If there is no rate specified in the lease contract, the next option is to use the implicit rate approach. GASB 87 refences Statement 62 as one resource that can be used. Accordingly, the implicit rate can be defined as the internal rate of return on all payments or receipts related to the lease.
In order to calculate the implicit rate, you will need to know the fair value of the asset (net of any related tax credit), the lessor’s initial direct costs, the unguaranteed residual value, and the annual payment amount.
In the example below, we show a lease with a 5-year term that has a net fair value of $200,000 and $20,000 residual value. Indirect costs of the lessor are $5,000 and 5 payments of $41,668 are made in advance (starting in year 0). Negative values in the table above represent outflows, while positive values represent inflows (from the lessor’s perspective). The implicit rate will be the discount rate that makes the net present values of all cashflows equal to zero (the far right column in the table below). If using Excel, use the IRR function and reference the values in the Net Cash Flow column below (resulting in an internal rate of return of 5.02%).
Using the 5.02% internal rate of return calculated in the example above, discount the lease payments and the residual value back to the beginning. The sum of these two values should equal the sum of the fair value of the asset (net of any related tax credit) plus the lessor’s initial direct costs.
One of the key difficulties with utilizing the implicit rate approach outlined above is that lessors are often unwilling to provide information on their initial direct costs. In situations where this information is not readily available, the incremental borrowing rate is the next best option.