Lessee initial measurement and the discount rate, including the private company risk-free election

• Identify the lease payments included in the lease liability under 842-10-30-5
• Measure the ROU asset from the liability, prepaid rent, incentives and initial direct costs
• Select the discount rate under 842-20-30-3 as amended by ASU 2021-09
• Evaluate the effect of the risk-free rate election on balances and disclosures

Lease payments

At commencement the lease liability is the present value of lease payments not yet paid, discounted at the discount rate for the lease (842-20-30-1). Under 842-10-30-5 lease payments include:

• fixed payments, including in-substance fixed payments, less lease incentives paid or payable to the lessee,
• variable payments that depend on an index or rate, measured using the index or rate at commencement,
• the exercise price of a purchase option the lessee is reasonably certain to exercise,
• termination penalties if the lease term reflects exercising a termination option,
• for a lessee, amounts probable of being owed under residual value guarantees.

Variable payments tied to performance or usage, such as a percentage of store sales, stay out of the liability and are expensed when incurred (842-10-30-6). A CPI escalator is measured at the commencement CPI; later CPI changes are not remeasured unless something else triggers a remeasurement.

The ROU asset

Under 842-20-30-5 the ROU asset at commencement equals:

• the initial lease liability,
• plus lease payments made at or before commencement, minus lease incentives received,
• plus initial direct costs incurred by the lessee.

Initial direct costs are incremental costs that would not have been incurred if the lease had not been obtained, such as a broker commission. Legal fees for negotiating terms are not incremental.

Choosing the discount rate

Under 842-20-30-3 a lessee uses the rate implicit in the lease whenever it is readily determinable. Lessees rarely know the lessor's residual value assumption and deferred costs, so the rate implicit is frequently not readily determinable. The lessee then uses its incremental borrowing rate: the rate it would 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 a risk-free rate, determined using a period comparable with the lease term. ASU 2016-02 made that election entity-wide. ASU 2021-09 allows the election by class of underlying asset and requires disclosure of the classes for which the risk-free rate is applied. ASU 2021-09 also requires a lessee to use the rate implicit in the lease whenever it is readily determinable for an individual lease, even if the risk-free election applies to that class.

Effects of the election

A risk-free rate is lower than an incremental borrowing rate, so it produces a higher lease liability and ROU asset. It can also push more leases into finance classification under criterion 4. Some clients elect it for real estate and keep the incremental borrowing rate for equipment, where a lower rate would distort covenant ratios.

Audit points

• Recompute the present value for a sample of leases from the signed lease.
• Test the source of the incremental borrowing rate: bank quotes, recent borrowings, adjusted for term and collateral. A single company-wide rate for leases of 2 and 15 years is a red flag.
• For the risk-free election, agree the rate to Treasury yields for a matching term at commencement and confirm the policy note names the asset classes.
• Agree initial direct costs and incentives to invoices and the lease agreement.

The lease calculator reproduces these computations.

Measuring a five-year office lease at Kestrel Dental Group, PC