Chapter 7 — Discount Rates

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).

 

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“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.

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).

 

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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.

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 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.