At a Glance
Main Takeaway
The time has come for nonprofit organizations to implement the new ASC 842 standards.
Under ASC 842, Nonprofits must determine which discount rates to choose to value their right-of-use assets and lease liabilities. Typically, the rate explicit or implicit in the lease should be used; however, this can be difficult to calculate accurately. Therefore, ASC 842 allows nonprofits to use a risk-free rate, simplifying the process.
Next Step
Learn how the risk-free rate allowed under ASC 842 standards for nonprofits can benefit your organization. Contact Windes for ASC 842 accounting services to assist with implementing the required standards.
How do you determine the Discount Rate under ASC 842?
A rate decision under ASC 842 refers to determining the discount rate to be used in calculating the lease liability. The discount rate is used to calculate the present value of the lease payments, which is the starting point for determining the value of the related right-of-use asset.
The discount rate represents the rate at which the lessee can borrow money over a similar term and with a similar credit risk as the lease (a collateralized loan). The rate decision can be influenced by the lessee’s creditworthiness, the lease’s length, and other factors.
NonProfits Allowed To Use a Risk-Free Rate
Under ASC 842, lessees must use the rate explicit or implicit in the lease agreement if it is determinable. In some cases, the explicit or implicit rate is not readily determinable, so lessees must use their incremental borrowing rate, which is often hard to estimate or calculate. This could be obtained by discussing with your bank what interest rate they would charge for a collateralized loan in the amount equal to the total value of the lease payments over the same term of the lease agreement. To help nonprofits that struggle with determining these rates, and recognizing that these bank conversations can be unnecessarily burdensome, the FASB issued Update No. 2021-09, allowing the use of a risk-free rate.
Under the FASB Accounting Standards Update in Topic 842: Discount Rate for Lessees That Are Not Public Business Entities, nonprofits can use a risk-free rate for the period comparable with the lease term. Private companies and nonprofits can use the risk-free rate by class of underlying lease asset. The rate to be used would be the borrowing rate for a zero-coupon U.S. Treasury instrument for the same lease period.
In other words, the risk-free rate represents the investor’s expected return rate on a risk-free investment, such as a U.S. Treasury bond. It is typically the yield on U.S. Treasury bonds with a term closest to the lease term. For example, if the lease term is ten years, the risk-free rate would be based on the 10-year U.S. Treasury bond yield.
The risk-free rate is used as a starting point to determine the discount rate for leases. The lessee’s credit risk can then be factored in to determine the final discount rate. The risk-free rate will likely be lower than the incremental borrowing rate, resulting in higher values for your right-of-use asset and lease liability. It is a trade-off that is often worthwhile in the long run for nonprofits.
Explore the Benefits of Using the Risk-Free Rate
Choosing the correct lease discount rate is important because it significantly impacts the amount of the lease liability recognized on your nonprofit’s statement of financial position. Depending on whether the lease is an operating or financing lease, it can affect the timing of when expense is recognized and what portion of the lease expense affects interest expense on the statement of functional expenses.
Contact Windes accounting professionals to determine whether your nonprofit can benefit from using the risk-free rate allowed for ASC 842 leases. Our ASC 842 experts will provide peace of mind for your organization by identifying gaps between where your nonprofit stands today on lease accounting and what changes are needed for compliance with the new standards.