Determining a leases discount rate
The definition of the lessee’s incremental borrowing rate states that the rate should represent what the lessee ‘would have to pay to borrow over a similar term and with similar security, the funds necessary to obtain an asset of similar value to the right-of-use asset in a similar economic environment.’ In applying the concept of ‘similar security’, a lessee uses the right-of-use asset granted by the lease and not the fair value of the underlying asset.
This is because the rate should represent the amount that would be charged to acquire an asset of similar value for a similar period. For example, in determining the incremental borrowing rate on a 5 year lease of a property, the security for the portion of the asset being leased (i.e. the 5 year portion of its useful life) would be likely to vary significantly from the outright ownership of the property, as outright ownership would confer rights over a period of time that would typically be significantly greater than the 5-year right-of-use asset contained in the lease.
In practice, judgement may be needed to estimate an incremental borrowing rate in the context of a right-of-use asset, especially when the value of the underlying asset differs significantly from the value of the right-of-use asset.
An entity’s weighted-average cost of capital (‘WACC’) is not appropriate to use as a proxy for the incremental borrowing rate because it is not representative of the rate an entity would pay on borrowings. WACC incorporates the cost of equity-based capital, which is unsecured and ranks behind other creditors and will therefore be a higher rate than that paid on borrowings.
The use of WACC would therefore result in the carrying amounts of both lease liabilities and right-of-use assets being understated.
|
Consider this! |
Use of rate of implicit in the lease vs. incremental borrowing rateThe rate implicit in the lease is the rate that would cause the present value of the lease payments and unguaranteed residual to equal the sum of the fair value of the underlying asset(s) and initial direct costs incurred. Using the implicit rate presents the true financing cost of leasing an asset as opposed to paying for it up-front or Allowing the incremental borrowing rate to be used acknowledges that a lessee is often not able to determine the implicit rate. A lessor often does not disclose the rate in the contract, or may offer a rate as being promotional (i.e. a below market interest rate), but also charge above-market lease rates to compensate for the low interest rate). Ultimately, to calculate the rate implicit in the lease requires not only information about the fair value of the leased asset at the start of the lease, but also its ‘unguaranteed residual value’ (the fair value at the end of the lease if the residual value is not being guaranteed). However, in many leases it will not be possible to make a reliable estimate of this, particularly where the lease term is less than the leased asset’s useful economic life. Therefore, it is likely that many lessees will use their incremental borrowing rate for a wide variety of leases. Interest rate implicit in the lease for lease and non-lease componentsIf a lessee uses the interest rate implicit in the lease to measure leases (not the lessee’s incremental borrowing rate), the lessee must also consider lease and non-lease components. While IFRS 16 contains a practical expedient that permits lessees to combine lease and non-lease components in the measurement of a lease contract (e.g. an automobile lease payment with built in maintenance services), in general, lessees still must bifurcate these payments for purposes of determining the rate implicit in the lease. This is because the practical expedient (IFRS 16.15) permits lessees to not separate lease and non-lease components by accounting for them as a single lease component. In determining the interest rate implicit in the lease, lessees must still comply with the definition, which states that it 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’. The term ‘lease payments’ is defined as ‘payments made by a lessee to a lessor relating to the right to use an underlying asset…’, meaning that the input into the determination of the rate implicit in the lease relates only to lease components, not non-lease components. This creates additional complexity for entities using the rate implicit in the lease for the measurement of lease contracts. Timing of the determination of the discount rateThe timing of the determination of the discount rate may affect lease measurement if there is a delay between contract inception and the commencement of the lease This can arise in situations where significant events occur between the inception and commencement dates, which would affect either the lessee’s incremental borrowing rate or the rate implicit in the lease. For example, credit deterioration of the lessee would affect the incremental borrowing rate and significant geopolitical or technological events could affect the fair value of the underlying asset, which would in turn impact the rate implicit in the lease. in general, the determination of the discount rate from the lessee’s perspective is at the commencement date of the lease, as IFRS 16.23 requires a lessee to measure the right-of-use asset at the commencement date. The applicable discount rate is a component of the measurement of the lease, therefore, it is determined at the same time as other components of the measurement of the lease. For lessors, the guidance differs, as IFRS 16.66 states that lease classification between operating and finance type occurs at the inception date. The applicable discount rate is a component in determining how a lease is classified, as it affects the criteria used to analyse whether a lease is finance or operating. Consequently, the discount rate is determined at the inception of the lease contract for lessors. Discount rate for leases acquired in a business combinationIFRS 3 includes the following requirements for the measurement of leases acquired in a business combination when the acquiree is a lessee (emphasis added):
This raises the question of whether, in a transaction where a business combination is effected through the acquisition of a separate legal entity (e.g. a corporation), when applying IFRS 3.28B, does the acquiring entity determine a discount rate from its own perspective (i.e. the acquirer) or from the perspective of the acquiree? Note that if a lease is acquired by the acquirer in a business combination through methods other than the acquisition of a separate entity (i.e. a trade and asset purchase, which requires the acquirer to amend the underlying lease contract to make the acquirer the new lessee), then the lease is a new contract at the acquisition date, and the applicable discount rate would be determined from the perspective of the acquirer. This affects the measurement of the lease contract when the lessee’s incremental rate of borrowing is used, as the effects of various economic factors (in particular credit risk) are included when the rate is determined. In a business combination where the lease liability and right-of-use asset are measured at an amount equal to one another, this will not have a net impact on goodwill. However, when leases have ‘off-market’ terms, then this will impact the determination of goodwill in the business combination because the off market terms will be reflected in the measurement of the right-of-use asset. IFRS 3.28B requires the acquirer to apply IFRS 16 in measuring the acquired lease as if it were a new lease as at the commencement date. In measuring a new lease, entities must consider all relevant information in determining inputs such as the lease term, lease payments, etc. In determining the discount rate used to measure the lease liability, assuming that the interest rate implicit in the lease is not available and the lease is not restructured at the date of the business combination, then the lessee’s incremental rate of borrowing is determined from the perspective of the party to the contract (i.e. the lessee/acquiree in the business combination). This is consistent with IFRS 16.BC160: ‘The IASB’s objective in specifying the discount rate to apply to a lease is to specify a rate that reflects how the contract is priced.’ Regardless of the fact that the lease acquired is a new lease from the perspective of the acquirer, the initial recognition is still driven by the guidance in IFRS 16, therefore, the ‘lessee’ remains the acquiree in the business combination. This means that the subsidiary cannot default to the parent IBR. However, the acquirer’s incremental rate of borrowing may be relevant if the leases acquired in the business combination are simultaneously restructured at the time of the business combination to include the addition by the new parent of credit enhancements to the lessee (e.g. a guarantee provided by the parent to the lessor). In such cases, the credit enhancement is considered in the determination of the incremental rate of borrowing, and hence in the initial measurement of the lease contracts in the acquirer’s purchase price allocation. Determining the incremental borrowing rateIFRS 16 does not contain significant guidance on how to determine the incremental borrowing rate beyond the definition provided (emphasis added): ‘The rate of interest that a lessee would have to pay to borrow over a similar term and with similar security, the funds necessary to obtain an asset of similar value to the right-of-use asset in a similar economic environment.’ In the absence of specific requirements in IFRS, preparers will have to apply judgment in determining the incremental borrowing rate. For entities with relatively small lease portfolios that are not material in the context of the entity’s financial statements, then the work effort involved in determining the incremental borrowing rate for those leases may be lower. For entities with significant lease portfolios, the determination of the discount rate may have a very material impact on the statement of financial position as well as financial performance. Determining the incremental borrowing rate is more complex than simply determining the weighted rate that an entity pays on its current borrowings. Such borrowings may have economic characteristic entirely dissimilar to the definition of the lessee’s incremental borrowing rate as noted above. in general, the following methodology may provide a reasonable base for determining the incremental borrowing rate for a lease, as it incorporates the key elements denoted above in italics:
IFRS 16 Base rate for economic factors: similar economic environment, term and valueThe starting point in estimating the incremental borrowing rate is a ‘base rate’, which may be a risk-free rate derived from government bonds or other types of low risk financing. To achieve a ‘similar economic environment’, this rate should consider the applicable geographic location where the lessee operates. For example, the risk-free rate in the United States of America and sub-Saharan Africa would be very different. The base rate should also consider the term of the lease, as risk-free rates differ depending on the period of time of the lending arrangement. For example, the risk-free rate for a 3-year lease of equipment would differ from the risk-free rate for a 20-year real estate lease, as the cost of borrowing tends to increase as the period of time increases. An issue arises in developing this base rate, as there are often significant differences in the timing of cash flows between risk-free rates and leases. Low risk lending arrangements, such as government bonds, tend to have cash flows heavily weighted towards the end of the term (i.e. a ‘bullet loan’). In some cases, all cash flows, including interest, may be deferred until this point in time. In contrast, most leases have period cash flows that occur over the lease term on a weekly, monthly, or annual basis. However, IFRS 16 does not contain specific guidance for the determination of the incremental borrowing rate. At its September 2019 meeting, the IFRS Interpretations Committee (the Committee) issued an agenda decision in respect of determining the lessee’s incremental borrowing rate. In its agenda decision, the Committee observed that an entity must apply judgment in determining its incremental rate of borrowing. The Committee observed that it would be consistent with the Board’s objective for an entity to refer to readily observable rates for loans with similar payment profiles in developing the entity’s incremental borrowing rate for a lease. Many lease contracts are amortising in nature with regular payments, meaning that an appropriate approach would be to use readily observable rates for loans that would also be amortising in nature (e.g. an amortising government bond with similar payment profile to the underlying lease). One approach could be to use the yield curve for government bonds (which have a bullet repayment on maturity), with an appropriate rate being used to discount each of the lease payments. This would result in the determination of a ‘base rate’ which reflected the capital repayment profile of the lease. An alternative approach which may be acceptable to account for this difference in the timing of cash flows (depending on the contractual payment terms of the lease) would be for entities to select reference bonds with cash flows that approximate the weighted cash flows for the underlying lease. For example, the rate attributable to a 10-year property lease with monthly cash flows may be satisfactorily represented by a 5-year bond with a bullet capital repayment on maturity. The weighted cash flows of the bond would be approximately 5-years. However, this may not always be an appropriate approach, for example where rates are low for the initial five year period but increase sharply for years five to ten. IFRS 16 Discount rate Financing factorsIFRS 16 is clear that the intention of the discount rate guidance is to ensure the discount rate reflects how the contract is priced. As the ‘base rate’ discussed above represents a risk-free rate of borrowing, it must be adjusted to consider the credit risk of the entity. Entities may consider using readily observable rates for loans with similar payment profiles as a starting point. Once an appropriate base rate is determined, it must be adjusted for characteristics of the lease that are dissimilar from the reference rate. This may be accomplished by obtaining credit spread information for the entity itself from recent borrowings; however, obtaining this information specific to one particular entity may be difficult in practice. Entities may also consider utilising industry data and making adjustments for the entity’s specific credit risks relative to industry composites. It should be noted that in group structures where central treasury functions obtain financing for groups across multiple jurisdictions, special considerations may apply. It is common for conglomerates and large corporate entities to centralise their borrowing function in order to lower borrowing costs for the group as a whole through economies of scale. In determining an appropriate incremental borrowing rate, entities must consider that it would generally not be appropriate to use a ‘consolidated’ borrowing rate for the group as a whole. This is because a group borrowing rate generally considers the blended credit characteristics of all entities in the group, which will normally differ from the terms of a lease obtained in each individual subsidiary. For example, a group treasury rate for a revolving credit facility may consider guarantees and diversification adjustments, which lower the rate for the group as a whole and not for each separate subsidiary. Upon consolidation of many entities within a corporate group, the incremental borrowing rate may differ significantly across different entities that operate in different geographic regions and industries, even if the underlying leased asset is similar. Special consideration – Foreign currency leasesEntities may enter into lease agreements in currencies other than their functional currency. For example, an entity may have a functional currency of Euro, and enter into leases for aircraft, which are routinely denominated in US dollars worldwide. in general, entities should determine their incremental borrowing rate based on the rate of interest they would have to pay in the same currency in which the lease payments are denominated. In some situations, an entity may utilise foreign currency derivatives in order to achieve a similar economic outcome as borrowing in the foreign currency itself. Using the example noted above, the entity may acquire a loan in Euros and then acquire a cross-currency swap to economically modify the payments to be in US dollars. In a situation where an entity routinely enters into such arrangements, then depending on the precise facts and circumstances, it may be appropriate to use this ‘swapped’ borrowing rate in determining the incremental borrowing rate for a lease in the swapped currency. Factors to consider include the approach that an entity actually uses in practice for borrowing USD and which approach would give a lower cost of borrowing. Special consideration – Use of ‘real’ discount rates and interrelationship with inflationIn some jurisdictions, lease payments are adjusted on a regular basis to reflect the accumulated inflation of the past twelve months. This may be more common in jurisdictions with relatively high rates of inflation. This results in the lease having variable payments that are dependent on an index or rate. This raises the question of whether a nominal or a real rate should be used in determining the lessee’s incremental rate of borrowing. A nominal discount rate does not consider inflation, whereas a real discount rate does. A real discount rate aims to remove the effects of inflation to reflect the real cost of debt to the borrower and thus is lower than the nominal discount rate. in general, a nominal discount rate is required to be used because the lessee’s incremental borrowing rate is defined as: ‘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.’ The rate a lessee ‘would have to pay to borrow’ funds would be a nominal rate, not a real rate. IFRS 16 Discount rate Asset factors In determining how the type of asset affects the incremental borrowing rate, entities should consider that a lease is in substance a ‘secured loan’, in that the lessor typically has recourse to repossess the underlying asset (which includes the lessee’s right-of-use asset) if a lessee defaults. IFRS 16 intends the incremental borrowing rate to represent the rate that would be charged to purchase the right-of- However, there are conceptual differences in achieving this in practice. For example, a lessor is typically exposed to residual value risk in leasing to an entity, which it would be expected to incorporate into the rate implicit in the lease. in general, it would not be appropriate for the lessee to incorporate an asset risk premium for residual value risk because this is not consistent with the definition of the incremental borrowing rate. While the incremental borrowing rate and the rate implicit in the lease share many characteristics, exposure to residual value risk via an asset risk premium is not the same as security risk that a lender bears through the term of a borrowing arrangement. in general, it would still be appropriate to adjust the rate by a value that considers a borrower’s view as to the risk of the type of asset that is being leased (e.g. the risk related to repossessing right-of-use assets for laptop computers compared to commercial office space would differ substantially). Significantly different costs would exist for these two examples, and the ability of a lender to realise a residual amount from the underlying collateral would differ substantially. |
buying it outright without financing.
use asset.
Case – Determination of Discount Rate for a Portfolio of Similar Leases |
||||||||||||||||||||||||||||||||||||
|
Note: this example illustrates the concepts discussed above in determining the discount rate for lease contracts. Additionally, this example illustrates how a lessee may make materiality decisions concerning the discount rate in measuring lease contracts. Such decisions must be made by management with appropriate analysis to support the simplifications used. The decisions noted below may not be appropriate to every entity; careful analysis of the facts and circumstances in each case is required. Entity L is a new freight and logistics firm that has entered into a large number of leases for railcars in order to The interest rate implicit in the leases is not readily determinable, therefore, Entity L will discount the lease liability upon initial recognition of the leases using its incremental borrowing rate. In determining the discount rate to apply to the total portfolio of leases, Entity L elects to utilise the practical expedient to apply IFRS 16 to a portfolio of leases with similar characteristics. Entity L’s major lease portfolio consists of two major types of railcars: heavy rail and light rail, therefore, Entity L will determine the discount rate for these portfolios of leases separately. These portfolios are hereafter referred to as the ‘heavy portfolio’ and ‘light portfolio’. The smaller equipment lease portfolio (e.g. automobiles and forklifts) is referred to as the ‘minor equipment portfolio’. For all leases, Entity L will make quarterly payments in advance of equal amounts over the related lease term. Entity L applies the methodology discussed in the previous section to determine the discount rate for these three portfolios. IFRS 16 Base rate for economic factors: similar economic environment, term and valueHeavy portfolio Entity L analyses its portfolio of leases and notes that the lease terms vary between 4 and 6 years, with the leases being evenly dispersed over that period (in number and value). Consequently, Entity L concludes that the weighted average lease term is 5 years. Entity L then reviews interest rates applicable to high quality bonds in its jurisdiction and notes that:
Consequently, Entity L concludes that a reasonable approximation of the ‘base’ rate will be obtained by referring to the interest rate for bonds with a 2.5 year duration. Utilising instruments with a duration equal to 50% of the weighted average lease term accounts for the fact that the referenced bonds are bullet loans with ‘back loaded’ cash flows compared to the cash flows of the lease, which are evenly dispersed. The base rate is determined to be 3.10%. If the lease portfolio had been different, then additional analysis would have been required. For example, Entity L might have found that while the average lease term is 5 years, there are a significant number of leases in this portfolio with lease terms of 18 months-2 years compared to another large number of leases with terms of 7-8 years. While the applicable reference bonds for these more granular segments carry different interest rates, Entity L would need to carry out a sensitivity analysis to determine whether the use of a single 2.5 year reference rate would potentially have a material impact in the measurement of the lease contracts. In addition, if an approximation is used, it is necessary to revisit the approach as and when additional leases are added in future to determine whether the approximation remains acceptable. Light portfolio Entity L performs an analysis similar to above, noting that the average lease term in the light portfolio is 3 years. The applicable rate after referencing a series of high quality bonds in the applicable jurisdiction is 2.65%. Minor equipment portfolio The minor equipment portfolio is made of many different types of equipment with various lease terms ranging from 1 to 4 years, with lease terms and values evenly spread in this range. Entity L notes that the minor equipment portfolio is immaterial in comparison to its railcar portfolios and to the financial statements as a whole Consequently, Entity L considers that it is acceptable to use a 3.00% discount rate for the minor equipment portfolio of lease contracts, rather than determining different rates for various sub-portfolios of different types of equipment with different lease terms. Entity L performs a sensitivity analysis and notes that a reasonably possible shift in the discount rate would not result in a material difference in the measurement of this portfolio. Although financing factors are also considered, an adjustment for asset factors is not considered necessary as its effect would be immaterial. IFRS 16 Discount rate Financing factors Heavy portfolio To adjust the base rate for credit risk factors, Entity L refers to the spread between the credit rating of bonds in the reference portfolio compare to Entity L’s own credit risk. The credit rating for the bonds in the reference portfolio were AAA, meaning they have a low risk of defaulting on the payments. Entity L consults with several banks in its jurisdiction and obtains a number of different interest rate ‘spreads’ between AAA borrowers and Entity L for loans of 2.5 years in duration. The average of these spreads is 1.75%. Light portfolio Entity L performs an analysis similar to above, however, for a reference portfolio with an average duration of 1.5 years (i.e. half of the light portfolio’s weighted average lease term). The average of these spreads is 1.25%. Minor equipment portfolio Entity L considers the range of lease terms in this portfolio and the credit spreads for the heavy and light portfolios. It concludes that a reasonable approximation of the credit spread applicable to the minor equipment portfolio is 1.50%. IFRS 16 Discount rate Asset factorsHeavy portfolio The base rate and credit spread determined above relate to an unsecured borrowing position. Entity L notes that the security in its leases are the underlying right-of-use asset, therefore, an adjustment to the borrowing rate should take this into account. Entity L consults with several banks on the adjustment to the rate on a secured borrowing position. Entity L notes that in discussions with banks, they note that the underlying asset provides less relevant security than say, commercial real estate in a major city centre, since realising on the underlying security (rail cars) is more difficult and would include more significant costs. The adjustment for the asset factors is -0.45%. Light portfolio Entity L performs an analysis similar to above, however, the nature of the security (light rail cars) differs slightly. The banks that Entity L consults that light rail cars are used less frequently and have shorter useful lives, therefore, the nature of the security provides a lower adjustment than the heavy portfolio. The adjustment for the asset factors is -0.35%. Minor equipment portfolio Entity L performs an analysis similar to that of the heavy portfolio. As the minor equipment has a relatively short useful life, Entity L believes the adjustment for asset factors is minor. The adjustment for asset factors is -0.10%. Examples – Summary outcomes
|
transport its customers’ goods. It has also entered into a number of leases for smaller equipment such as automobiles and forklifts.|
base rate + |
financing factors + |
asset factors |
|
|
Heavy portfolio = |
3.10% + |
1.75% + |
(-0.45%) |
|
Heavy portfolio = |
4.40% |
||
|
Light portfolio = |
2.65% + |
1.25% + |
(-0.35%) |
|
Light portfolio = |
3.55% |
||
|
Minor equipment portfolio = |
3.00% + |
1.50% + |
(-0.10%) |
|
Minor equipment portfolio = |
4.40% |
|
Case – IFRS 16 Negative Implicit Interest Rates |
|
Entity M leases a unit in a shopping centre for 5 years. Lease payments are fixed at CU 150,000 per annum plus a 5% variable payment dependent on Entity M’s annual sales revenue. The lessee’s incremental borrowing rate is 8%. The unit in the shopping centre has a current fair value of CU 1,300,000 and an unguaranteed residual value of CU 350,000. Initial direct costs are nil. Assessment IFRS 16 first requires the rate implicit in the lease to be used, if it is readily determinable. As Entity M knows the fair value of the property at the commencement of the lease and has estimated the fair value of the asset at the end of the lease, the rate implicit in the lease agreement can be calculated. IFRS 16 defines the ‘interest rate implicit in the lease’ as: “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.” Based on the facts provided above, the discount rate that causes the present value of (a) and (b) to equal the sum of (i) and (ii) is minus 8.52%. If this were used it would result in the lessee recognising interest income rather than interest expense over the lease term. If the fair value of the property at the beginning and end of the lease are reasonably determinable and a significant portion (or all) of the lease payments are variable (and therefore not included in the measurement of the lease liability), the rate implicit in the lease may be negative. This is because the lease payments in (a) exclude the variable payments equal to 5% of sales revenue and therefore do not reflect what the lessor ultimately anticipates to be the ‘true’ return over the lease term. The use of a negative discount rate in such circumstances is not appropriate, because it does not reflect the objective which is to reflect how the contract is priced. In addition, it will be very rare that a lessee will have information about the lessor’s direct costs and other expectations that would be required to calculate the rate implicit in the lease. Consequently, the lessee will use its incremental borrowing rate to discount the lease payments. |
Excerpts from IFRS Standards come from the Official Journal of the European Union (© European Union, https://eur-lex.europa.eu). Individual jurisdictions around the world may require or permit the use of (locally authorised and/or amended) IFRS Standards for all or some publicly listed companies. The information provided on this website is for general information and educational purposes only and should not be used as a substitute for professional advice. The specific status of IFRS Standards should be checked in each individual jurisdiction. Use at your own risk. Annualreporting is an independent website and it is not affiliated with, endorsed by, or in any other way associated with the IFRS Foundation. For official information concerning IFRS Standards, visit IFRS.org or the local representative in your jurisdiction.
Determining a leases discount rate Determining a leases discount rate Determining a leases discount rate Determining a leases discount rate Determining a leases discount rate Determining a leases discount rate Determining a leases discount rate Determining a leases discount rate Determining a leases discount rate Determining a leases discount rate Determining a leases discount rate Determining a leases discount rate Determining a leases discount rate Determining a leases discount rate Determining a leases discount rate Determining a leases discount rate
Determining a leases discount rate Determining a leases discount rate Determining a leases discount rate Determining a leases discount rate Determining a leases discount rate Determining a leases discount rate Determining a leases discount rate Determining a leases discount rate Determining a leases discount rate Determining a leases discount rate Determining a leases discount rate Determining a leases discount rate Determining a leases discount rate Determining a leases discount rate Determining a leases discount rate Determining a leases discount rate Determining a leases discount rate Determining a leases discount rate Determining a leases discount rate Determining a leases discount rate Determining a leases discount rate
Determining a leases discount rate Determining a leases discount rate Determining a leases discount rate Determining a leases discount rate Determining a leases discount rate Determining a leases discount rate Determining a leases discount rate Determining a leases discount rate Determining a leases discount rate Determining a leases discount rate Determining a leases discount rate Determining a leases discount rate Determining a leases discount rate Determining a leases discount rate Determining a leases discount rate Determining a leases discount rate Determining a leases discount rate Determining a leases discount rate Determining a leases discount rate Determining a leases discount rate Determining a leases discount rate