How to determine an appropriate discount rate is rapidly becoming the hot topic of lease accounting under IFRS 16. This is because it is one of the most judgmental and complex areas of the standard and also because a small change in discount rate can have a significant impact on assets and liabilities recognised.
What does IFRS 16 require?
At the commencement date of the lease, IFRS 16 requires the lessee to discount the lease payments using the ‘rate implicit in the lease’ if that rate can be readily determined. If that rate cannot be readily determined, the lessee is required to use its incremental borrowing rate.
The rate implicit in the lease is the rate of interest that causes the present value of (a) the lease payments and (b) the unguaranteed residual value to equal the sum of (i) the fair value of the underlying asset and (ii) any initial direct costs of the lessor.
In the Basis of Conclusions of the standard, the IASB acknowledges that because the rate implicit in the lease takes into account the lessor’s estimate of the residual value of the underlying asset at the end of the lease, and may be affected by taxes and other factors known only to the lessor (such as initial direct costs of the lessor), it may be difficult for lessees to determine the rate implicit in the lease for many leases. This will particularly be the case for leases where the underlying asset is likely to have a significant residual value at the end of the lease, for example such as property leases.
Special provisions apply on transition to IFRS 16 for those entities applying the modified retrospective approach. Under this transition approach, lessees are required to determine the lease liability and right-of-use asset using the incremental borrowing rate of the lessee at the date of initial application. Therefore, the rate implicit in the lease will not be relevant for the purposes of transition when the modified retrospective approach is used.
In practice, we expect a majority of lessees will need to use an incremental borrowing rate for at least some (if not most) of their lease contracts.
What is the lessee’s incremental borrowing rate?
IFRS 16 provides the following definition:
“The rate of interest that a lessee would have to pay to borrow over a similar term, and with a similar security, the funds necessary to obtain an asset of a similar value to the right-of-use asset in a similar economic environment.”
Therefore, the rate takes into account the credit standing of the lessee, the length of the lease, the nature and quality of the collateral provided and the economic environment in which the transaction occurred. Consequently, the lessee’s incremental borrowing rate for one lease will be different to the rate relevant to another lease with substantially different terms.
In practice, determining the appropriate incremental borrowing is likely to be complex and may require the use of a valuation expert. The process will likely involve examination of:
- The entity’s current financing structure (eg what debt instruments does the entity have and what are the terms of those instruments)
- Relevant reference rates (currency, economic environment and term will need to be considered, government bond yields or interest rate curves may be appropriate)
- Relevant lease terms including the nature of the underlying asset.
We are commonly asked:
- Can an entity use its Weighted Average Cost of Capital (WACC) as an approximation for the incremental borrowing rate?
This will usually be inappropriate as the WACC takes into account both debt and equity financing and is not specific to the underlying lease.
- Can a property yield be used as the discount rate for a property lease?
Again this is not usually appropriate as whilst a property yield will be specific to an individual property, it does not take into account factors such as the length of the lease or the credit rating of the lessee. A property yield may, however, be a relevant starting point from which to make adjustments to derive an appropriate incremental borrowing rate.
- Can one group entity use the borrowing rate of another group entity?
Generally, it will not be appropriate to use the same rate across a group without appropriate adjustments being made.
Why does it matter?
The table below illustrates the impact of a small change in discount rate for a 100-year lease with annual lease payments of £100,000pa.
Present Value (‘000)
A three percent increase in the discount rate reduces the present value of the lease payments in this scenario by 37%. This would therefore result in:
- A lower liability and right-of-use asset being recognised
- Lower annual depreciation charge and, therefore, improved operating profit
- Higher annual interest charge and therefore reduction in interest cover,
Care should, therefore, be taken to ensure discount rates used are appropriate.
For help and advice on accounting for leases please get in touch with your usual BDO contact or Mark Edwards.
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