Key Takeaways:
- A risk-free discount rate is the rate of return an investor expects to earn from an investment with zero risk. It is often used in financial valuation models to calculate the present value of an investment's expected future cash flows. The risk-free rate is typically based on the yield of a government-issued bond, such as the US Treasury bond, which is considered to be virtually free of default risk.
- We’ve made it easy to calculate the risk-free discount rate on your lease portfolio. Use our free discount rate calculator in Excel linked below.
- Communicate early and often with your auditors. Share your assumptions for the risk-free rate calculation, including the source of your data and methodology. Provide supporting documentation to back up your calculation. This will help create a smooth transition to ASC 842.
FAQ Series: Calculating Incremental Borrowing Rates (ASC 842)
For public companies, the calculation of the incremental borrowing rate has represented no small challenge. Fortunately, for most private companies and not-for-profit organizations, the FASB has issued a practical expedient to help ease the pain.
The guidance states that these entities are “permitted to use a risk-free discount rate for the lease, determined using a period comparable with that of the lease term, as an accounting policy election for all leases”. (ASC 842-20-30-3)
This is great news, but what exactly is the risk-free rate and how does it apply to your lease portfolio?
We’ve broken it out into 3 simple steps to ensure you get this right.
- Segment your lease portfolio into general buckets based on lease term and contract currency (e.g. 2, 5, 10 years, USD, CAD, GBP, EUR, AUS)
- Align the risk-free rates found here (https://www.bloomberg.com/markets/rates-bonds/government-bonds/us) or here (treasury.gov) with the terms and jurisdictions outlined above.
- Document (including screenshots of the rates) and discuss with your auditors as early as possible during the transition process to ensure alignment.
It’s important to note that this practical expedient must be applied to all leases in your portfolio, and it will likely result in a lease liability and ROU asset that is greater than if the incremental borrowing rates were calculated separately. Additionally, the risk-free rate cannot be less than zero.
At Netgain, we have made the calculation easy by developing a free discount rate calculator in excel to determine the applicable risk-free rate. Simply input your lease term and commencement date, and the tool will automatically calculate the risk-free rate to be used for your leases. Within the tool, you’ll be able to see the data and formulas used to calculate the rate as support for your auditors.
Additionally, we have drafted an example accounting policy memo that can be used to document your decision to use this method to calculate your discount rate. This can act as additional support for your auditors.
Bottom line:
You are going to want to get the calculation of your incremental borrowing rate completed and signed off by your auditors well in advance of transitioning to the new standard. We’ve seen too many companies make the change post-transition, which requires unnecessary rework and journal entry reversals. Using our free tool and policy memo, calculating, and disclosing the risk-free rate for your leases can be a quick and easy process.
