A lessee, generally computes the present value of the minimum lease payments using its incremental borrowing rate. This rate is defined as: “The rate that, at the inception of the lease, the lessee would have incurred to borrow the funds necessary to buy the leased asset on a secured loan with repayment terms similar to the payment schedule called for in the lease.”
To determine whether the present value of these payments is less than 90 percent of the fair market value of the property, Delta discounts the payments using its incremental borrowing rate. Determining the incremental borrowing rate often requires judgment because the lessee bases it on a hypothetical purchase of the property.
However, there is one exception to this rule. If (1) Lessee knows the implicit interest rate computed by Lessor and (2) it is less than Lessee ’s incremental borrowing rate, then Lessee must use Lessor ’s implicit rate.
What is the interest rate implicit in the lease? It is the discount rate that, when applied to the minimum lease payments and any unguaranteed residual value accruing to the lessor, causes the aggregate present value to equal the fair value of the leased property to the lessor.
The purpose of this exception is two fold. First, the implicit rate of Lessor is generally a more realistic rate to use in determining the amount (if any) to report as the asset and related liability for Lessee. Second, the guideline ensures that Lessee does not use an artificially high incremental borrowing rate that would cause the present value of the minimum lease payments to be less than 90 percent of the fair market value of the aircraft. Use of such a rate would thus make it possible to avoid capitalization of the asset and related liability.