In November 2021, the FASB board rejected an extension request for the effective date of the new lease accounting standards. That means that the time is now imminent for nonprofits to adopt these requirements.
Your organization’s discount rate is an important item to both understand and determine as you begin the implementation of Accounting Standards Update No. 2016-02 (Topic 842). The discount rate impacts both lease classification and liability.
Importance of the Discount Rate
To determine lease liability, the discount rate is applied to all future lease payments. This is needed to calculate the present value of lease payments. Because a right-of-use asset is based on lease liability, the discount rate will impact the initial value of a right of use asset.
Determining Lease Classification
There are two lease classifications:
- Finance lease
- Operating lease
To determine the classification of a lease, consider whether the present value of lease payments is equal to or almost all of the fair value of the asset.
Now you can see how the discount rate can impact the income statement and the balance sheet. It depends on how you determined the lease classification.
Determining Discount Rate
For lessees, the discount rate is the rate stated in the lease. If the rate cannot be readily determined, you can use either the incremental borrowing rate or the risk-free rate.
What if a lease needs to be remeasured? Then a new discount rate is established at remeasurement.
You Can Elect the Risk-Free Rate
To make things easier, entities that are not public may make an accounting policy election to adopt a risk-free discount rate as their discount rate instead of the incremental borrowing rate. This rate should be applied using a term comparable to the lease term based on the earliest date the lease is presented in the financial statements.
However, if the rate is readily determinable from the lease agreement, that rate should be used instead of the risk-free rate. The risk-free rate can only be used when the rate implicit in the lease is not readily determinable. You can find risk-free rates on the Treasury website.
The bottom line: the rate to be used must be the one that best reflects the accuracy of the transaction and be easily determined. Nonprofits should create various financial what-if scenarios to see how each discount rate affects their income statement and balance sheet. Then choose the one that makes the most sense from both an accuracy and transparency situation as well as what makes the most sense for their financial needs.
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