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Given the equipment-intensive nature of commercial construction, the new leasing standard, Accounting Standards Codification Topic 842 (Topic or ASC 842), could have a profound impact on a contractor’s financial statements and ratios. The most significant change under the new leasing standard requires a lessee to calculate a lease liability at each balance sheet date for both its operating and finance (formerly “capital”) leases. The only exception applies to certain leases with an original term at lease commencement of 12 months or less. This exception is quite beneficial to contractors given the frequency of short-term equipment rentals on projects. Accordingly, rental expense can be treated as they were in the past.  

While there is the burden of calculating a lease liability on long-term leases at lease inception and each subsequent reporting date, the discount rate used to calculate the lease liability is determined only at lease inception, unless the lease is subsequently modified. 

The question arises as to what requirements are placed on, or options are available to, a lessee in determining the lease liability discount rate under ASC 842. The general rule under Topic 842 is that a lessee should use the discount rate implicit in the lease. The rate implicit in the lease is the interest rate that results in the aggregate present value of the lease payments, plus the amount a lessor expects to derive from the underlying asset at the end of the lease term (e.g., via sale), to equal the fair value of the underlying asset(s); net of certain credits and costs. Simply put, the interest rate is solved to result in the present value of the aforementioned items to equal the fair value of the asset(s) at the date the lessee takes control.     


The problem in determining the rate implicit in the lease is that the lessee usually will not know, or be able to reliably estimate, the values for all the inputs required to calculate the lease liability. In particular, the lessee will usually not know certain costs incurred by the lessor to enter into the lease, or what amounts the lessor expects to derive from the leased asset(s) at the end of the lease term. As a result, a lessee will not be able to determine the interest rate implicit in the lease in most cases.   

Given that the implicit rate will most likely not be readily determined, the lessee must use its incremental borrowing rate (IBR). The IBR is the interest rate the lessee would have to pay to borrow funds on a collateralized basis over a similar term, in a similar economic environment. For the construction industry, obtaining the IBR for equipment is not overly difficult since it is common for contractors to finance equipment via debt. Accordingly, lenders should be able to provide a reliable discount rate assuming the data points are available.  

PRIVATE COMPANIES

A lessee that is not a public business entity is permitted to make an accounting policy election to use a risk-free discount rate for the lease. The risk-free discount rate would be based on the borrowing rate for the U.S. federal government or a similar entity, for a period comparable to the lease term. Usually, the rate of a zero-coupon U.S. Treasury instrument for the commensurate term provides an appropriate rate. Once a lessee makes this accounting election, it must use the risk-free rate (which cannot be negative) for all of its leases on a go-forward basis. 

Although making the “private company” election can significantly simplify the discount rate calculation, doing so is not without the following possible drawbacks:

  • The lessee is locked into using a risk-free rate for future leases.
  • Since the risk-free discount rate will generally be lower than the lessee’s IBR, the resulting lease liability and right-of-use assets will likely have higher values at inception. This has a pronounced negative impact on working capital since there is no current portion of property and equipment.
  • Using a risk-free discount rate will make it more likely that the lease is classified as a finance lease since the fair value of future lease payments is more likely to equal, or exceed, substantially all of the fair value of the underlying asset.
REASSESSING THE DISCOUNT RATE

Lessees are required to reassess the lease liability discount rate when there is a subsequent change to the initial lease terms or scope, assuming the changes are not accounted for as a separate lease or contract. Additionally,  if there is a change to the original assessment as to whether the lessee is reasonably likely to exercise an option to buy the leased asset(s) at the end of the lease term, then the discount rate may need to be reassessed.

When the discount rate changes, the lessee is required to remeasure the lease liability using the new discount rate and adjust the associated asset. In some cases, these re-measurements can result in a profit or loss.

As a contractor, it’s critical to understand the impacts that discount rates can have on financial statements.  Once an effective process is put into place to determine appropriate discount rates, a contractor will be well positioned to navigate and maintain reliable information under the new lease standard.   

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