By correctly calculating your discount rate, you will save your district money as well as potential difficulties during your annual audit.
For most school districts, preparations are well under way to make the transition from the old lease accounting to the new as required by the Governmental Accounting Standards Board (GASB) Statement No. 87, Leases. One of the most common questions I’m getting from districts as they prepare to comply with GASB 87 is “How do we determine the right discount rate for our organization?”
If all leases included a stated discount rate, this question would not come up. You would simply review each lease agreement, and there the rates would be. But we have found that more often than not lease agreements do not include a stated rate.
Another option is to get the implicit rate but that can be easier said than done. In fact, as a lessee, you are unlikely to be able to find out just by asking the lessor, since it would likely require the lessor to provide information they may not want to divulge, such as commissions and fees. But if you have access to amortization schedules showing principal and interest payments you could be in a position to recalculate the implicit rate.
Most likely, you will need to use an incremental borrowing rate, or IBR. This is an estimate of the interest rate that would be charged for borrowing the lease payment amounts during the lease term. There is no one size fits all approach to developing this rate. But there are certain key elements that you will need to take into account before you get started.
The key pieces of information you will need are:
- Commencement date: This year, this should be determined as of the date of implementation of GASB 87. Otherwise, it should be the date of commencement or within a reasonable time frame of that date.
- Lease term: The IBR for a three to five year lease may be different than the IBR for a 20 year lease. Given a typical upward sloping yield curve, a longer-term lease would have a higher IBR, holding all else constant, with a diminishing marginal increase.
- Credit worthiness: This is any recent rating by a major credit rating agency, if available. Public school districts are generally considered less risky since they have taxing power that provides guarantees.
- If you are the lessor, you will also need to consider the lessee’s industry.
Once you have this information, you are ready to calculate the specific IBR for each lease. You have a choice of two approaches, actual borrowing cost or bottom-up analysis.
Actual borrowing cost
- Credit rating: If your district has been rated by a major credit rating agency, this will be considered throughout the analysis.
- Outstanding debt: Does your district have bonds or other publicly traded debt? You can extract an implied yield based on current pricing as a useful benchmark. If the district does not have publicly traded debt, but has recently completed debt financing, this can be the benchmark.
- Adjustments to actual borrowing cost: If you are using the actual borrowing cost as the benchmark, you will need to make certain adjustments (i.e. security interest, changes in credit risk since a transaction, underlying risk-free differentials, term structure of credit risk).
If you cannot draw reliable conclusions from your district’s actual cost of borrowing, you will need to conduct a “bottom-up” analysis, in which the district determines a credit rating for the district, makes certain adjustments to arrive at a secured rating and map that rating into an appropriate yield curve.
As you prepare for the transition to this new accounting standard, the discount rate assumption is one of the most important judgments your district’s finance team will need to make. It can have a significant quantitative impact on the lease asset and liability valuations. By correctly calculating your discount rate, you will save your district money as well as potential difficulties during your annual audit.