Also called the "Rate Implicit in the Lease"
The implicit rate for a lessee lease is calculated by EZLease when it has sufficient information. For a lease classified under any of the new standards (ASC 842, IFRS 16, GASB 87), the implicit rate is defined as:
"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." (ASC 842-10-20; the language is almost identical in IFRS 16, Appendix A) GASB 87 does not explicitly define the implicit rate, though it refers to paragraphs 173-187 of GASB 62, which provides general guidance on calculating interest rates.
Generally, there is no investment tax credit, so we don't worry about that. (This was a feature of the federal tax code before 1987; it may exist in other countries, or at the state level. If so, it should be subtracted from the fair value.)
The lessor's initial direct costs are often unknown. If that is the case, no implicit rate can be calculated. EZLease displays "Unknown" for lessor's initial direct costs as a default answer. If the IDC is known to be zero, the user should enter that. The IDC must be numeric for EZLease to calculate an implicit rate (except for GASB 87, which does not reference it).
For ASC 842 and IFRS 16, then, the following data is required to calculate an implicit rate:
- Rent schedule
- Fair value of leased asset at inception
- Any estimated residual values, both guaranteed and unguaranteed
- Lessor's initial direct costs
The definition has been interpreted (in the ASC 842 examples and in Big Four accounting guides on leases) to mean that if the lessor's initial direct costs (IDC) are unknown, no implicit rate can be calculated by the lessee. EZLease has a field for lessor's IDC, which by default is set to "Unknown." This must be changed to a numeric value (which can be zero) for an implicit rate to be calculated. (For the Lessor Edition, the IDC is zero by default, and this does not hinder calculating the implicit rate, since the lessor is considered always to know what his costs are.)
One more limitation on calculating the implicit rate is that the undiscounted value of the lease's rent plus residuals must be greater than the fair value plus lessor's IDC. (If less, the rate would be negative.) Often, a lessee doesn't know what the unguaranteed residual is; lessors frequently do not provide this information, so as to hide how much of a profit they're making on the deal. However, if you have a fair market value purchase option at the end of the lease, that should be considered the unguaranteed residual value. (If you also have a guaranteed residual, the unguaranteed residual should be reduced by that amount to prevent double-counting.)
If the implicit rate can be calculated, it is always to be used as the discount rate for a lease under the new standards. However, since most lessees don't know the lessor's initial direct costs or unguaranteed residual value, it usually cannot be calculated.
The implicit rate is defined the same way, but the impact is different. The lessor, of course, knows their initial direct costs, so "Unknown" is not a valid answer for a lessor. Note that the IDCs are assumed not to be deferred if the fair value is different than the cost or carrying amount. However, once classification is determined, the implicit rate is recalculated based on whether or not the initial direct costs are actually deferred (see Initial direct costs for those rules).
It should usually be possible to calculate an implicit rate for a lessor if information is properly filled in. However, if the unguaranteed residual is not filled in for a relatively short-term lease, no implicit rate may be available, because the undiscounted rent plus residuals may be less than the fair value. In addition, no implicit rate can be calculated if no fair value is entered (and "Fair value not determinable" is checked), which could be the case for a lease on a part of a building.
A lease runs for 5 years (60 months), with rent of 1000/month (paid in advance), and an unguaranteed residual of 5000. The fair value at inception is 50,000. The lessor's initial direct costs are 1500.
The Excel formula to calculate the rate is:
=RATE(60, 1000, -(50000 + 1500), 5000, 1) * 12
We multiply by 12 because the rate is otherwise by month, since the payments are made monthly. The fifth parameter is 1 to indicate payments in advance rather than arrears (the vast majority of leases are payments in advance). The resulting implicit rate is 9.183%. For the lessee lease, the ROU asset and liability is 48,335. For the lessor lease (assuming the cost or carrying amount is the same as the fair value), the receivable is 48,335, and the unguaranteed residual asset is 3,165.
FAS 13/IAS 17
The formula for the implicit rate under the previous standards did not include lessor's initial direct costs. The implicit rate is used as the interest rate for the present value test (to determine if a lease is capital or operating) only when it is lower than the incremental borrowing rate. Once a lease is determined to be capital, however, the gross asset is limited to the fair value of the underlying asset, which effectively requires the implicit rate to be used if the present value at the incremental borrowing rate would be greater than the fair value.