Discount Rate and the Implicit Rate in the Lease
To calculate the present value of the lease liability, a discount rate is required.
The standard states that the lessee should use the rate implicit in the lease when calculating the discount rate.
This is the interest rate being charged by the lessor to the lessee for leasing the asset. That's why, from a lessee's perspective, lease payments consist of a portion of principal and interest, unlike other commercial transactions like a loan where the interest rate is clearly stated and is a critical factor in deciding whether to enter into the transaction or not. With a lease agreement, a lessee will unlikely be communicated the interest rate in the lease payments.
A clue in calculating this number is in its name. It's the implicit rate in the lease, not the explicit rate.
Conversely, for a lessor who has determined the commercial terms of the lease and owns the leased asset, calculating the implicit rate in the lease is far easier.
The Definition
The rate of interest that, at a given date, causes the aggregate present value of (a) the lease payments and (b) the amount that a lessor expects to derive from the underlying asset following the end of the lease term to equal the sum of (1) the fair value of the underlying asset minus any related investment tax credit retained and expected to be realized by the lessor and (2) any deferred initial direct costs of the lessor.
So what does that mean? Here is the above definition summarized and each key term defined:
Defined terms:
Present value: Is the current value of a future sum of money or stream of cash flow given a specified rate of return. For further details on the definition of present value, refer here.
Lease payments: The known payments at the outset of the contact between the lessee and lessor
Residual asset value: the estimated value of the leased asset at the end of the agreement's term that is not the responsibility of the lessee.
Fair value: The price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date.
Investment tax credit: This amount will be deducted from the fair value amount of the asset
Deferred lessor initial recognition costs: Incremental costs of a lease that would not have been incurred if the lease had not been obtained. These amounts are added to the fair value.
How it Works In Cradle
In the Initial Recognition tab in the Key Financial Input section you will see the checkbox:
When this box is checked the following field will appear:
Input the total fair value, this includes:
Fair value less tax credits
Deferred lessor initial recognition costs
Cradle will then calculate the XIRR of the lease aka the rate implicit in the lease. For more information on how the XIRR function works, refer here.
How to recalculate Cradle's Rate Implicit in the Lease
The following video demonstrates how to use the Cradle discount rate calculator to calculate the implicit discount rate in the lease, and also provides instructions on how to verify the calculation:
Video length: 3 minutes
Alternatively, here is an example and the steps to calculate the discount rate implicit in the lease:
Commencement Date: 2022-01-01
Accounting End Date: 2024-09-10
Payment Frequency: Monthly
Payment Timing: In Arrears
Fixed payment Amount: $1,250
Payment Interval: 1
Payment Start Date: 2022-02-01
Fair Value: $29,720
Step 1: Input the above details in the Initial Recognition Tab
Note: All lease payments impact the XIRR calculation.
Step 2: To recalculate the Rate Implicit in the Lease, Go to Reports → Discount Rate Calculator
Step 3: Input the start date of the lease in the As-of field, and the fair value of the underlying asset then click Calculate
Here is the calculated discount rate using the implicit in the lease
Step 4: To verify the accuracy of the calculation. Click Export Excel
Step 5: Go to the second tab of the excel file
Step 6: Use the XIRR formula to include the dates and payments to recalculate the discount rate
FAQ
Why is the discount rate zero?
If the value of the lease payments is greater than the fair value, that will result in a negative discount rate that Cradle will round to zero.
Is it better to have a high or low discount rate?
In terms of complying with the lease accounting standards, that's not applicable. However, from a commercial perspective, the lower the discount rate, the lower your rate of return, and vice versa.