The risk-free rate election lets a lessee that is not a public business entity discount its lease payments at a US Treasury rate for a period comparable to the lease term, instead of building an incremental borrowing rate. Since ASU 2021-09 the election is made by class of underlying asset rather than for the whole entity, and it must be disclosed. It is cheap to apply and it produces a larger lease liability, because a lower discount rate leaves a larger present value.
There is a second rule inside ASU 2021-09 that gets left out of most summaries, and it is the one that causes restatements. Making the risk-free election does not release you from the top of the discount rate hierarchy. If the rate implicit in the lease is readily determinable for an individual lease, you must use that rate, election or no election. The risk-free rate substitutes for the incremental borrowing rate. It never substitutes for the implicit rate.
Who can make the election
Only a lessee that is not a public business entity. That covers most private companies, and it also reaches not-for-profit entities and employee benefit plans that are not otherwise captured by the public business entity definition. If you file with the SEC, or your financial statements are included in an SEC filing, the election is not available to you and you are building incremental borrowing rates.
The rate itself is a risk-free rate determined using a period comparable with that of the lease term. In US GAAP practice that means a US Treasury yield at a matched tenor: a five year lease reads off the five year point on the Treasury curve as of the commencement date. The comparable period requirement is not optional, so a single Treasury rate applied to every lease regardless of length fails for the same reason a single revolver rate does.
What ASU 2021-09 changed
The FASB issued ASU 2021-09 on November 11, 2021, after private company stakeholders reported that the original all-or-nothing election was unusable. Companies with a few large real estate leases and hundreds of small equipment leases had to choose between grossing up the balance sheet on the leases that mattered, or paying for a valuation exercise on the leases that did not.
| Before ASU 2021-09 | After ASU 2021-09 | |
|---|---|---|
| Scope of the election | Entity-wide, all leases or none | By class of underlying asset |
| Interaction with the implicit rate | Not addressed clearly | Implicit rate must be used whenever readily determinable, regardless of the election |
| Disclosure | Policy election disclosed | Policy election disclosed, plus the class or classes it applies to |
The FASB's own illustration of the intent is worth repeating because it is exactly how the election is used in practice: apply the risk-free rate to an asset class with high volume and low dollar leases, such as equipment, and use the incremental borrowing rate for an asset class with low volume and high dollar leases, such as real estate.
What the election actually costs you
Take a private company with two asset classes. Real estate is three leases: an office at $200,000 a year for seven years, a warehouse at $120,000 a year for five years, and a retail unit at $90,000 a year for four years. Equipment is forty leases at $6,000 a year for three years each. All operating, all paid annually in arrears.
| Policy | Real estate liability | Equipment liability | Total lease liability | vs all-IBR |
|---|---|---|---|---|
| Incremental borrowing rate everywhere | $1,912,021 | $630,988 | $2,543,009 | baseline |
| IBR for real estate, risk-free for equipment | $1,912,021 | $666,654 | $2,578,675 | $35,666 higher |
| Risk-free everywhere | $2,053,269 | $666,654 | $2,719,923 | $176,914 higher |
Real estate rates used are 6.55%, 6.10% and 5.85% by tenor for the incremental borrowing rate, and 4.20%, 4.00% and 3.90% risk-free. Equipment is 6.90% against 3.95%. Those are illustrative inputs, not current market data.
Read the middle row carefully, because it is the entire argument for the asset-class election. Taking the free ride on forty equipment leases costs $35,666 of extra liability, about 1.4% of the total. Taking it on the three real estate leases as well costs another $141,248. The cheap option is nearly free where the leases are small and short, and expensive where they are large and long, which is precisely where a company would rather have the accurate number anyway.
Why the balance sheet effect matters beyond the balance sheet
Private company lease liabilities land inside debt covenant definitions more often than people expect. If funded debt in this example is $3.5 million and EBITDA is $1.9 million, the leverage ratio runs 3.18x under an all-IBR policy, 3.20x under the mixed election, and 3.27x if everything is discounted at a risk-free rate. A covenant set at 3.25x passes in the first two cases and fails in the third, on identical leases and identical cash flows.
That is worth modeling before the election is locked in rather than after, because an accounting policy election is not something you flip back and forth once financial statements are issued. Talk to the lender early too. Many credit agreements written before ASC 842 adoption define indebtedness in a way that sweeps in operating lease liabilities that did not exist on the balance sheet when the agreement was signed, and the fix is usually a definitional amendment rather than a different discount rate. If you have to walk owners or an audit committee through the impact, the adoption memo generally turns into a short deck with the three policy scenarios side by side.
The disclosure you owe if you elect
Two things have to appear in the footnote. First, the fact that the election has been made, disclosed as an accounting policy election. Second, the class or classes of underlying assets it has been applied to. That second requirement came in with ASU 2021-09 and exists so a reader can tell which part of the liability is measured at a benchmark rate and which part reflects the company's own cost of borrowing.
The election also shows up indirectly in the weighted average discount rate, which will be visibly lower than a private company's real borrowing cost if the election covers a large share of the portfolio. Expect a question about it. The rest of what has to appear alongside it is set out in the ASC 842 disclosure requirements.
How to decide, in order
Work through it lease population first, policy second. The order matters because the hierarchy decides some of this for you before any election is available.
- Split the population into classes of underlying asset. Real estate, vehicles, IT equipment, production equipment. These classes are what the election attaches to, so define them before you decide anything.
- For each class, find the leases where the rate implicit in the lease is readily determinable. Stated equipment and vehicle schedules with an asset price and a purchase option often qualify. Those leases use the implicit rate whatever you elect.
- For the rest of each class, size the gap. Discount the class at a Treasury curve and at an indicative borrowing rate and look at the difference in dollars, the way the table above does.
- Elect the risk-free rate where the gap is immaterial and the lease count is high. Build an incremental borrowing rate where the gap is large, which is usually real estate.
- Test the result against every leverage and fixed charge covenant you are subject to before the policy is final.
- Document the classes, the rate source, and the date each rate was read. That documentation is what discount rate testing asks for.
Frequently asked questions
What is the risk-free rate election under ASC 842?
An accounting policy election available to lessees that are not public business entities, permitting a risk-free discount rate determined using a period comparable with the lease term instead of the incremental borrowing rate. Since ASU 2021-09 it is made by class of underlying asset, and both the election and the classes it covers must be disclosed.
Can public companies use the risk-free rate for ASC 842?
No. The election is restricted to lessees that are not public business entities. A public business entity that cannot readily determine the rate implicit in a lease must use its incremental borrowing rate, which means building a rate from credit, term and collateral rather than reading a Treasury yield.
Does the risk-free rate election override the rate implicit in the lease?
No, and this is the rule most summaries omit. ASU 2021-09 requires a nonpublic lessee to use the rate implicit in the lease whenever that rate is readily determinable for an individual lease, whether or not the risk-free election has been made. The election replaces the incremental borrowing rate only.
Does the risk-free rate increase the lease liability?
Yes, in almost every case. Treasury yields sit below a company's secured borrowing rate, and a lower discount rate produces a larger present value. In the portfolio above, electing the risk-free rate across all classes raises the total lease liability from $2,543,009 to $2,719,923, an increase of about 7%.
Which Treasury rate do I use for the risk-free rate?
The one matching the lease term as of the commencement date. A five year lease uses the five year Treasury yield, a three year lease the three year yield. ASC 842 requires a period comparable with that of the lease term, so applying one rate across leases of different lengths does not meet the requirement.
Can I elect the risk-free rate for some leases and not others?
Only by class of underlying asset, not lease by lease. You can elect it for equipment and not for real estate. You cannot elect it for two of five office leases. The class definitions should be reasonable and applied consistently, and they have to be disclosed.
Can I change the election later?
Changing it is a change in accounting policy, which requires demonstrating that the new policy is preferable and applying the change under ASC 250. That is a materially higher bar than making the choice correctly the first time, which is why the covenant modeling belongs before adoption rather than after.
Does the risk-free rate election apply to IFRS 16?
No. There is no equivalent risk-free rate practical expedient in IFRS 16. It is a US GAAP accommodation for private companies specifically. A dual reporter will need an incremental borrowing rate for IFRS purposes regardless of what it elects under ASC 842.
Where the inputs come from
The election is a rate decision, but everything the rate is applied to comes out of the lease documents: the commencement date that fixes when the rate is read, the term including options reasonably certain of exercise that fixes the tenor, and the payment schedule that gets discounted. Getting a Treasury yield is the easy part. Knowing that a lease is a seven year lease rather than a five year lease with two options nobody assessed is the part that goes wrong.
That is what abstraction is for. Upload the population and each lease comes back with its dates, term, options with notice deadlines, payment schedule and escalation basis linked to the clause each value was read from, which is also what the incremental borrowing rate build-up needs as its tenor and payment inputs, and what the lease liability calculation consumes next. If you are still working through adoption sequence rather than a single policy question, the ASC 842 implementation guide covers the order the decisions come in.