The new lease standard becomes effective for nonpublic entities in fiscal years beginning after December 15, 2021. As a result, private companies and organizations with calendar fiscal years are already living under the new guidance. The most significant change entailed in the new standard is the recognition of operating lease right-of-use assets and liabilities on the balance sheet. Similar to capital leases under the previous guidance, the new guidance requires the future stream of operating lease payments to be converted to an asset and liability through the application of a discount rate. If the lessee knows the discount rate implicit in the lease, then the implicit rate should be used to measure the asset and liability associated with the operating lease. If the rate implicit in the lease is not readily determinable, private entities have two options: the incremental borrowing rate and the risk-free rate.
Option #1: The Incremental Borrowing Rate (IBR)
The IBR is the interest rate a lessee would pay to borrow on a collateralized basis for a similar period and amount to the terms of the lease. There are four common methods available for estimating the IBR:
- Obtain quotes from creditors
- Estimate the IBR based on existing debt agreements
- Approximate the IBR based on the lease discount rates published by a similar entity
- Calculate an applicable IBR through yield curve modeling
From a financial reporting standpoint, the IBR offers the most precise reflection of the borrowing costs applicable to the specific lessee and economic environment. However, determining a reliable estimate of the IBR can be time consuming, complex, and even unfeasible, regardless of the method used.
Option #2: The Risk-Free Rate
Given the challenges inherent in estimating the IBR, private entities have the option to use the risk-free rate instead. The risk-free rate is the interest rate on U.S. treasury securities for the time period comparable to the lease term. For example, if a lessee were measuring the right of use asset and liability for a 5-year lease, it would simply use the interest rate on 5-year treasury bonds on the date of lease commencement. This practical expedient may be elected by class of underlying asset. For example, an entity is permitted to apply the risk-free rate for its vehicle leases, but then still use the IBR for its real estate leases.
Using the risk-free rate will save lessees considerable time when calculating their right of use assets and lease liabilities. However, given that the risk-free rate is smaller than the IBR, its application will result in comparatively larger lease-related assets and liabilities being recognized on the balance sheet.
Develop an Implementation Plan
As discussed above, there are pros and cons to using both the IBR and the Risk-Free Rate. Private entities should weigh the costs and benefits of both options and develop an organized implementation strategy prior to adopting the new leasing standard on their financial statements.
If you have questions about the new lease standard or any of the information outlined above, McKonly & Asbury’s experienced professionals are here to help. Please contact us or visit our website to watch our webinar titled “ASC 842 Leases: Moving Forward and Implementation.”