The effective date of the new lease standard, Leases (Topic 842), is rapidly approaching for private companies and certain not-for-profits that are not conduit debt obligors (herein referred to as companies or company) who have chosen not to early adopt. The new standard will become effective for annual periods beginning after December 15, 2021, and interim periods within fiscal years beginning after December 15, 2022.
The new standard requires a lease liability and right-of-use asset to be recorded on a company’s balance sheet for all leases, including operating leases. An accounting policy election may be made by class of underlying asset for leases with terms of 12 months or less to not recognize lease liabilities and assets for those leases.
In preparing to implement the new lease standard, a company should:
- Identify and evaluate its lease contracts
- Separate lease and non-components
- Determine the lease term, lease payments and lease classification
- Select a transition method
- Determine which practical expedients to elect
Among these considerations, a company must also determine the appropriate discount rates to use for calculating the lease liabilities at the application date, for new leases after the application date, and for lease modifications.
Here’s how to plan for the new lease standard (ASC 842).
Discount Rate Implicit in the Lease: Required If Readily Determinable
Lessees are required to use the rate implicit in the contract unless the rate cannot be readily determined, in which case the lessee should use its incremental borrowing rate (IBR). Alternatively, companies are permitted to make an accounting policy election to use a risk-free discount rate for leases. Each scenario is discussed in further detail below.
The discount rate implicit in the lease must be used if readily determinable. This is defined as:
“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.”
The implicit rate in the lease may be considered readily determinable if the lessor disclosed the rate to the lessee or if the lessor provided the lessee all relevant information necessary to calculate the rate.
More commonly, a lessee does not know the residual value the lessor expects to derive at the end of the lease term, whether the lessor obtained an investment tax credit, or the lessor’s deferred initial direct costs. Also, it may be difficult to obtain the fair value of the underlying asset.
Readily determinable is not defined in the standard, and therefore leaves the lessee with a low burden of proof to conclude that the implicit rate was not readily determinable. Even in related party leases in which the lessor and lessee are under common control and an implicit rate could be determined through judgments made by the lessor, the lessee may still reasonably conclude that the implicit rate is not readily determinable due to the amount of effort that may be involved in determining the fair value of the underlying asset or estimating the expected residual at the end of the lease.
Incremental Borrowing Rate
If the implicit rate is not readily determinable, the lessee should use its IBR, unless an accounting policy election is made to use the risk-free rate. The IBR is defined as:
“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.”
Prior to ASC 842, the legacy definition of incremental borrowing rate was defined as:
“The rate that, at lease inception, the lessee would have incurred to borrow over a similar term the funds necessary to purchase the leased asset.”
Here are the key differences in determining the IBR under the new standard compared to the legacy standard:
| Attribute of Hypothetical Borrowing | New Standard: ASC 842 | Legacy Standard: ASC 840 |
|---|---|---|
| Secured vs. Unsecured | Requires discount rate to be based on a collateralized borrowing | Consideration of collateralized borrowing not required |
| Amount | Based on amount equal to sum of lease payments determined under ASC 842 | Based on an amount equal to the value of the leased asset |
| Term | Based on lease term under ASC 842, which may include optional extension periods | Based on lease term under ASC 840 |
While there is no authoritative guidance on determining the incremental borrowing rate, and there are many factors and methods in practice, three primary considerations should be included in developing the IBR:
- The company’s credit risk
- Presumption of full collateralization
- Payment terms
Companies often start with their own borrowing rates as a basis for determining their IBR. While this is a reasonable starting point, terms generally won’t sufficiently align to be used as the IBR. This is because borrowings may be unsecured, have differing durations or have older terms. However, current borrowings may have some information from the lenders regarding credit profiles of the company.
Additionally, financial health of the entity, including leverage, cash flows, etc. can also be useful in determining the credit risk of the company, which could be used to develop a base rate. The base rate could then be tailored to a lease class based on collateralization and payment terms. Collateralization would reduce a borrowing rate in comparison to an unsecured financing arrangement. The magnitude of collateralization on an IBR can vary; collateralization may have less of an impact for companies with high credit ratings and historically strong financial positions. Also, prepayments tend to reduce rates, and longer lease terms tend to result in higher rates. Management should clearly document their considerations and support for their assumptions when developing their IBRs.
Accounting Policy Election to Use the Risk-Free Rate
A private company or eligible not-for-profit lessee may make an accounting policy election to use a risk-free rate using a period comparable with that of the lease term. This option reduces the cost and complexity of determining the appropriate discount rate; however, it also generally results in lower discount rates and larger lease liabilities.
Current guidance requires the risk-free option to be used for all leases if elected; however, in June 2021, the FASB released an exposure draft for a proposed Accounting Standard Update (ASU), Leases (Topic 842): Discount Rate for Lessees That Are Not Public Business Entities. The comment period was closed in July of 2021, and on September 15, 2021, the Board completed its redeliberations on the proposed ASU and has directed the staff to draft a final ASU for vote by written ballot. The proposed update makes the risk-free rate election more flexible, allowing lessees to make an accounting policy election to use the risk-free rate by class of underlying asset instead of requiring the election to be applied to all leases. The proposed ASU will also require the lessee to use the discount rate implicit in the lease instead of the risk-free rate, if readily determinable. The final ASU is expected to be issued prior to December 15, 2021.
For companies that did not early adopt ASC 842, this new ASU will apply and be effective at the adoption date of ASC 842 and will supersede the prior risk-free rate election guidance. Transition and effective date provisions in ASC 842-10-65-1 will apply.
For companies who have already adopted ASC 842 prior to the issuance of the final ASU, the amendments will be effective for annual reporting periods beginning after December 15, 2021, and interim periods beginning after December 15, 2022. Early adoption is permitted. Upon adoption of the final ASU, an entity may choose to apply or discontinue the use of the risk-free rate previously made for any class of asset. The lease liability for affected leases will be remeasured at the adoption date using the new discount rates and remaining lease terms with a corresponding offset to the right-of-use asset. If the right-of-use asset is reduced to zero or the adjustment would increase a previously impaired right-of-use asset, the offset should be recognized in retained earnings.
Considerations for Applying the New Lease Standard
Making an election to apply the risk-free rate appears to be the path of least resistance when contemplating ease of implementation; however, before moving forward with this decision, companies should first evaluate potential repercussions the higher resulting lease liability may have on financial position, loan covenant compliance and the perception of users of the financial statements.
The new lease standard (ASC 842) can be complicated. Here’s what you need to know about implementation and how to best approach the new guidance.
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