Questions Answered About Fair Market Value Leases
As ASC 842 compliance became effective for public companies, and private companies are now...
ASC 842 requires lessees to use the rate implicit in the lease agreement for the Net Present Value (NPV) calculations furthermore required to set up lease liabilities and ROU assets for virtually every lease. However, the FASB recognized that implicit rate information is not always readily available. ASC 842 allows the use of an Incremental Borrowing Rate (IBR) when the rate information is not included in the lease agreement
To fully calculate the implicit rate in a lease, the lessee has to know about many variables. Most of which are typically controlled very closely by the lessor. Some even impact negotiations and therefore the lessor is seldom likely to release all information. Therefore, the IBR is used most often in practice as lessees comply with lease accounting guidelines.
ASC 842 defines the IBR specifically as, “The rate of interest that a lessee would have to pay to borrow on a collateralized basis over a similar term an amount equal to the lease payments in a similar economic environment.”
ASC 842 also allows private companies to use a risk free rate. However, many private companies are opting to calculate an IBR as opposed to using the risk free rate. This is because of the required present value calculations. The charts below show a stream of 5 annual payments that add up to $500,000. Applying the NPV calculation in Excel using various discount rates proves that the lower the discount rate, the higher the NPV. Because NPV is the basis for the Lease Liability under ASC 842, many companies are correspondingly opting to use the higher IBR vs the risk free rate. Thus reducing the impact to the balance sheet.
There are many appropriate methods for capturing and maintaining the IBR. Some companies have contracted with firms that specialize in valuations, some work with their bankers on a regular basis to obtain the information, some work with their internal Treasury department, and the list goes on. Because the IBR is a key variable with a major impact on lease accounting calculations, it is important for companies to set an IBR policy and review with auditors. Below is one a practical method many companies use:
This is one practical method for capturing and maintaining effectively used IBR data. There are, however, others that may be appropriate. The best practice is to identify a reasonable method, document internally, and review with auditors.
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