Interest Rate Volatility & Lease Accounting

Market fluctuations create challenges for 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.

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 and adjust the organization’s incremental borrowing rate (IBR) more frequently.  

How will interest rate volatility impact lease accounting?

ASC 842 requires discount rates to be applied to the accounting for most leases. The guidance prefers that the implicit rate of each lease is used “whenever that rate is readily determinable.” However, lessees are rarely privy to all the assumptions made by lessors to calculate the implicit rate.

Therefore, most companies use their own incremental borrowing rate (IBR) – or the risk-free rate for private companies only – to calculate the initial value of the lease liability. While IBR is calculated with company-specific factors like credit rating and lease terms, it’s also determined by current interest rates and economic conditions.

In the past, treasury departments may have adjusted IBR only once or twice a year. But interest rate volatility requires more regular adjustments. And these adjustments must be readily available for accounting teams to apply the correct discount rates to new leases or any changes to lease terms in a portfolio.

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 a lease is to be classified as finance. The correct discount rate is essential to accurate net present value calculations and directly affects a company’s finance and operating lease mix.

When applying updated discount rates to lease adjustments, a lease may become reclassified from finance to operating (or vice versa). On a company’s financial statements, the difference between the two classifications is that finance lease expenses are amortized as interest and depreciation, and operating lease expenses are amortized as straight-line lease expenses.

Therefore, if a lease is misclassified, it is not only a balance sheet problem, but also an income statement problem as well. 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. Careful adherence to policies must be maintained to avoid misclassifications and financial misstatements.

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