Three different interest rates are used for lease accounting.
“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).
Discount rate (also called the capital rate, imputed interest rate, or internal rate of return)
If a lease is finance, an interest rate is calculated for purposes of breaking down every rent payment into interest and principal repayment. The right-of-use asset (called gross asset in FAS 13) and initial liability of the lease are equal to the present value of the rents, excluding executory costs, at the discount rate. In FAS 13, this is never lower than the implicit or incremental rate; it is higher if the present value of the rents using the other rates is greater than the fair value of the asset (so that the gross asset is never greater than the fair value). In ASC 842/IFRS 16, this is the implicit rate if known, otherwise the incremental borrowing rate. This rate is normally calculated automatically by EZLease. (The few situations where you enter the discount rate yourself are described in Lease modifications.)
Implicit interest rate (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] 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.
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.
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.