What the Risk-Free Rate Exposure Draft Means for Lease Accounting
There’s no doubt that the changes to the lease accounting standard present their share of adoption challenges as organizations start to record all lease assets and liabilities on their balance sheet. In an effort to make the road to ASC Topic 842, Leases, easier for nonpublic companies and not-for-profit organizations, the Financial Accounting Standards Board (FASB) has been seeking post-implementation feedback from public business entities. From these conversations and roundtables came a recent exposure draft designed to make discount rate determinations easier for lessees that are in looking to adopt the lease accounting standard for fiscal years beginning after Dec. 15, 2021.
The following explores what you need to know about the proposed update to the use of the risk-free discount rate.
First, a Recap on 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. They should use the rate implicit in the lease if readily determinable, otherwise the lessee should use its 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.
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 debt that aligns with the terms of all the entity’s leases and for the lessee to have debt and lease arrangements that commenced during similar economic environments. The second option would assume there is a like-kind (same credit rating) public entity with lease arrangements having similar terms and conditions. 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 is generally accomplished by working with a valuation specialist.
The Appeal of the Risk-Free Rate and How the Proposed Accounting Standard Helps
The risk-free rate is designed to be a practical expedient that private entities can use to bypass IBR estimation. Initially, private entities could only select the risk-free rate practical expedient at the entity-wide level, which presented obstacles for lessees that had vastly different leases. In the original accounting standard update for leases (ASU 2016-02), because the use of a risk-free rate is an accounting policy election, lessees would have to use the risk-free rate consistently for all leases even if the lessee was able to estimate an IBR for some leases. In addition, the original accounting standard update was not clear about whether the risk-free rate overruled the requirement to use the rate implicit in the lease if it was readily determinable.
The proposed accounting change would allow private entity lessees to utilize a risk-free rate by class of the underlying lease asset giving the entity considerable flexibility. It also clarifies 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 has elected to use the risk-free rate for other leases.
Private entities would be required to disclose the asset classes to which the risk-free rate is applied. The change would be effective upon adoption of the lease accounting standard, which for private entities is for fiscal years beginning after Dec. 15, 2021, and interim fiscal years beginning after Dec. 15, 2022.
Comments on the proposed accounting standard change were due by July 16, 2021, but it is widely expected that the exposure draft will be approved.
Our team is monitoring lease accounting developments and will communicate further updates as they become available. For comments, questions or concerns about the proposed accounting change, please contact us. Published on August 24, 2021