ASU 2021-09: Revised practical expedient for non-PBE lessees

David Wentzel, Ryan Walker
| 12/8/2021
Revised practical expedient for non-PBE lessees

Overview

In November 2021, the FASB issued Accounting Standards Update (ASU) 2021-09, “Leases (Topic 842): Discount Rate for Lessees That Are Not Public Business Entities,” which amends Topic 842 to provide a lessee that is not a public business entity (PBE) – including a not-for-profit conduit bond obligor – greater flexibility in how to use the existing risk-free rate practical expedient. Topic 842 allows non-PBE lessees to elect to use the risk-free rate to measure lease liabilities when the rate implicit in the lease is not readily determinable. Prior to the issuance of ASU 2021-09, the election had to be made at the entitywide level – that is, if elected, it had to be applied to all leases. Upon adopting ASU 2021-09, non-PBE lessees will now have the flexibility to elect the risk-free rate practical expedient at the “asset class” level (for example, electing to use the risk-free rate for all equipment leases while using the incremental borrowing rate for real estate leases).

Breaking it down

Electing the practical expedient by asset class versus at the entitywide level

Topic 842 requires reporting entities to use the rate implicit in the lease, when readily determinable, to initially measure right-of-use (ROU) assets and lease liabilities for all lease contracts within its scope. If the rate implicit in the lease is not readily determinable, then a reporting entity must use its incremental borrowing rate, which is the interest rate a lessee would have to pay to borrow, on a fully collateralized basis, an amount equal to the lease payments over a term similar to the lease term. Because determining an entity’s incremental borrowing rate can be complex, Topic 842 provides non-PBE lessees with a practical expedient that allows them to use the risk-free rate as the discount rate, which substantially eliminates judgment from management’s determination of the discount rate.

ASU 2021-09 provides non-PBE lessees enhanced flexibility in applying the risk-free rate practical expedient by permitting them to use the risk-free rate as the discount rate for some classes of underlying assets, rather than applying the risk-free rate expedient to all leases. For example, a lessee might determine the incremental borrowing rate for material classes of leases that are entered into on a less frequent basis (such as real estate leases) while having the ability to use the risk-free rate as the discount rate for its other leases (for example, leased assets that are lower dollar and higher volume).

Observation

We believe this ASU will enable non-PBE lessees to report more decision-useful information under Topic 842, as the flexibility to use the incremental borrowing rate for certain leases, as opposed to the risk-free rate, will result in lessees reporting lease liabilities that more closely resemble the hypothetical borrowing needed by the entity to finance the payments under the lease obligation.

In addition, the ASU alleviates some concerns voiced by stakeholders through the FASB’s post-implementation review of Topic 842 that applying the risk-free rate (instead of the incremental borrowing rate) to all of an entity’s leases has the effect of significantly increasing lease liabilities reported and in some cases could result in finance lease classification for leases otherwise designed to be operating leases.

The ASU also clarifies that a lessee must use the rate implicit in the lease when that rate is readily determinable, regardless of whether the lessee has made the risk-free rate election. In practice, we believe this situation will rarely apply because a lessee typically cannot determine all relevant inputs used by the lessor in determining the lease’s implicit rate. For example, if a lessee does not know or cannot reliably substantiate the lessor’s estimate of the asset’s residual value at the end of the lease or the amount of initial direct costs deferred by the lessor, the rate implicit in the lease will not be readily determinable. The board affirms this sentiment in paragraph BC18 of the ASU, noting that the readily determinable threshold is a high bar, and “the Board does not expect that an entity would have to expend much effort substantiating that it cannot readily determine the rate implicit in the lease.”

Observation

Lessees that currently apply or intend to apply the risk-free rate practical expedient should consider whether they expect to meet the definition of a PBE in the future. An entity that applies the risk-free rate practical expedient and later meets the definition of a PBE will be required to retrospectively adjust its historical financial statements by unwinding the application of the practical expedient and recasting its leases using the incremental borrowing rate.

Disclosures

Lessees electing to use the risk-free rate practical expedient must disclose the class(es) of underlying assets to which it applied the risk-free rate.

Effective dates and transition

  • Entities that had not yet adopted Topic 842 as of the issuance date of the ASU are required to apply the amendments in the ASU when they initially adopt Topic 842. These entities will follow the transition requirements in Topic 842, which is effective for private companies and certain not-for-profit entities for annual periods beginning after Dec. 15, 2021, and interim periods within annual periods beginning after Dec. 15, 2022.
  • Entities that previously adopted Topic 842 as of the issuance date of the ASU shall apply the amendments in the ASU on a modified retrospective basis to leases affected by the amendments that exist at the beginning of the year of adoption of this ASU. The amendments are effective for annual periods beginning after Dec. 15, 2021, and interim periods within annual periods beginning after Dec. 15, 2022. Early adoption is permitted. Entities are required to disclose the nature of and reason for the change in accounting principle, the cumulative effect of the change on opening retained earnings, and the amount of the change in lease liabilities and corresponding ROU assets resulting from the transition adjustment.

Observation

Entities that previously adopted Topic 842 should consider these transition observations:

  • At the date of adoption of this ASU, entities can change their election to apply or not apply the risk-free rate to leases for any class of underlying asset without evaluating the accounting policy change under Topic 250, “Accounting Changes and Error Corrections.”
  • The transition adjustment does not result in the lessee remeasuring and reallocating consideration in the contract (including lease payments) or reassessing the lease term, purchase options, or lease classification.
  • The adjusted lease liability will be calculated based on the discount rate and remaining lease term at the beginning of the fiscal year of adoption of this ASU. A corresponding adjustment is made to the ROU asset, except:
  1. If the carrying amount of the ROU asset is reduced to zero, the remaining amount of the adjustment is recognized as an adjustment to opening retained earnings at the beginning of the year of adoption.
  2. If the adjustment would increase an ROU asset that was previously impaired, the entity would instead recognize the amount as an adjustment to opening retained earnings at the beginning of the year of adoption.

Contact us

David Wentzel
David Wentzel
Partner
Ryan Walker
Ryan Walker