Three different interest rates are used for lease accounting.
Incremental borrowing rate
Lessee
“The rate that, at the inception of the lease, the lessee would have incurred to borrow over a similar term the funds necessary to purchase the leased asset.” [¶5l] Note that this is a borrowing rate, not a cost of capital rate; all leasing is considered borrowing, and the rate is to be what it would cost to borrow additional funds. Typically, this information is available from a company treasurer’s or controller’s office. It is often based on the prime interest rate (at least for shorter duration leases).
Lessor
“The rate that, at the inception of the lease, the lessee would have incurred to borrow over a similar term the funds necessary to purchase the leased asset.” [¶5l] This is used by the lessor only under FAS 13 for a combined land and building lease where the value of the land is more than 25% of the total asset value (to calculate the portion of rent to be allocated to the land).
Discount rate
Lessee
ASC 842/IFRS 16: Previously called the capital rate, this is the interest rate used to present value the rents to determine the initial asset and liability for a lease, and then to accrue interest over the life of the lease. It is the Lessor’s implicit interest rate if known; if not known, the Lessee’s incremental borrowing rate is used.
If a finance lease is system-classified, it is filled in automatically. If the lease is user-classified finance, you are required to enter the discount rate. Enter the rate as a percentage (10% is entered as 10, not as .10). You can enter up to 12 digits to the right of the decimal place.
Lessor
(Previously called capital rate) If the lease is operating, this field is blank. If a finance lease is system-classified, it is filled in automatically. If the lease is user-classified finance, you are required to enter the discount rate. Enter the rate as a percentage (10% is entered as 10, not as .10). You can enter up to 12 digits to the right of the decimal place.
The most common reason to user-classify a lease is because a special situation requires overriding the normal classification process. It is generally best not to user-classify a lease finance even if you know it is finance, because you may not know the correct rate to use. Instead, let EZLease do the calculations based on the rent, fair value, and related information.
Implicit interest rate
Lessee
Also called the interest rate implicit in the lease; “The discount rate that, when applied to (a) the minimum lease payments, excluding… executory costs…, and (b) the unguaranteed residual value accruing to the benefit of the lessor causes the aggregate present value at the beginning of the lease term to be equal to the fair value of the leased property to the lessor at the inception of the lease.” [¶5k] This is often not known by a lessee; lessors often will not reveal their estimate of the unguaranteed residual value, to keep their expected profit to themselves. (For ASC 842/IFRS 16, it is even less likely to be known, because the lessor's initial direct costs are added to the fair value to determine the implicit rate.) If you know the unguaranteed residual (and lessor's IDC), you can enter that and EZLease will calculate the implicit rate.
Lessor
Also called interest rate implicit in the lease; “The discount rate that, when applied to (a) the minimum lease payments, excluding… executory costs…, and (b) the unguaranteed residual value accruing to the benefit of the lessor causes the aggregate present value at the beginning of the lease term to be equal to the fair value of the leased property to the lessor at the inception of the lease.” [¶5k] EZLease calculates this when you enter the unguaranteed residual; alternatively, you can enter the amount directly. For ASC 842/IFRS 16, any initial direct costs are added to the fair value to calculate the implicit rate, unless
ASC 842/IFRS 16
The implicit interest rate is now the discount rate that causes the present value of the rents plus unguaranteed residual to equal the fair value of the asset plus any deferred initial direct costs of the lessor. Since the lessor’s initial direct costs are not usually known, in most cases the implicit interest rate is unknown and therefore not used.
Discount rate: This is the name now used for what was called the capital rate. If the implicit interest rate is known, it is used as the discount rate. Otherwise, the incremental borrowing rate is used. This means that the right-of-use asset is no longer limited to the fair value of the underlying asset.
GASB 87
The implicit interest rate is not specifically defined in GASB 87, which refers to paragraphs 163-187 of GASB 62 for guidance. This passage does not specifically include initial direct costs, but defines the fair value in a way that would be consistent with including them. If an interest rate is stipulated in the contract, it should be used unless clearly inappropriate.
The final step in gathering the needed information for the classification of a lease is determining the appropriate Fair Value.