Selecting the Right Lease Discount Rate for You

Among the many changes for lessee accounting in ASC Topic 842 is the requirement for lessees to record all lease assets and liabilities on the balance sheet based on the present value of the future lease payments. Determining the present value of future lease payments will require some valuation work. Namely, it will require determining an appropriate discount rate for each of the company’s leases.

Lessees have options when it comes to which method they use to determine their lease discount rate. It’s important to understand what those options are, how they differ, and the relative advantages or disadvantages of each in order to ensure the best method has been selected to address your lease arrangements.

Background

Over the course of a lease, the value of the lease payments will change due to changes in market rates, fewer remaining payments, and other factors. To estimate the present value of future lease payments, entities will need to determine an appropriate discount rate.

Lessees have three options for the lease discount rate:

• Rate implicit in the lease, if readily determinable
• Risk-free rate (private companies only)
• Lessee’s incremental borrowing rate

Some situations may limit the lease discount method used. For example, the rate implicit in the lease might not be reasonable estimable. The rate implicit in the lease is the rate of interest, at a given date, that causes the aggregate present value of (i) the lease payments and (ii) the amount that a lessor expects to derive from the underlying asset following the end of the lease term to equal the sum of (a) the fair value of the underlying asset minus any related investment tax credit retained and expected to be realized by the lessor and (b) any deferred initial direct costs of the lessor.

Public companies do not have the option to use a risk-free rate as their lease discount rate, as the risk-free discount rate is available for private companies only.

Even if your company qualifies for the risk-free rate, it may not want to use it. The risk-free rate method results in a comparatively larger liability than the other two methods. In rare cases, the present value could exceed the fair value of the leased asset, resulting in the classification of the lease as a finance lease instead of an operating lease. With finance leases, entities will generally recognize lease expenses sooner than with operating leases. Use of a risk-free rate could also make it more difficult to execute an initial public offering.

Incremental Borrowing Rate

In the third option for determining the lease discount rate, lessees calculate their incremental borrowing rate (IBR). Topic 842 defines IBR as the rate of interest that the lessee would have to pay to borrow, on a collateralized basis over a similar term in a similar economic environment, an amount equal to the lease payments.

There are a few different ways lessees can determine their IBR:

• Existing debt
• Lender quotes
• Estimating IBR

The downside to using existing debt is that it is unlikely to match the terms of all the leases, and it is unlikely to reflect a similar economic environment. Lender quotes are good for situations where lessees have a good relationship with a lender.

Depending on your circumstance, you may have no choice but to use the third option, which requires some additional valuation work.

Estimating the IBR

To estimate the IBR, lessees take a mosaic approach, combining different data points to get a full picture. Existing debt—its term, level of collateral, and date of issuances or market trades—will be one input. Lessees would also want to look at recent financing proposals for their term and collateral.

Credit ratings, either from a third party or synthetic source, are another input. A credit rating reflects a rating agency’s opinion of the buyer’s capacity and willingness to meet its financial commitments when due. Credit ratings can be given for the entire company or for a specific debt issuance. In instances where credit ratings are not available, valuation providers can help estimate a synthetic credit rating using: linear regression, an Ordered Logit Model, Damodaran’s Model or Moody’s online credit rating tool.

Taken all together, the data points help frame a rate and build a company’s collateralized yield curve. The complexity of the IBR estimation depends on your circumstances. Take the following examples.

Case Study 1: Manufacturing

A manufacturing company recently issued a two-year collateralized note with a yield of 3.5%. Its leases have remaining terms of one to 15 years.

To estimate its IBR, the manufacturer needs to “fit” its company’s note to a relevant corporate yield curve. A fit, in this case, would be a curve that comes as close as possible to the 3.5%, two-year yield on its recently issued debt. The manufacturer calculates the spread between its existing debt and the identified yield curve, and then applies that spread to the rest of the market yield curve.

Case Study 2: Health Care

A health care company has existing, unsecured debt that it issued two years ago. The debt is not traded or rated. Its leases have remaining terms of one to 30 years.

The health care company could try to fit the debt to a market yield curve from two years ago and roll it forward to a current curve, but that would assume the company’s outlook hasn’t changed since its debt issuance. Instead, the company estimates a synthetic credit rating to identify the appropriate yield curve. The identified yield curve is then “notched up” to approximate a secured curve.

Portfolio Approach to IBR

When adopting the changes to Topic 842, entities may be able to transition their leases using a portfolio approach, provided the grouped leases share common characteristics (i.e., term and underlying asset).
The portfolio approach may apply to the lease discount rate as well.

For More Information

If you have comment, questions or concerns about how to calculate the lease discount rate, please contact Charles Higgins .