12.20.21 | Assurance Chat
It’s finally here, folks! As we ring in the New Year, we also ring in the new lease accounting standard – Topic 842! But wait, there’s news about using a risk-free rate!
The key takeaways from the FASB’s post-implementation review of Topic 842 focused on the costs and complexities of applying the new standard. In response, the FASB amended Topic 8421 on November 11, 2021. The amendment grants non-public business entity lessees, including all not-for-profits and employee benefit plans, more flexibility in determining the discount rate for their leases by allowing them to elect to use the risk-free rate for a period comparable to that of the lease term (aka, the risk-free rate election). Here is a brief FAQ summarizing questions that have come my way:
- Couldn’t I make the policy election to use a risk-free rate before this amendment? Absolutely, but you have to make the risk-free rate election for all leases. The amendment allows lessees to make the election by class of underlying asset.
- Should I use the same risk-free rate for all my leases of a particular class? Not necessarily. The risk-free rate election is a policy election. You still need to look at the term or remaining term of the lease and align the risk-free rate to one applicable to that term.
- What if there is a discount rate implicit in the lease? If there is a readily determinable discount rate implicit in any individual lease, you are still required to use that rate, not the risk-free rate or incremental borrowing rate, regardless of the risk-free rate election for a particular asset class.
- What if I am first adopting Topic 842 now (after November 11, 2021)? This guidance is effective for fiscal years beginning after December 15, 2021, and interim periods within the fiscal years beginning after December 15, 2022, with early application permitted. Just apply the guidance to any new leases and follow the original transition guidance for existing leases, incorporating any elections made. You may choose:
- A modified retrospective basis with the cumulative-effect adjustment recognized in opening retained earnings at the beginning of the period or
- Retrospectively with the cumulative-effect adjustment recognized in opening retained earnings of the earliest period presented.
- What if I early adopted Topic 842 (before November 11, 2021)? No worries! You may choose to start or stop using a risk-free rate for any class of underlying asset upon implementation of the new guidance. Just apply these amendments on a modified retrospective basis to new leases and those that exist at the beginning of the fiscal year of adoption. You will adjust your lease liability, now calculated based on the appropriate risk-free rate and remaining lease term, at the beginning of the fiscal year of adoption, with an adjustment to the corresponding right-of-use asset. No remeasurement and reallocation of the lease payments (or other consideration in the contract) nor reassessment of the lease term or classification is necessary.
- Are there additional disclosure requirements? You need to disclose that you made the policy election, which asset classes you elected to apply a risk-free rate, and the amount of the transition adjustment to the lease liabilities and corresponding right-of-use asset as of the beginning of the fiscal year of adoption only.
- Are there any disadvantages to using the risk-free rate? In the current economic environment, with inflation creeping up, risk-free rates may be lower than the average incremental borrowing rates. Using the lower risk-free rates will most likely increase an entity’s lease liability and the corresponding right-of-use asset.
The ability to make the risk-free rate election by class provides an opportunity for you to simplify the Topic 842 implementation and subsequent accounting.
Wishing everyone a happy and HEALTHY New Year!
Questions? I can be reached at 516.806.1193 | BMannFalk@BERDONLLP.COM or reach out to your Berdon advisor.
Bonnie Mann Falk is a Partner in the Quality Control (QC) Department of Berdon LLP with nearly 30 years of experience in public accounting and expertise in a variety of areas including quality management, compliance, and risk management. As a QC Partner, Bonnie advises the Firm on policies and procedures to enhance quality, increase efficiency, and elevate communication.