The advent of ASC 842 on leases brought with it considerable changes to the way companies accounted for leases.
On June 16, 2021, the FASB released a proposed ASU for comment that seeks to simplify the standard for non-public entities, as well as produce some cost savings. The proposed ASU currently under review focuses on enhancing the uses of the risk-free rate practical expedient.
In order to form a proper understanding and appreciation for the proposed ASU, you should understand the three main rates prevalent throughout the ASC 842 codification. These rates are significant as they dictate which rate companies should use in their adoption and implementation work of ASC 842. Those rates are listed and further explained below.
• Discount rate for the lease
o For a lessee, the discount rate for the lease is the rate implicit in the lease unless that rate cannot be readily determined. In that case, the lessee is required to use its incremental borrowing rate.
o For a lessor, the discount rate for the lease is the rate implicit in the lease.
• Rate implicit in the lease
o The rate of interest that, at a given date, causes the aggregate present value of (a) the lease payments and (b) the amount that a lessor expects to derive from the underlying asset following the end of the lease term to equal the sum of (1) the fair value of the underlying asset, minus any related investment tax credit retained and expected to be realized by the lessor, and (2) any deferred initial direct costs of the lessor. However, if the rate determined in accordance with the preceding sentence is less than zero, a rate implicit in the lease of zero shall be used.
• Incremental borrowing rate
o The rate of interest that a lessee would have to pay to borrow on a collateralized basis over a similar term an amount equal to the lease payments in a similar economic environment.
ASC 842-20-30-3 permits a lessee (that is a non-public business) to use a risk-free discount rate for the lease, determined using a period comparable with that of the lease term. Should a non-public business wish to use the risk-free discount rate, an accounting policy election must be made. Use of the risk-free discount rate is reserved for instances in which the rate implicit in the lease is not readily determinable and it would be cost-prohibitive to determine the incremental borrowing rate. Electing to use the risk-free discount rate is currently on an entity-wide basis, meaning that once this policy is elected, all leases—regardless if there is a readily determinable rate implicit in the lease—were required to use the risk-free rate.
As you might imagine, use of the risk-free rate on the surface seems to be the easier approach for non-public business entities. While it is indeed an alluring option for non-public business entities, to rationalize the position you will take, it is important to understand two key potential challenges associated with use of the risk-free rate. First, using the risk-free rate election raises the likelihood that the present value of the lease payments and any residual value guaranteed by the lease would equal or exceed the fair value of the leased asset, potentially resulting in classification of the lease as a finance lease and potentially leading to a day-one impairment charge. Second, use of a lower rate would increase the initial measurement of a lessee’s lease liability and right-of use asset.
The FASB recently promulgated a proposed ASU (PASU) that would update and improve discount rate guidance for lessees that are not public business entities—including private companies, all not-for-profit organizations (whether or not they are conduit bond obligors) and employee benefit plans. It is intended to reduce the expected cost of implementing the lease standard (Topic 842) for those entities, while retaining the expected benefits for users of financial statements. The biggest change under the PASU would allow non-public businesses to use the risk-free rate election by class of underlying asset rather than at the entity-wide level, as required under the existing ASU 2016-02. An entity that makes the election to apply a risk-free rate would be required to disclose that asset classes to which it has elected to apply a risk-free rate. The amendment also requires the use of the rate implicit in the lease if it can be readily determined, regardless of whether an entity has made the risk-free rate election.
If accepted in its current form, the PASU would mitigate the potential drawbacks of electing the risk-free rate option for non-public businesses. Application of the risk-free rate on an asset class level, as opposed to a business-wide level, can help businesses avoid a day-one impairment while preserving reduced cost and effort of adoption and implementation associated with determining the incremental borrowing rate. Currently, the PASU is undergoing comment until July 16, 2021, and has yet to receive final approval and admission into the codification.
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Material discussed is meant for informational purposes only, and it is not to be construed as investment, tax, or legal advice. Please note that individual situations can vary. Therefore, this information should be relied upon when coordinated with individual professional advice.