ASC 842 Discount Rate

The ASC 842 Discount Rate Hierarchy

A lessee works down a short list. It uses the rate implicit in the lease if that rate is readily determinable, otherwise its incremental borrowing rate. Some private companies may elect a risk-free rate instead. Almost every lessee ends up on the incremental borrowing rate, so the practical question is which inputs support it.

ASC 842-20-30-3 says: "A lessee should use the rate implicit in the lease whenever that rate is readily determinable. If the rate implicit in the lease is not readily determinable, a lessee uses its incremental borrowing rate."

Step 1: the rate implicit in the lease

The Glossary defines the rate implicit in the lease as the rate that makes the present value of the lease payments plus the lessor's expected residual value equal a sum. That sum is the underlying asset's fair value (less any investment tax credit the lessor retains and expects to realize) and the lessor's deferred initial direct costs. It is the lessor's measure. If that calculation gives a rate below zero, a rate of zero is used.

A lessee can use it only when it can actually compute it. KPMG's Leases handbook (Question 5.6.20) says the answer is no in all but rare cases. The lessee would need both the lessor's residual value estimate and its deferred initial direct costs. For the lessee-side argument, see implicit rate versus IBR for lessees.

KPMG notes one case where the picture can change: a lease that transfers title automatically or has a bargain purchase option, where the lessor's residual value would be zero. Even then the lessee must be able to conclude that the lessor's initial direct costs would not move the rate.

Step 2: the incremental borrowing rate

When the implicit rate is not readily determinable, the lessee uses its incremental borrowing rate. Because lessees rarely have the lessor's inputs, KPMG observes that lessees use this rate for nearly all leases.

The Glossary defines it as "the rate of interest that a lessee would have to pay to borrow on a collateralized basis over a similar term an amount equal to the lease payments in a similar economic environment." Three phrases do the work. Each limits what a reasonable estimate looks like.

• Collateralized basis. The hypothetical borrowing is secured by collateral, so an unsecured facility is not the whole answer.
• Similar term, an amount equal to the lease payments. The hypothetical loan matches the lease term and the size of the lease payments.
• Similar economic environment. The estimate reflects the conditions at commencement, including the currency of the payments.

The Codification's own example shows the same idea. In ASC 842-10-55-227 (Example 25, Case A), the lessee's rate is 8 percent. It "reflects the rate at which Lessee could borrow an amount equal to the lease payment in the same currency, over a similar term, and with similar collateral as in the lease."

How you build that estimate is a separate subject. See approaches to determine the incremental borrowing rate for the methods.

Which Rate Applies: Situations at a Glance

The table pairs common situations with the rate that applies and what happens to it later. It states the rules above and below; each row cites its paragraph.

A termination of the whole lease before the end of its term ends the lease instead. The lessee removes the right-of-use asset and the lease liability and recognizes the difference in profit or loss (ASC 842-20-40-1).

An index or rate change on its own does not remeasure the lease liability; the difference is variable lease cost. The index is updated only when the liability is remeasured for another reason (ASC 842-10-35-4(b), 842-10-35-5; Example 25, Case A, ASC 842-10-55-231).

Two cautions. A lessee that elects the risk-free rate for a class applies it to leases in that class, not lease by lease. The exception is a lease whose implicit rate is readily determinable, which still uses that rate (ASC 842-20-30-3). And a company that is a public business entity has no risk-free option at all.

Risk-Free Rate Under ASC 842 for Private Companies

A lessee that is not a public business entity may use a risk-free discount rate instead of its incremental borrowing rate. ASC 842-20-30-3 describes it as a rate "determined using a period comparable with that of the lease term, as an accounting policy election made by class of underlying asset."

What the election replaces

The election replaces the incremental borrowing rate, nothing else. The rate implicit in the lease still comes first when it is readily determinable. Grant Thornton's snapshot on ASU 2021-09 puts it this way: the risk-free rate is "an alternative only to the incremental borrowing rate."

By class of underlying asset

ASU 2021-09 changed the unit of the election. Before it, a nonpublic lessee elected the risk-free rate for all of its leases. Grant Thornton reports that the amendment lets the lessee elect it by class of underlying asset. The election and the asset classes it covers are disclosed (ASC 842-20-50-10).

For entities that had already adopted ASC 842 by November 11, 2021, Grant Thornton reports that the amendment applies for fiscal years beginning after December 15, 2021. It applies to interim periods within fiscal years beginning after December 15, 2022. Other entities follow ASC 842's own effective date.

Who cannot use it

Public business entity status is a defined term, and it catches some companies that are not listed. KPMG's handbook reports (Question 5.6.05) that the SEC staff has said public business entities may not use the risk-free rate. That includes an entity that is a public business entity solely because its financial statements or summarized financial information are included in a registrant's SEC filing.

An IPO ends the election too. KPMG (Question 5.6.06) says a private company going public must reassess what its incremental borrowing rate would have been at each lease's commencement. It then accounts for the lease as if that had always been the rate. A company that may go public should weigh that before electing.

What a risk-free rate actually is

ASC 842-20-30-3 does not name a benchmark. The Codification's Example 2 (ASC 842-20-55-19) refers to 5-year zero-coupon U.S. Treasury instruments as a risk-free rate. Deloitte's Roadmap: Leases (section 7.2) says a U.S. dollar lease would generally use the U.S. Treasury rate. Choose the source, document it, and apply it consistently within each asset class.

When the Rate Is Set, and When It Changes

Set at commencement

ASC 842-20-30-2 says the discount rate for the lease is "calculated on the basis of information available at the commencement date." The lease liability is then the present value of the lease payments not yet paid at that date (ASC 842-20-30-1).

That is why the rate does not float with the market. After commencement, an operating lease liability is measured using the rate established at commencement, unless it has been updated under ASC 842-20-35-5 (ASC 842-20-35-3(a)). Finance lease interest follows a constant periodic rate on the remaining balance (ASC 842-20-35-1(a)).

Updated on certain remeasurements

KPMG's handbook (paragraph 6.6.150) reads ASC 842-20-35-4 and 35-5 this way. The lease liability gets an updated discount rate only if the remeasurement is due to a change in the lease term. The same is true for a change in the assessment of a purchase option. For any other reason, the rate is not updated.

KPMG adds that the rate is not updated for those two triggers if the original rate already reflected the lessee's option to extend, terminate or purchase. Per the handbook, the Board's reasoning was that a term or purchase option change is a significant change in the economics. Otherwise the rate is not reassessed, consistent with amortized cost accounting for other, similar financial liabilities.

Updated on certain modifications

ASC 842-10-25-11 requires a lessee to remeasure the lease liability "using a discount rate for the lease determined at the effective date of the modification" for a modification that:

• grants an additional right of use and is not accounted for as a separate contract;
• changes the lease term other than through an existing option;
• fully or partially terminates the lease; or
• changes the consideration only.

A modification accounted for as a separate contract is not in that list. It is a separate lease, so it carries its own commencement and its own rate. The mechanics of modification and remeasurement are on the modifications and remeasurement page.

Do not refresh rates each quarter; the standard ties a new rate to a remeasurement or a modification. Keep a record of why each one did or did not change the rate.

One Rate for a Portfolio of Leases

A lessee does not need a separate rate for every lease when the leases are alike. KPMG's handbook (Question 5.6.40) notes that the Board expected some lessees to use a portfolio approach to determine the discount rate for leases with similar characteristics. That holds provided doing so would not materially affect their accounting (Example 2, ASC 842-20-55-18 through 55-20; ASU 2016-02, BC 120 and BC 201; KPMG Handbook: Leases, Question 5.6.40).

KPMG suggests practical groupings by lease term, lease currency and geographic location. It also says controls should make sure a portfolio rate is applied only to leases with similar characteristics. Rates are updated periodically for changes in the interest rate environment.

Under ASC 842-20-30-2 the rate is fixed at commencement, so a refreshed portfolio rate applies to new leases. Existing leases get a new rate only on a remeasurement under ASC 842-20-35-5 or a modification under ASC 842-10-25-11. The trade-offs are covered in portfolio versus lease-specific IBR.

Where the Discount Rate Shows Up

The rate drives two visible numbers. It sets the starting lease liability and the right-of-use asset built on it, which flow to the balance sheet, and it drives the interest on the liability in each period.

It is also a disclosure. ASC 842-20-50-4(g)(4) requires the weighted-average discount rate, separately for finance and operating leases. ASC 842-20-55-12 says to compute it from each lease's discount rate and the remaining balance of its lease payments at the reporting date.

Rate choice can also change classification. ASC 842-10-25-2(d), one of the finance lease criteria, compares the present value of the lease payments and any residual value guaranteed by the lessee with substantially all of the asset's fair value. It uses the discount rate for the lease.

A different rate can therefore move a lease between operating and finance. See lease classification for the five tests.

What Auditors Ask About the Discount Rate

These are questions auditors commonly ask in practice; ASC 842 does not prescribe them. Keep the answers in a file that outlasts staff turnover.

• Why was the implicit rate not readily determinable, and who concluded that?
• If you elected the risk-free rate: which asset classes, and where is the election documented?
• What inputs and date support the incremental borrowing rate, and does it match the lease term, amount and currency?
• How are portfolio groupings defined, and who approves the rate for each?
• For each remeasurement or modification, was the rate updated or deliberately kept, and why?

For documentation detail and common findings, see the IBR documentation requirements page and discount rate audit findings.