The Financial Accounting Standards Board (FASB) has issued Accounting Standards Update (ASU) 2021-09, Leases (Topic 842): Discount Rate for Lessees That Are Not Public Business Entities.
During public roundtable sessions hosted by the FASB, private company stakeholders raised concerns and expressed reluctance to use the risk-free discount rate practical expedient provided for in Topic 842. The practical expedient allows a lessee that isn’t a public business entity to make an entity-wide accounting policy election to use a risk-free rate as the discount rate for all leases.
To address these concerns, the amendments allow a lessee that isn’t a public business entity to apply this practical expedient by class of underlying asset—rather than at the entity-wide level.
Regardless of whether the practical expedient is elected, the amendments require the lessee to use the rate implicit in the lease when readily determinable for any individual lease.
The amendments apply to lessees that aren’t public business entities, including:
- Private companies
- Not-for-profit entities, whether or not they’re conduit bond obligors
- Employee benefit plans, whether or not they file or furnish financial statements with or to the Securities and Exchange Commission
During the FASB’s post-implementation review of Topic 842, private company stakeholders noted that using a risk-free rate—such as a US Treasury rate—in the current economic environment could increase a lessee’s lease liability and right-of-use asset recorded on the balance sheet.
This is because the risk-free rate is lower than the average incremental borrowing rates and using a lower rate results in a higher discounted balance.
Using this lower rate could also affect lease classification and cause leases that otherwise would be classified as operating lease to be classified as financing leases. For financing leases, the discount rate also impacts the timing of and amounts recognized as interest and amortization.
Topic 842 currently requires a lessee to use the rate implicit in the lease whenever that rate is readily determinable. If the rate implicit in the lease isn’t readily determinable, a lessee should use its incremental borrowing rate.
A lessee that isn’t a public business entity is permitted to use a risk-free discount rate as an accounting policy election for all leases. The risk-free discount rate should be determined using a period comparable with that of the lease term.
The amended guidance is intended to provide more flexibility for a lessee that makes the risk-free rate election. The amendments to Topic 842 allow the election to be made by class of underlying asset, rather than at the entity-wide level.
This provides lessees with an option to use their incremental borrowing rate to calculate the lease liability for material asset classes, while applying the risk-free rate election to asset classes that have lower values or greater volumes of leases.
Under the amended guidance, an entity that makes the risk-free rate election is required to disclose which asset classes it has elected to apply a risk-free rate.
When readily determinable for any individual lease, the amendments require the lessee to use the rate implicit in the lease—rather than a risk-free rate or an incremental borrowing rate—even if the risk-free rate accounting policy has been elected.
Effective Dates and Transition Requirements
Entities That Haven’t Adopted Topic 842
Entities that haven’t yet adopted Topic 842 as of November 11, 2021, should apply the amendments to all new and existing leases at the same time Topic 842 is adopted.
Topic 842 becomes effective for private companies and not-for-profit organizations that aren’t conduit bond obligors for fiscal years beginning after December 15, 2021, and interim periods within fiscal years beginning after December 15, 2022.
The same transition method elected for Topic 842 should be applied to the amendments in this ASU. In accordance with the existing transition provisions in paragraph 842-10-65-1, one of the following transition methods should be applied upon adoption:
- Apply the guidance to existing leases retrospectively with the cumulative-effect adjustment from transition recognized at the beginning of the earliest period presented
- Apply the guidance to existing leases on a modified retrospective basis with the cumulative-effect adjustment from transition recognized in the opening balance of retained earnings at the beginning of the period of adoption
Entities That Adopted Topic 842
For entities that have adopted Topic 842 as of November 11, 2021, the amendments in this ASU are effective for fiscal years beginning after December 15, 2021, and interim periods within fiscal years beginning after December 15, 2022. Earlier application is permitted, as of the beginning of the fiscal year of adoption.
The amendments should be applied on a modified retrospective basis to leases that exist at the beginning of the fiscal year of adoption. This means that a cumulative-effect adjustment should be recognized in the opening balance of the affected lease liabilities and right-of-use assets.
The cumulative-effect adjustment should be calculated for leases existing as of the beginning of the fiscal year of adoption using the remaining lease term and a discount rate assessed at the beginning of the fiscal year of adoption.
The adoption of the amendments shouldn’t be considered an event that would cause remeasurement and reallocation of the consideration in the contract—including lease payments—or reassessment of lease term or classification.
The nature of and reason for the change in accounting principle should be disclosed, as well as the change in lease liabilities and right-of-use assets resulting from the amendments and the cumulative effect of the change on retained earnings as applicable.
Upon adopting the amendments, an entity may choose to apply or discontinue the use of a risk-free discount rate previously made for any class of underlying asset without assessing the guidance in topic 250, Accounting Changes and Error Corrections.
After adoption, a change in the application of the risk-free rate election would be a change in accounting policy that would need to be evaluated under Topic 250, unless the election to use or not use a risk-free discount rate is for an immaterial asset class.
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For more information on how the implementation of Topic 842 could affect your business, contact your Moss Adams professional.