Interest Rate Volatility & Lease Accounting

Market fluctuations create challenges for accounting teams who are adjusting and applying appropriate discount rates to lease modifications.

Interest rates increased markedly in 2022 and directly impacted borrowing costs. But as the Federal Reserve pushed rates higher, U.S. economic growth slowed considerably, and recession concerns grew.

These factors may lead to an increase in interest rate volatility for 2023 and the long term.

What does interest rate volatility mean?

More changes to interest rates – up or down – require corporate treasury departments to keep a closer watch on market conditions. From there, they adjust the organization’s incremental borrowing rate (IBR) more frequently.  

How will interest rate volatility impact lease accounting?

The ASC 842 accounting standard requires companies to apply discount rates for most leases. The guidance states that users should apply the implicit rate of each lease “whenever that rate is readily determinable.” However, lessees are rarely privy to all the assumptions made by lessors to calculate the implicit rate.

First things first, what is a discount rate?

Understanding Discount Rate, Present Value & Net Present Value

First things first, what is a discount rate?

Most companies use their own incremental borrowing rate (IBR) to find the initial value of the lease liability. Private companies may use the risk-free rate instead. IBR relies on company-specific factors, such as credit rating and lease terms. But current interest rates and economic conditions also influence IBR.

In the past, treasury departments may have adjusted IBR only once or twice a year. But interest rate volatility requires more regular adjustments. These adjustments should be easy for accounting teams to access day to day. This way, they can apply the right discount rates to financial reports.

IBR and ASC 842 software

For organizations with numerous leases, calculating the IBR can be incredibly time-consuming. However, when you mix the right lease accounting software with accurate, verified data entry, you can streamline the process.

Automation🤝 Incremental Borrowing Rate

Approaching Incremental Borrowing Rate with ASC 842 Software

Automation🤝 Incremental Borrowing Rate

Finance or operating lease

When leases are put on the balance sheet with the assets and liabilities required by ASC 842, they are classified as a finance or operating lease. One of the tests for lease classification involves comparing the net present value of lease payments to the fair value of the leased asset.

The closer those two numbers are, the more likely it is that you're dealing with a finance lease. The right discount rate is important for accurate net present value calculations. It directly impacts the finance and operating lease mix in the lease portfolio.

When using new discount rates for lease adjustments, a lease may change from finance to operating or the other way around. In a company's financial statements, there is a key difference between the two types of leases. Companies record finance lease expenses as interest and depreciation. In contrast, companies record operating lease expenses as straight-line lease expenses.

Accounting for leases: no matter what type

The key differences between lease types

Accounting for leases: no matter what type

Therefore, if an accounting department misclassifies a lease, they create not only a balance sheet problem but also an income statement problem. A misclassification can also affect key metrics, for example: operating lease expenses are a part of EBITDA (earnings before interest taxes depreciation and amortization), while finance lease expenses are not. Companies must maintain careful adherence to policies to avoid misclassifications, skewed financial data and financial misstatements.

Manually tracking changes and applying updated discount rates becomes an arduous task for accounting teams. Companies must maintain adherence to ASC 842 policies to avoid misclassifications and financial misstatements.