Financial Accounting and Reporting-CPA Practice Exam

What interest rate is used in calculating the present value of lease payments?

1. The market rate available for similar leases

2. The lessor's marginal cost of capital

3. The lessee's incremental borrowing rate or rate implicit in the lease if known

4. The average cost of funds for the lessee

The correct answer is: The lessee's incremental borrowing rate or rate implicit in the lease if known

In the context of lease accounting, the interest rate used to calculate the present value of lease payments is primarily based on the lessee's incremental borrowing rate or the rate implicit in the lease if that rate is known. When the rate implicit in the lease is readily available and determinable, it should be used as it represents the true cost of borrowing from the lessor under the specific terms of the lease agreement. If that implicit rate is not available, the lessee's incremental borrowing rate is used instead. This rate reflects the interest rate that the lessee would have to pay to borrow, on a collateralized basis, over a similar term and amount as the lease payments. Using either of these rates allows for an accurate calculation of the present value of the lease payments, as it links the lease obligation to the cost of capital associated with the lessee’s financial situation. This approach ensures the financial reporting accurately reflects the economic reality of leasing transactions. Other options, such as the market rate for similar leases or the lessor's marginal cost of capital, may provide useful information in different contexts but do not directly reflect the appropriate calculation method mandated by financial reporting standards when determining the present value of lease payments.