The Risk-Free Rate Election: When It Helps and What It Costs

Every lease measured under ASC 842 has to be discounted, and choosing the rate is the hardest judgement in the whole measurement. Private companies have a way out that public companies do not, and it is worth understanding properly before you either take it or dismiss it.

What the election actually is

FASB ASC 842-20-30-3 permits a lessee that is not a public business entity to use a risk-free rate as its discount rate, in place of determining an incremental borrowing rate. The risk-free rate is taken over a period comparable to the lease term — in practice, a US Treasury rate of matching duration.

It is a policy election, not a one-off convenience. Once made, it applies consistently, and it has to be disclosed as an accounting policy.

Why FASB offered it

Determining an incremental borrowing rate means answering what you would pay to borrow, on a collateralized basis, over a term matching the lease. For a company with a revolving facility and recent term debt, that is a reasonable exercise. For a company with no external borrowing at all, it is close to hypothetical — you are estimating the price of a loan nobody has ever offered you. That difficulty is the whole reason the election exists, and it is covered further in our note on determining an IBR without external debt.

The trade you are making

The election removes a judgement and adds a cost, and the cost is not hidden — it is arithmetic. A risk-free rate is lower than what a private company would actually pay to borrow. Discounting the same lease payments at a lower rate produces a larger present value, so the lease liability and the corresponding right-of-use asset both come out higher than they would under an incremental borrowing rate.

Larger balances flow into the ratios that other people read. If you have debt covenants measured on total liabilities, leverage or return on assets, the election moves those numbers in the direction you would rather they did not go. Whether that matters is specific to your agreements, and it is the question to put to your lender before you decide rather than after.

It is not all or nothing

The election is made by class of underlying asset. You can apply it to one class and determine an incremental borrowing rate for another — a common shape is taking the election for a large population of small equipment leases where the effort per lease is hard to justify, while doing the work properly on a handful of significant real estate leases where the difference is material.

That distinction sits alongside the separate question of whether a single rate can serve a group of similar leases, which we cover in portfolio versus lease-specific rates.

When it is the right call

The election tends to be worth taking when several of these are true: you have little or no external debt to reason from, the portfolio is large and individually immaterial, nobody internally has a defensible method for estimating a borrowing rate, and no covenant is close enough to a threshold for the larger liability to matter.

It tends not to be worth taking when leases are few and large, when covenant headroom is thin, or when you are likely to be acquired or to raise finance — an acquirer's diligence will notice a liability inflated by a policy choice, and you will end up explaining it.

What you have to document

Taking the election does not remove the documentation obligation, it changes its shape. You still need to show which classes of asset the election applies to, the source and duration of the risk-free rate used, and the date it was taken. An auditor will test that the rate matches the lease term and that the policy has been applied consistently — inconsistency between classes, or drift over time, is what gets raised. Our note on documenting the discount rate covers what is typically requested, and common discount rate audit findings covers what typically goes wrong.

Changing your mind

Because this is an accounting policy election rather than a per-lease decision, moving away from it later is a change in accounting policy, with the disclosure that implies. It is not a reason to avoid the election, but it is a reason to make it deliberately, with the reasoning written down at the time rather than reconstructed two years later.

Where to go next

For the full picture of which rate applies and how the three options relate, see the ASC 842 discount rate. If you are determining an incremental borrowing rate rather than electing the risk-free alternative, calculating the incremental borrowing rate is the place to start. And for how discounting fits the rest of the standard, the ASC 842 Complete Guide covers measurement end to end.

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