Definition
Under ASC 842, the discount rate for the lease liability is the rate implicit in the lease when it is readily determinable. Lessees often cannot determine it, so they use their incremental borrowing rate (IBR): the rate they would have to pay to borrow on a collateralized basis over a similar term an amount equal to the lease payments in a similar economic environment. A lessee that is not a public business entity may elect, by asset class, to use a risk-free rate instead.
Why it matters in an audit or review
Small changes in rate move the liability and asset. Auditors evaluate how the rate was built: reference rate for the term, credit spread, collateral adjustment, and whether it is applied at lease commencement or the proper remeasurement date. Documentation, banker quotes, or a specialist's work may support it.
Example
(Illustrative) Five annual payments of $60,000, each made at year end. At 6% the liability is about $252,700. At a 4% risk-free rate it is about $267,100, a difference of about $14,400 that affects the ROU asset and interest expense.
Common mistakes
- Using the company's unsecured borrowing rate without a collateral adjustment.
- Using one rate for all leases regardless of term.
FAQ
Can private companies use the risk-free rate?
Yes, by election per class of underlying asset, with disclosure of that election.
Sources
- FASB ASC 842-20-30-3, Leases, discount rate for the lease liability (rate implicit in the lease, incremental borrowing rate, risk-free rate election)
- FASB ASU 2021-09, Discount Rate for Lessees That Are Not Public Business Entities
- FASB ASC 842-20-50, Leases, lessee disclosures
Definitions paraphrase AICPA and FASB guidance; read the standard itself before relying on a requirement. Example figures are illustrative. This page is guidance, not professional advice. Report an error