Are you preparing to implement ASC 842 and have questions about the risk-free rate policy election? Or, has your organization already adopted ASC 842 and made the risk-free rate policy election?
Here’s what you need to know about the risk-free rate policy when applying the new lease standard (ASC 842).
New Developments to ASC 842
On November 11, 2021, the Financial Accounting Standards Board (FASB) issued Accounting Standards Update (ASU) 2021-09 Leases (Topic 842): Discount Rate for Lessees That Are Not Public Business Entities. Prior to the new ASU, existing ASC 842 guidance provided that a private company or eligible not-for-profit lessee could make an accounting policy election to use a risk-free rate using a period comparable with that of the lease term. If elected, it was required that the risk-free rate be applied to all leases.
ASU 2021-09 supersedes the previous guidance and allows a lessee to make an accounting policy election to use a risk-free rate by class of underlying asset instead of requiring that a risk-free rate be applied to all leases. However, the rate implicit in any given lease must be used if readily determinable, regardless of whether the entity has made the risk-free rate election. The entity should disclose the election and the classes of underlying assets to which it has elected to apply a risk-free rate.
We answered some common questions on implementing new lease standard and created a guide to help simplify the implementation process.
Determining Classes of Underlying Assets
ASU 2021-09 does not define how classes of underlying assets should be defined by an entity; therefore, there appears to be room for reasonable interpretation. Nonauthoritative interpretive guidance suggests that segregating classes of leased assets by their general physical characteristics (real estate, office equipment, heavy machinery, etc.) would be a reasonable approach. Other views suggest that determining the class of underlying asset by grouping assets that share similar risks would also be appropriate and could result in further disaggregation beyond general physical characteristics in some cases.
Since there are other accounting policy elections provided by ASC 842 that may be elected by class of underlying asset (short-term lease election, election to not separate lease and non-lease components), once an entity has established its accounting policy for defining their underlying asset classes, they should use those established classes consistently in all their accounting policy elections.
Effective Dates and Transition Guidance
For entities that have not early adopted ASC 842, this new ASU will apply and be effective at the adoption date of ASC 842 (fiscal years beginning after December 15, 2021). Transition and effective date provisions in ASC 842-10-65-1 will apply.
For entities that have already adopted ASC 842 prior to the issuance of ASU 2021-09, 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 ASU 2021-09, 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. The adoption should not be considered an event that would cause remeasurement and reallocation of the consideration in the contract or reassessment of lease term or classification.
The new lease standard can be complicated.