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Lease classification

Question 3-17

Should a lessee assume the collateralized borrowing is recourse or non-recourse?

PwC response
A lessee should assume the lender has recourse to the other assets of the lessee. This assumption may
result in a lower incremental borrowing rate when the lessee has sufficient other assets (e.g., a high
credit quality corporation). However, if the entity has little to no other assets (e.g., a special purpose
entity with no other significant assets), this assumption may have little to no impact. In either
scenario, lessee specific facts and circumstances should be considered when determining the
incremental borrowing rate.

Example 3-16 illustrates how a lessee might determine the incremental borrowing rate.

EXAMPLE 3-16
Incremental borrowing rate – similar term

Lessee Corp enters into a lease of equipment with Lessor Corp. Lease payments are $100,000 per year.
The lease has a noncancellable term of 3 years with a 2 year renewal option. At lease commencement,
Lessee Corp concludes the renewal option is not reasonably certain of exercise (i.e., the lease term is 3
years).

At lease commencement, Lessee Corp obtains the following rate quotes from its third-party lender to
borrow on a fully collateralized basis:

□ 5% interest rate to borrow $300,000 for a 3-year term

□ 5.5% interest rate to borrow $300,000 for a 3-year term with an option to borrow an additional
$200,000 at the end of 3 years for an additional 2 years.

Assume Lessee Corp concludes the rates are reasonable and consistent with prevailing market rates
and its historical borrowings.

Which rate should Lessee Corp conclude represents the incremental borrowing rate?

Analysis

It depends. If Lessee Corp’s accounting policy is to utilize the lease term at the lease commencement
date (i.e., 3 years), the incremental borrowing rate of 5% would be appropriate.

If Lessee Corp’s accounting policy is to utilize the lease term inclusive of the renewal option, the
incremental borrowing rate of 5.5% would be appropriate. This rate considers that a lender would
adjust the rate to reflect the option in the arrangement to renew the borrowing for an additional 2
years even though the renewal option was not determined to be reasonably certain of exercise at the
lease commencement date. Generally, the inclusion of a renewal option will increase the incremental
borrowing rate, resulting in the recognition of a smaller right-of-use asset and lease liability.

Regardless of the accounting policy election made, Lessee Corp should apply the policy consistently to
all leases.

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