One important aspect of lease accounting under ASC 842 is determining the appropriate discount rate to use when calculating the present value of future lease payments. The risk-free rate is often mentioned in this context, as it represents the rate of return on an investment with no risk. This blog will explore the concept of the risk-free rate and its relevance in ASC 842 while also discussing alternative approaches for selecting a suitable discount rate.
Overview of ASC 842
ASC 842 was introduced by FASB with the primary objective of increasing transparency and comparability among organizations by recognizing lease assets and lease liabilities on the balance sheet for most leases. Under the previous guidance (ASC 840), operating leases were not recognized on the balance sheet, leading to inconsistencies in financial reporting and a lack of transparency for users of financial statements.
ASC 842 applies to all organizations that enter into lease agreements, including lessees (the party using the asset) and lessors (the party granting the right to use the asset). The standard requires lessees to recognize a right-of-use (ROU) asset and a corresponding lease liability for virtually all lease arrangements, with a few exceptions.
Discount rate in ASC 842
When applying ASC 842, lessees must calculate the present value of future lease payments to determine the initial measurement of the ROU asset and lease liability. The discount rate used in this calculation could play a significant role in accurately reflecting the value of the lease arrangement.
According to ASC 842, lessees should use the rate implicit in the lease as the discount rate, if readily determinable. The rate implicit in the lease is the rate that causes the present value of the lease payments and the residual value of the leased asset to equal the asset’s fair value. However, in most cases, lessees may not have access to the residual value to determine the rate implicit in the lease.
If the rate implicit in the lease is not readily determinable, lessees should use their incremental borrowing rate (IBR) as the discount rate. The IBR is defined as the rate of interest that a lessee would have to pay to borrow, on a collateralized basis, an amount equal to the lease payments for a similar term and in a similar economic environment.
Risk-free rate and its relevance to ASC 842
The risk-free rate represents the return on an investment with no risk of default by the investee. While the risk-free rate is often used as a benchmark in finance, it is generally not considered an appropriate discount rate for lease accounting under ASC 842.
The reason for this is that the risk-free rate does not account for the credit risk associated with the lessee, which is an essential factor in determining the appropriate discount rate. Since lease arrangements involve an obligation to make future payments, the lessee’s credit risk should be considered when calculating the present value of these payments.
Using the risk-free rate as the discount rate would likely result in an overvaluation of the ROU asset and lease liability, as the risk-free rate is typically lower than the lessee’s IBR.
EXCEPTION: Private companies may find it challenging and expensive to determine their IBR because their stocks and bonds are not traded in public markets and it is difficult to find appropriate benchmarks or proxy rates. In consideration of such challenges, FASB allows them to elect to use the Risk Free Rate in lieu of their IBR, as long as they use this method consistently across their leas portfolio. Treasury coupon rates serve as a good proxy for risk free rates, because they are near zero risk.
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