for payment. If the pricing of the lease depends solely on the lessee’s credit standing when the lease was negotiated, the lessee’s incremental borrowing rate should be used to measure the lease liability. However, if the pricing of the lease depends on the credit risk of an entity other than the lessee when the lease was negotiated (e.g., the lessee’s parent or a consolidated group), it will generally be more appropriate to use the incremental borrowing rate of that other entity.

Decentralized treasury functions within an organization may be an indicator that it is appropriate for the reporting entity to use the incremental borrowing rate of the subsidiary (i.e., the lessee in the arrangement) when measuring the lease liability. However, this fact is not individually determinative and should be considered along with the determination of whether the subsidiary’s (lessee’s) credit standing was used in the negotiation of the lease agreement. This view is consistent with paragraph BC201 of ASU 2016-02, which states, in part:

The Board . . . considered that, in some cases, it might be reasonable for a subsidiary to use a parent entity or group’s incremental borrowing rate as the discount rate. Depending on the terms and conditions of the lease and the corresponding negotiations, the parent entity’s incremental borrowing rate may be the most appropriate rate to use as a practical means of reflecting the interest rate in the contract, assuming the implicit rate is not readily determinable. For example, this might be appropriate when the subsidiary does not have its own treasury function (all funding for the group is managed centrally by the parent entity) and, consequently, the negotiations with the lessor result in the parent entity providing a guarantee of the lease payments to the lessor. Therefore, the pricing of the lease is more significantly influenced by the credit standing of the parent than that of the subsidiary.

The two examples below highlight scenarios commonly encountered in practice. In both examples, the credit of the parent or group is assumed to be superior to the credit of the subsidiary/lessee.

Example 7-2

On January 15, 20X1, Group A negotiates and executes a lease on behalf of Subsidiary B, one of the subsidiaries consolidated by A. The treasury function is maintained at A’s level (i.e., B does not have a stand-alone treasury function), and pricing of the lease is based on A’s creditworthiness. While both A and B are the named parties in the lease agreement, B is identified as the party that will occupy the leased property.

Since treasury operations (including the negotiation of lease agreements) are conducted centrally at A’s level, it would generally be appropriate for B to use A’s incremental borrowing rate (as opposed to B’s rate) when measuring B’s lease liability. This is because the negotiations with the lessor and the resulting pricing of the lease are based on the creditworthiness of A rather than that of B.

Example 7-3

On April 15, 20X1, Lessee A negotiates a building lease with Lessor B. Lessee A has its own treasury function that negotiates all significant agreements, including leases. However, A’s parent, ParentCo, provides a guarantee of lease payments to B as part of the negotiated terms of the lease.

Although A has its own treasury function and negotiates the term of its lease, it would be reasonable to conclude that the pricing of the lease was significantly influenced by the creditworthiness of ParentCo (as evidenced by ParentCo’s guarantee to the lessor). As a result, it would generally be appropriate for A as the reporting entity to measure the lease liability by using ParentCo’s incremental borrowing rate.

7.2.5 Determining a Discount Rate at a Portfolio Level

ASC 842-20

55-17 Example 2 illustrates the determination of the discount rate for the lease.

Example 2 — Portfolio Approach to Establishing the Discount Rate for the Lease

55-18 Lessee, a public entity, is the parent of several consolidated subsidiaries. During the current period, 2 subsidiaries entered into a total of 400 individual leases of large computer servers, each with terms ranging between 4 and 5 years and annual payments ranging between $60,000 and $100,000, depending on the hardware capacity of the servers. In aggregate, total lease payments for these leases amount to $30 million.

55-19 The individual lease contracts do not provide information about the rate implicit in the lease. Lessee is BBB credit rated and actively raises debt in the corporate bond market. Both subsidiaries are unrated and do not actively engage in treasury operations in their respective markets. On the basis of its credit rating and the collateral represented by the leased servers, Lessee’s incremental borrowing rate on $60,000 through $100,000 (the range of lease payments on each of the 400 leases) would be approximately 4 percent. Lessee notes that 5-year zero-coupon U.S. Treasury instruments are currently yielding 1.7 percent (a risk-free rate). Because Lessee conducts its treasury operations centrally (that is, at the consolidated group level), it is reasonably assumed that consideration of the group credit standing factored into how each lease was priced.

55-20 Lessee may determine the discount rate for the lease for the 400 individual leases entered into on different dates throughout the current period by using a portfolio approach. That is, Lessee can apply a single discount rate to the portfolio of new leases. This is because during the period, the new leases are all of similar terms (four to five years), and Lessee’s credit rating and the interest rate environment are stable. Because the pricing of the lease is influenced by the credit standing and profile of Lessee rather than the subsidiaries (that is, because Lessee conducts treasury operations for the consolidated group), Lessee concludes that its incremental borrowing rate of 4 percent is an appropriate discount rate for each of the 400 leases entered into by Lessee’s 2 subsidiaries during the period. Because Lessee is a public entity, it is not permitted to use a risk-free discount rate.

The FASB concluded that it may be appropriate in certain circumstances for an entity to apply the lease accounting guidance at a portfolio level. One such circumstance could be the lessee’s determination of the discount rate. When applying the guidance at a portfolio level, the lessee would need to appropriately stratify the lease population subject to this approach in such a manner that application of the lease guidance at the portfolio level results in an outcome that would not materially differ from the outcome that results from applying the guidance on a lease-by-lease basis. Examples of attributes that the lessee should consider in this exercise include lease term, form of underlying collateral, and amount of lease payments.

Connecting the Dots

Determining a Discount Rate at a Portfolio Level

During its redeliberations, the FASB considered how costly and complex it would be for preparers to apply the guidance in ASC 842. To alleviate this burden, the FASB decided to permit both lessees and lessors to apply the guidance in ASC 842 at a portfolio level. The Board noted that, when a portfolio approach is applied, it would be less costly not only to group similar leases together but also in other respects (e.g., when an entity uses judgments and estimates in recognizing a lease).

For example, paragraph BC121 of ASU 2016-02 indicates that it may be useful for an entity to use a portfolio approach when determining a discount rate:

The cost relief also could be particularly high for certain aspects of the leases guidance for which entities need to make judgments and estimates, such as determining the discount rate or determining and reassessing the lease term. For example, rather than establishing a specific discount rate for a single leased asset, an entity might conclude that it can establish a single discount rate applied to all leases in a portfolio because using that discount rate would not result in a materially different answer than using a discount rate determined for each.

We believe that determining a discount rate at a portfolio level could help reduce the cost and complexity of applying this guidance.

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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.