Using the ASC 842 Risk-Free Rate Practical Expedient

The accounting standard ASC 842 changed how businesses account for leases by requiring most to be recognized on the balance sheet. This process involves calculating the present value of future lease payments, which requires a specific discount rate. To ease the burden of this requirement, the Financial Accounting Standards Board (FASB) introduced several practical expedients. One such option is the ability for certain entities to use a risk-free interest rate as their discount rate, an election designed to reduce the cost and complexity associated with determining a more specific rate.

Eligibility for the Risk-Free Rate Election

The practical expedient to use a risk-free rate is restricted to a lessee that is not a public business entity. An entity is considered a public business entity if it is an SEC filer required to file financial statements with the U.S. Securities and Exchange Commission. This category also includes entities whose securities are traded on a public market, such as a stock exchange, or certain not-for-profit entities that have issued securities that are traded in a public market.

Consequently, private companies, most not-for-profit organizations, and employee benefit plans are the primary users who can elect this simplified accounting treatment. The election was designed to provide relief to these organizations, acknowledging they may not have the resources to calculate a more complex discount rate. If an entity meets the criteria of a public business entity, it must use a different rate for its lease calculations.

Understanding the Alternative The Incremental Borrowing Rate

Under ASC 842, the default discount rate for a lease is the rate implicit in the lease itself. When this rate is not readily determinable, a lessee must use its incremental borrowing rate (IBR). The IBR is defined as the rate of interest a lessee would have to pay to borrow funds on a collateralized basis, over a similar term, and in an amount equal to the lease payments in a similar economic environment.

Determining the IBR is a complex process that involves significant judgment and estimation. A company must consider its own creditworthiness, the term of the lease, and the nature of the underlying asset being leased. Calculating a proper IBR can be costly and time-consuming, often requiring external valuation experts or significant internal analysis. The rate must be established for each lease, considering the economic conditions at the time of lease commencement.

Applying the Risk-Free Rate Practical Expedient

For an eligible entity electing the practical expedient, the first step is to identify an appropriate risk-free rate from an observable source, with U.S. Treasury rates being the most common choice. The selected rate must have a term that is comparable to the term of the lease. For example, a five-year lease would use a five-year Treasury yield as its basis. The U.S. Department of the Treasury publishes these rates daily on its public website.

Once the rate is identified, it is used to calculate the present value of the future lease payments. This determines the initial value of the lease liability and the corresponding right-of-use (ROU) asset. Since a risk-free rate does not include any credit risk premium, it is almost always lower than the company’s IBR. Using a lower discount rate results in a higher present value calculation.

This means that electing the risk-free rate will lead to a larger lease liability and a higher ROU asset on the balance sheet compared to using an IBR. For instance, for a lease with $10,000 annual payments for five years, a 5% IBR might result in a $43,295 liability, while a 3% risk-free rate would result in a higher $45,797 liability. This “gross-up” effect can influence financial ratios and covenants, which is an important consideration before making the election.

Policy Election and Disclosure Requirements

The decision to use the risk-free rate is a formal accounting policy election. This election does not have to be an all-or-nothing decision for the entire entity. A non-public entity can choose to apply the risk-free rate practical expedient by class of underlying asset.

“By class of underlying asset” means an organization can group its leases based on the type of asset being used. For example, a company could elect to use the risk-free rate for its portfolio of office equipment leases. For its more material leases, such as for real estate or large machinery, it could calculate the IBR.

Once an entity elects to use the practical expedient for one or more asset classes, it must disclose the accounting policy election. It must also specify the asset classes to which the risk-free rate has been applied. This transparency ensures that users of the financial statements understand the basis for the lease liability and ROU asset calculations.