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Lease classification

discount rate, the identification of lease and nonlease components, the allocation of consideration to
the components, and the fair value of the underlying asset.

3.3.4.6 Discount rate

Lessees and lessors should discount lease payments at the lease commencement date using the rate
implicit in the lease. If the information necessary to determine the rate implicit in the lease is not
readily available, a lessee should use its incremental borrowing rate.

Rate implicit in the lease

The rate implicit in the lease is defined in the ASC 842 Glossary.

Partial definition from ASC 842 Glossary
Rate Implicit in the Lease: 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.

A lessor may be required to calculate different discount rates when classifying a lease. When
evaluating the lease payments criterion to determine whether the lease is a sales-type lease, the rate
implicit in the lease should include initial direct costs if, at lease commencement, the fair value of the
underlying asset equals its carrying value. However, if the fair value of the underlying asset does not
equal its carrying value, the rate implicit in the lease should exclude initial direct costs.

If the lease is not classified as a sales-type lease, a lessor should include initial direct costs when
calculating the rate implicit in the lease to determine whether the lease is a direct finance lease or an
operating lease. In this case, initial direct costs should be included regardless of whether or not the fair
value of the underlying asset is equal to its carrying value.

If a lessee can ascertain the fair value of the underlying asset, the residual value estimated by the
lessor, and initial direct costs incurred by the lessor, it can calculate the lessor’s implicit rate. For
example, it may be possible for a lessee to calculate the rate implicit in the lease if (a) the lease
includes an automatic transfer of title or a bargain purchase option because the lessor’s estimated
residual value would be zero, and (b) the lessee concludes that any reasonable amount of initial direct
costs would have an insignificant effect on the rate. A lessee may also be able to obtain the necessary
information directly from the lessor. However, such information is rarely available to the lessee
considering the sensitive nature of the information to the lessor and the potential impact it could have
on existing or future lease negotiations. Accordingly, lessees and lessors will often use a different
discount rate for the same lease.

Although a lessee might be able to reasonably estimate the elements required to calculate the rate
implicit in the lease, it may not do so. If the rate implicit in the lease is not readily determinable, a
lessee must use its incremental borrowing rate for purposes of classifying the lease and measuring the
right-of-use asset and lease liability.

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