# How Do You Calculate the Lessor Implicit Rate?

The lessor implicit rate, also known as the internal rate of return (IRR) or the discount rate, is an interest rate used by the lessee to discount future lease payments. It is a critical component of a lessee’s financial statement disclosure under ASC 842.

Generally, a lessee will recognize a lease liability by discounting the lease payments at the interest rate implicit in the lease if it is readily determinable. If this is not possible, then the lessee must use an incremental borrowing rate.

#### How Do You Calculate the Lessor Implicit Rate?

To calculate the lessor implicit rate, a lessee must know some information about the lessor and the underlying asset under the lease. This includes the fair value of the underlying asset, any initial direct costs of the lessor and the expected residual value of the underlying asset at the end of the lease term.

A lessee can estimate the implicit rate using the payment terms in a lease, some research into the underlying asset and an Excel present value function. A reasonable estimate of the implicit rate will help the lessee make a better decision about whether to purchase the leased asset or lease it.

#### What Is an Implicit Rate?

An implicit rate is the interest rate that causes the present value of the lease payments and the unguaranteed residual value to equal the sum of the fair value of the underlying asset, the lessor’s initial direct costs and investment tax credits. The implicit rate is the least-manipulative interest rate, and should be used when the lessee can determine it.

When determining an implicit rate, a lessee must ensure that it includes all lease payments made to the lessor, including fixed payments (including in-substance fixed payments) and variable payments linked to some index or rate. However, the lessor can exclude those that are based on sales or usage.

Several factors can affect the implicit rate, including the timing of the lease payments and the type of assets pledged as collateral. If the assets are low-value, the benefit of having security may be insignificant and the rate would need to be adjusted accordingly.

#### Incremental Borrowing Rate – How to Calculate It

When it comes to calculating the implicit rate, GASB states that entities should first use the interest rate implicit in the lease if readily determinable and then, if unavailable, use an estimated incremental borrowing rate. If the implicit rate is unavailable, the entity should use a risk-free interest rate or a municipal bond index rate instead.

The lessor incremental borrowing rate can be difficult to determine, but it is essential for statewide accounting purposes. It is also an important consideration for companies that need to make a lease versus buy decision.

A reasonable estimate of the lessor implicit rate can help an organization decide if they should lease or buy. It can help them compare the break-even point and the total cost of the lease to a comparable outright purchase of the asset. It can also help a company negotiate for better terms.