Entities that are not public business entities (i.e. private companies, not-for-profit entities, and employee benefit plans, hereafter collectively “private entities”) received a green light to use a risk-free discount rate more selectively for their adoption of ASC 842. In a move designed to make applying the new lease accounting standard less costly, the Financial Accounting Standards Board (FASB) released Accounting Standards Update (ASU) 2021-09 in mid-November. ASU 2021-09 provides private entity lessees more flexibility in how they determine the discount rate for measuring lease assets and liabilities.
The following explores what lessees need to know about how the change to the risk-free discount rate can reduce cost when applying the lease accounting.
The Need for Discount Rates in Lease Accounting
Lessees account for the right-of-use assets in their leases by adding together the present value of the lease payment not yet paid (the lease liability), initial direct costs of the lease, any prepaid lease payments, and then subtracting any lease incentives they received from the lessor.
The first item, the present value of the lease payment not yet paid, is where the discount rate initially comes into play. As we discuss below, this is easier said than done and can significantly affect the lessee’s recorded right-of-use assets and lease liabilities. Non-public lessees have three options for determining the discount rate for their leases:
- The rate implicit in the lease, if readily determinable
- The lessee’s incremental borrowing rate (IBR), or
- A risk-free rate for a period comparable to the lease term.
Rate Implicit in the Lease
The rate implicit in the lease is the interest rate that results in the present value of the lease payments and lessor’s expected future value of the residual asset equaling the fair value of the underlying leased asset less the lessor’s related investment tax credit plus the lessor’s deferred initial direct costs.
When leasing from third parties, the rate implicit in the lease is usually not readily determinable as the lessee generally will not have insight into the lessor’s assumptions such as the investment tax credit, initial direct costs or estimated residual value of the asset. The bottom line – lessees that have leases from third parties frequently will need to use a different discount rate.
A Closer Look at the Incremental Borrowing Rate
The IBR is the rate of interest a lessee would have to pay to borrow on a collateralized basis over a similar term in an amount equal to the lease payments in a similar economic environment. To reach this determination, lessees have several options: evaluate existing debt, draw comparisons to similar entities, solicit lender quotes; or estimate their IBR through the use of adjusted yield curves.
Using any of the first three options for determining their IBR may be a tall order for a lessee. The first requires the lessee to have collateralized debt that aligns with the terms of all the entity’s leases and for the lessee’s debt and lease arrangements to have commenced in similar economic environments. The second option would assume there is a like-kind (same credit rating) public entity with lease arrangements or collateralized debt with similar terms and commencing in similar economic environments. To get lender quotes, lessees would need an existing relationship with a lender, or lenders, and be able to evaluate whether the quotes are reliable. Left with these choices, many private entity lessees find that they must estimate their IBR.
Estimating IBRs is a challenging estimation process that uses existing debt borrowing rates or comparisons to like-kind entities, and credit ratings as inputs to build a collateralized yield curve and may require hiring a valuation specialist. The cost of determining the incremental borrowing rate in this fashion was a significant factor cited by the FASB in deciding to provide additional flexibility in the use of the risk-free rate.
The Appeal of the Risk-Free Rate
The risk-free rate is designed to be a practical expedient that private entities can use to bypass IBR estimation and thus reduce cost of applying lease accounting. Initially, private entities could only select the risk-free rate practical expedient at the entity-wide level. Although the election of the risk-free rate could significantly reduce costs of determining a discount rate, many lessees were hesitant to elect the risk-free rate entity-wide because it would result in large, long term leases (such as typical real estate leases) being recorded at significantly larger liabilities than if the IBR had been used.
ASU 2021-09 allows private entity lessees to utilize a risk-free rate by class of the underlying lease asset giving the entity considerable flexibility.
As a result of this change, private entities may find advantage in assessing their common lease practices by class of asset to find the ideal mix of providing benefits of more accurate rates and the cost of determining the discount rate for each new lease. For instance, a private entity may wish to use the risk-free rate for leases where the discount rate has a smaller effect (smaller dollar and shorter term leases) and for classes of underlying assets where they enter into leases frequently resulting in a need to determine discount rates often (and thus incurs greater cost), for examples for leases of office equipment.
At the same time private entities may wish to retain use of the IBR for their larger leases (such as real estate) where the long length or high dollar amount of the leases results in the rate having a significant impact on the amount of the asset and liability. Leases of long length or high dollar amounts may also cause the lease to be accounted for as a finance lease instead of an operating lease. For the longer, high-dollar leases that are infrequently entered into, the cost of determining an IBR may be worthwhile when measured against the benefit provided to the financial statement users by the more accurate measurement.
The FASB also clarified that if there is a rate implicit in the lease, lessees must use that rate to calculate present value of the lease payments even if the lessee uses the IBR for other leases in that class of underlying assets or has elected to use the risk-free rate for other leases of the same class. This clarification means that related party leases will likely need to be accounted for based on the rate implicit in the lease. If the related party leases has a non-market lease payment that could result in unusually high or low interest rates for those leases.
Private entities will also now be required to disclose the asset classes to which the risk-free rate is applied. The FASB rejected added additional disclosures, but lessees will continue to be required to disclose the weighted average discount rate for operating and finance leases consistent with the original issued standard.
The change is effective upon first time adoption of the lease accounting standard, which for calendar yearend private entities that did not early adopt, is for fiscal years beginning after Dec. 15, 2021. For private entities that have already adopted the standard as of November 11, 2021, ASU 2021-09 is effective for fiscal years beginning after Dec. 15, 2021 and interim periods within fiscal years beginning after Dec. 15, 2022.
For comments, questions or concerns about the new accounting standard, please contact us.