One challenge that often comes up when companies begin applying the new lease accounting standard (ASC 842) is how to determine the appropriate interest rate to use to calculate the initial lease liability. In the past, only certain amounts relating to operating leases were recognized on the balance sheet — generally deferred rent and liabilities relating to landlord funded tenant improvement allowances. Under ASC 842, companies must recognize a right of use asset and lease liability for all operating leases with a term exceeding 12 months. Upon adoption, the lease liability is measured as the present value of the future payments over the non-cancellable term. Companies must now determine the appropriate discount rate for each operating lease obligation.
If the lease agreement provides the interest rate, or if the rate is implicit in the lease, GAAP requires you use this rate. Implicit means you can determine the rate based on known factors such as payment schedule and the purchase price of the asset.
A Tale of Two Options
If the discount rate is not implicit in the lease agreement, there are two alternatives available for private companies: the incremental borrowing rate or the risk-free rate.
The incremental borrowing rate is the rate the lessee would pay to borrow an amount equal to the lease payments under a repayment schedule that is the same as the scheduled lease payments. The borrowing is assumed to be secured, and the right of use asset itself is not suitable as collateral for the debt.
The risk-free rate is the theoretical rate of return that would be received on an investment with zero risk. US Treasury rates are commonly used as risk-free rates and are permitted to be used under GAAP for this purpose in ASC 842. A lessee can use the treasury yield curve from treasury.gov to find a suitable rate for their lease term, commencing at the adoption date (January 1, 2022, for companies with a calendar year end).
Evaluating the Trade-offs
Since the incremental borrowing rate will almost certainly be higher than the risk-free rate the net present value of the future lease payments will result in a lower lease liability and right of use asset upon adoption. The selection of the rate has no impact on the P&L. The amount of rent expense recognized each period will be the same under both approaches.
Determining the incremental borrowing rate is much more complex than just considering the rate the lessee may be paying on existing debt facilities. The theoretical borrowing must be on a secured basis, and the right of use asset itself is not suitable as collateral for the debt. The lessor must be able to pledge another asset. In many cases, a lessee's assets may be fully encumbered by existing borrowings, and they may need to consider the interest rate it would be required to pay under a loan with a lender granting a second security interest at a much higher rate. This will be different for each lessee based on their own attributes as a borrower. If the lessee has a good banking relationship, their lender may be able to assist with an interest rate estimate, but the specifics matter.
Decisions Based on Asset Class
Originally, the lease standard required that a lessee make a general policy election to adopt the risk-free rate. This required lessees to make big decisions to apply the risk-free rate to all their leases under ASC 842 other than those with stated interest rates (either implicit or explicit). During the fall of 2021, the FASB revised the guidance to allow lessees to make an asset-class policy election for the risk-free rate (ASU 2021-09). This means that a lessee could use the risk-free rate on all its office leases and use the incremental borrowing rate for other types of leases that do not have stated rates.
For private companies, we believe that the risk-free rate will be the most frequently used option because it is significantly easier to determine. Companies that are considering going public or have some other need to present financial statements that are comparable to public companies may choose to use the incremental borrowing rate.
While the risk-free rate results in a higher lease liability, this liability is generally not considered a true debt obligation and there is no impact on the P&L. The recognition of a lease liability for an operating lease is generally not anticipated to negatively impact how a lender or investor would perceive a company's balance sheet.