Don’t miss part one! Read it here: Nonprofits – Are you Ready to Implement Lease Accounting? Part 1.

Choosing a Discount Rate

Once leases have been identified and the relevant data has been extracted from them, lessees need to choose a discount rate.

The discount rate helps determine the present value of the lease payment that is not yet paid. Under ASC 842, lessees are required to use the rate implicit in the lease, if that's readily determinable. If the implicit rate is not readily determinable, lessees are required to use the incremental borrowing rate; but nonpublic business entities can elect to use a risk-free rate by asset class. The risk-free rate should be used for a period comparable to the lease term.

The rate implicit in the lease often is not determinable, and the incremental borrowing rate can be difficult to calculate or estimate. The risk-free rate, which can be used by class of underlying lease asset by not-for-profits and private companies, is the borrowing rate for a zero-coupon U.S. Treasury instrument for the same period as the lease. The risk-free rate is likely to be lower than the incremental borrowing rate, so the risk-free rate is likely to result in higher values for the lease asset and lease liability.

It is very possible that your organization might appear to be much larger after adoption than it did before, because a 10- or 15-year office lease can be a very large right-to-use asset and lease liability to add to the financial statements. You need to consider what your financials will look like after adoption, especially those organizations with numerous leases.

Financial Statement and Organizational Impacts

Adoption of ASC 842 will dramatically impact many organizations’ statements of financial position or balance sheets, adding significant levels of assets and related debt. These changes in financial position will result in increased debt levels which could impact debt to equity ratios, liquidity ratios, and more. These could negatively impact debt covenants. Furthermore, many debt agreements put limitations on your ability to enter into debt without approval. As leases under ASC 842 now are reflected as an obligation on your statement of financial position, this could pose a problem for you every time you want to enter into an equipment or property lease.

It is important for you to sit down with your bankers to work through changes in debt covenants with them in consideration of the impact of ASC 842. Similarly, the change to your statement of financial position could impact other stakeholders such as government funders, donors, your Board, and more. It is important to get ahead of the curve and discuss this with them before they are surprised by a dramatic change in your numbers.

KLR is here to help with your implementation. Please reach out to us with any questions.