Determining a leases discount rate
IFRS 16.26 sets out the discount rate requirement as follows:
“At the commencement date, a lessee shall measure the lease liability at the present value of the lease payments that are not paid at that date. The lease payments shall be discounted using the interest rate implicit in the lease, if that rate can be readily determined. If that rate cannot be readily determined, the lessee shall use the lessee’s incremental borrowing rate.”
Given a significant number of organisations are unlikely to have the necessary historical data to determine the interest rate implicit in the lease (“IRIIL”) for transition, it seems logical that the use of the incremental borrowing rate (“IBR”) will be relatively common at the date of adoption.
Additionally, any company choosing to use one of the modified retrospective approaches is required to use the IBR. For leases signed after transition, companies may be more readily able to determine IRIIL, however it is likely that companies will enter into leases which require the continued use of the IBR.
|
Lessee’s incremental borrowing rate “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.” |
Additional detail on determining the incremental borrowing rate can be found in the guidance outlining the transition related practical expedient for using a single discount rate for a portfolio of leases:
“a lessee may apply a single discount rate to a portfolio of leases with reasonably similar characteristics (such as leases with a similar remaining lease term for a similar class of underlying asset in a similar economic environment).”
Combining these two aspects together results in the six factors (in green) requiring consideration in determining an IBR, either for an individual lease or a portfolio of leases.
A three-step approach to the composition of discount rates
A three-step approach to the composition of discount ratesThe composition of the IFRS 16 IBR
The six key factors outlined above bring together certain elements of a lease’s characteristics in a way which should be considered in setting the discount rate for an individual lease or a portfolio of leases.
While a discount rate is a single value, it is typically derived from a number of different data sources and can factor in various adjustments so that the overall discount rate is appropriate for its intended use. Comparison of the IBR with other rates used in IFRS, such as the capitalisation rate in IAS 23 “Borrowing Costs” or the discount rate in IAS 36 “Impairment of Assets”, shows that the IBR is not a direct match for these. Companies’ existing processes and data for determining these rates will therefore not necessarily be appropriate for determining an IFRS 16 IBR and so there is a need to start with a fresh approach.
The IBR, and specifically the six factors (in green) outlined above, can be determined by considering three key components, as follows:
Step 1: Determining the reference rate
Step 2: Determining the financing spread adjustment
Step 3: Determining the lease specific adjustment
Here we go……..
Step 1: Determining the reference rate
Determining an appropriate reference rate through the use of risk free rates (eg government bond yields or interest yield curves such as LIBOR) is a relatively well understood and comprehensively documented process but companies adopting IFRS 16 have to ensure they consider the three factors outlined below.
|
Example 1: Foreign currency leases Consider a company with a Euro functional currency, which has a treasury policy to obtain financing in Euros. The company leases a ship; the lease payments are specified in US Dollars and the interest rate implicit in the lease is not readily determinable. The company has to determine the incremental borrowing rate, 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.’ Illustrative example 13 in IFRS 16 makes reference to determination of an incremental borrowing rate: ‘The interest rate implicit in the lease is not readily determinable. Lessee’s incremental borrowing rate is 5 per cent per annum, which reflects the fixed rate at which Lessee could borrow an amount similar to the value of the right-of-use asset, in the same currency, for a 10-year term, and with similar collateral.’ This clarifies that the currency in which the lease is determined forms part of the economic environment for which the borrowing rate is assessed. For the company in question it is the US dollar incremental borrowing rate that has to be determined. |
|
Example 2: Currency union – practical considerations Consider a currency union comprising 10 countries with average economic growth of 1.5% per annum over the past 50 years. Country A has had average economic growth consistently above this average at around 2.5% per annum and Country B has had average economic growth consistently below this average at around 0.25% per annum. All other countries have been broadly in-line with the average. The currency union has publicly traded bonds, issued on behalf of all 10 countries. In determining a reference rate for leases entered into in any of these 10 countries, it would be normal to start by considering the risk free rates of the traded bonds. However the differing economic environments between Country A and Country B would, in our view, warrant some level of adjustment to the risk free rate in order to reflect the situation a lessee in each of these two countries would find themselves in when negotiating with a lessor. Country Y and Country Z, neither of which are in the currency union, have average economic growth rates similar to Country A and Country B respectively as well as other similar economic factors. Benchmarking the risk free rates of Y and Z could therefore provide an indication of what quantum of adjustment could be made to the risk-free rates of the currency union in order to arrive at appropriate rates for A and B. |
|
Example 3: Currency used is that of another country Consider Country A which uses and is responsible for Currency A, with monetary policy being set based on the economic growth factors of Country A only. Country B has given up using its own currency and now officially uses Currency A as its own national currency. Country B has no input into the economic policies or factors used by Country A in setting its monetary policy. If a company based in Country B were to enter into a lease, with payments being in Currency A, they would initially start to determine a reference rate by obtaining data for the risk free rates for Country A. While those risk-free rates will align with the currency in which the lease payments are denominated, the rates are unlikely to be reflective of the economic environment of Country B, the location in which the lease was entered into. The company would therefore need to consider how to adjust the risk-free rate data points available in order to arrive at a reference rate which reflects both the currency and economic environment of Country B. This could include consideration of any publicly traded government bonds issued by Country B and the related data points, or perhaps looking at the credit rating ascribed to the country by lenders to determine a quasi-credit adjustment as if Country B were a corporate entity. |
|
Example 4: Determining a weighted average lease term The weighted average lease term was estimated based on the following market standard approach:
The table below illustrates this for (a) a 10 year £100m government bond (no interest assumed for simplicity) and (b) a 10 year lease with £10m annual payments made at the end of the year. The resulting ratio is 55%.
The resulting graph below outlines how the maturity payment ratio varies against the total duration of the lease.
This graph shows that:
A typical approach used for setting discount rates to determine defined benefit pension scheme liabilities also matches bond durations against the weighted average duration of the pension liabilities, rather than the maximum term of the liabilities. A similar approach for leases would therefore appear appropriate. |
In general there is publicly available data available for risk free rates, interest rate yield curves and government bonds however there may be some circumstances when exact matches to the characteristics of an underlying lease cannot be made for the currency, the term or the date on which the risk free rate was measured. In such cases, a degree of judgement or estimation may be required to determine a suitable reference rate.
Applying a portfolio approach to leases denominated in different currencies, with different terms or in different economic environments may not give an answer that is materially consistent with determining individual IBRs. If applying the full retrospective approach then the lease commencement date will also be an important factor in determining portfolios. Care should therefore be taken when using the portfolio approach to ensure the risk free rates used as a starting point to determine the IBR are appropriate for the portfolio as a whole
Step 2: Determining the financing spread adjustment
The data available to companies to calculate their financing spread adjustment will depend on the type of organisation and the financing structures they have chosen to use. Below three examples of possible financing structures are shown; for each debt structure there are differences in the data points available to calculate the component of the IFRS 16 discount rate.
There are two key points to note:
-
For companies which have issued debt listed on a public exchange, it may be that they have rates available which comprise both the reference rate and the financing spread adjustment – an “all-in rate”.
-
For some organisations data may be available for individual lessee entities, where subsidiaries are themselves debt issuers (see the first and second combinations below). For other organisations, data may only be available for the Group, being the parent company itself or dedicated financing companies operating on the parent company’s behalf (see the third and fourth combinations below).
Combinations of possible data points
Care should be taken when using an “all-in rate” as typically companies have only a limited number of data points available (e.g. only certain currencies, or certain terms) and so it may also be appropriate to separately determine a reference rate and financing spread adjustment to ensure the three factors outlined in Step 1: Determining the reference rate (Currency, Economic environment and Term) are fully assessed.
For companies with zero debt and/or net cash balances, this process may require consideration of both historical as well as future debt facilities, in order to assess whether the historical position is representative of the underlying position of the business. In general it is not considered reasonable to assume that companies in this situation will have a zero spread, as IFRS 16 requires the discount rate to reflect the rate of interest the lessee would have to pay to borrow.
For companies with few, if any, individual data points on their credit spread, it may be appropriate to seek indicative pricing from several banks or look to other data points available, such as similar sized companies in a similar industry as different sectors and industries can differ widely in terms of credit risk. The illustrative graph below sets out why this is the case.
*Similar to example 4 above, there is a need for companies to consider the weighted average lease term against the weighted average payment period for their debt, rather than the absolute term durations. For example, high yields or unusual repayment profiles may mean that the duration of the debt is not appropriate for matching directly to the weighted average lease term, and so additional analysis may be required.
|
Example 5: Determining a group and subsidiary credit adjustment A Group with international operations principally in Asia has a range of debt financing arrangements, including bank overdrafts, revolving credit facilities and bonds of both medium-term and long-term durations. The Group policy is to obtain all debt financing centrally from a parent company and head office perspective, in order to minimise the costs of finance. The data points for its debt arrangements are included in the graph below, the currency of which matches the currency of the majority of lease cash flows throughout the Group. For one subsidiary that operates in South America, the Group has allowed it to obtain a small local bank facility in order to comply with local regulatory and tax requirements. The Group has not guaranteed this facility, which is shown in red in the graph below.
In determining a group credit adjustment, it may be appropriate for the company to exclude the local bank facility, on the basis that it does not provide reliable evidence to the credit adjustment for the Group as a whole. Additionally the local bank facility is likely to be insignificant in value when compared with the larger value Group banking facilities and so on a weighted value basis would have negligible impact compared to the other data points. Given the shortage of data points at medium-term durations, it may then be appropriate to estimate the credit spread using the remaining short-term and long-term data points to determine a Group credit spread curve, as illustrated. When determining a subsidiary credit adjustment for the South American entity, this single data point provides some valuable context for the individual lessee entity. It indicates a 200-300bps margin on top of the Group debt facilities of similar short-term duration. For longer durations, the company could start by estimating the South American entity credit spread by consistently supplementing the Group credit spread curve with an additional 200-300bps margin, however it is likely that the subsidiary credit spread adjustment would need to be increased for longer duration leases. |
For a number of entities, credit spreads obtained from key financing arrangements (as described in the table ‘Types of debt financing’ in Step 2: Determining the financing spread adjustment) will relate to the parent company of a group, which may or may not be the entity that is party to the lease arrangements.
-
While companies may want to take into consideration the group’s debt structure and historical funding mechanisms to argue that all borrowings are group-led, IFRS 16 is very clear that the incremental borrowing rate is lessee specific.
-
Given the lessee is responsible for making the lease payments, it is appropriate to consider what rate the lessee would achieve on their own, even if theoretically all funding would ultimately be achieved through a group debt structure.
-
Depending on who the issuer is, and whether there are written guarantees for the lease payments in place, it may mean that in some instances it is appropriate to determine a group credit spread that is applicable to all lessees in a group.
To determine the lessee credit spread in the situation where group credit spread data points are available, we think companies should be taking into account the following factors:
Levels of indebtedness
In considering the value of the lease in determining an IBR, we would expect that a lender considers the overall level of indebtedness of the entity (ie leverage) and whether the value of the lease results in a change to the leverage ratio such that it warrants a higher IBR.
Typically leverage is assessed by financers using the ratio of EBITDA to net debt (or an equivalent metric). Lenders have typically adjusted net debt under IAS 17 to include their estimate of the operating lease impact and so while the accounting under IFRS 16 will be different and therefore net debt: EBITDA ratios will likely change, we would expect the level of indebtedness to remain a relevant factor in considering whether to finance a new lease arrangement.
In practice, different financing structures may lead to additional assumptions when accounting for the overall level of indebtedness:
-
Revolving credit facility – Revolving credit facility rates are a useful data point for assessing the credit spread to be used in the IBR. Taking into account revolving credit facility rates preparers should consider the relevance of any tiered rates or utilisation fees depending upon their level of indebtedness which includes lease liabilities.
-
Term loans/Bonds – When these types of debt funding are used as a means to determining the level of indebtedness, the lessee should consider if they would be able to raise additional funds at the same level as their previous funding achieved or if additional indebtedness would likely lead to a higher margin being charged (in line with the principles of the utilisation fees discussed above).
One notable exception is that property assets are typically financed on a loan to value basis (“LTV”) and so the LTV ratio is also a relevant consideration in addition to the level of leverage for the lessee company. The LTV ratio is discussed further on the following page.
In considering the value of the lease in determining an IBR, we would expect that a lender considers the overall level of indebtedness of the entity (i.e. leverage) and whether the value of the lease results in a change to the leverage ratio such that it warrants a higher IBR.
Step 3: Determining the lease specific adjustment
The key requirement of IFRS 16 is that the discount rate is directly linked to the asset itself, rather than being a general incremental borrowing rate. In theory, the risk of default is mitigated for the lessor as they have the right to reclaim the underlying asset itself. With the right of use asset effectively being pledged as collateral against the risk of default, this is a secured lending arrangement. This is important because:
-
when the lessee-specific credit spread is derived from corporate borrowings, these are typically unsecured lending arrangements; and
-
taking into account the security of the underlying asset could reduce the credit spread charged by a lender.
While all leases will reflect a secured borrowing position, in practice certain assets may be more valuable to a lessor and easier to redeploy. For example:
-
the costs of repossessing an asset of low value and/or short duration (eg a printer) would be high relative to the underlying value of the asset and the associated lease cash flows, so the benefits of having this security would likely be relatively insignificant; or
-
for larger value assets and/or leases with a longer duration (eg a car or a property) the benefit of having security is more valuable as there is increased likelihood of the lessor obtaining value in the event of default.
Assuming the loan financing arrangement is at fair value, the value of the lease financing is equal to the value of the underlying asset which would be obtained by the financer. This means that the LTV ratio would therefore be 100%. In theory, a secured financing adjustment for a particular asset class would be broadly equal for each lease, irrespective of the individual nature of the leased assets.
For most companies with unsecured borrowings, they will not have data points available to determine an adjustment for the lease itself, to reflect the secured position the lessor has. As such, they may need to approach their bank or lender to get indicative rates for unsecured and secured borrowings of different durations, in order to be able to determine an appropriate adjustment.
A potential, complementary, approach is obtaining data to support the relative magnitude of the final discount rate or the lease specific adjustment for specific asset classes (property yields below).
Property yields IFRS 16 Incremental borrowing rate
In the basis for conclusions of IFRS 16, property yields is specifically identified as a potential data point for companies to consider:
“The IASB noted that, depending on the nature of the underlying asset and the terms and conditions of the lease, a lessee may be able to refer to a rate that is readily observable as a starting point when determining its incremental borrowing rate for a lease (for example, the rate that a lessee has paid, or would pay, to borrow money to purchase the type of asset being leased, or the property yield when determining the discount rate to apply to property leases). Nonetheless, a lessee should adjust such observable rates as is needed to determine its incremental borrowing rate as defined in IFRS 16.”
In general terms, the lower the risk associated with the income from a property, the lower the applicable yield and the higher the multiplier driving the valuation.
In considering how a property yield would need to be adjusted to arrive at an IFRS 16 IBR, we have set out in the table below a summary of how it typically compares to the IBR and IRIIL definitions in IFRS 16.
It will be difficult for companies to quantitatively adjust property yields for the above factors to arrive at an IBR. However property yields provide some evidence of:
-
the range in which an IBR for a property lease would sit, with the property yield likely to represent the upper end of the range; and
-
the adjustments required between IBRs for properties of different types and in different locations (i.e. determining a lease specific adjustment).
For companies wanting to use property yields to help them determine lease specific adjustments, there are several important assumptions to be aware of:
-
the currency of property lease cash flows are aligned with the currency in which the property is valued (ie its home market);
-
the duration of the property yield data points available are aligned to the weighted average term of the lease, or that sufficient property yield data points exist bearing in mind that the longer the lease the lower the yield due to the longer period of rental income security; and
-
the property yields are aligned to the characteristics of the property lease being assessed (i.e. in the quality, sector and location of the property).
While there are some publicly available data sources for benchmark property yields, these data points bring their own challenges, as they typically reflect agents’ views of likely pricing for hypothetical “best in class” assets. Each asset is unique, and a bespoke view of yield could be applied to each asset, reflecting differences in perceived asset quality.
If it is not practical to get a property valuer’s view of the specific yield applicable to each asset, companies may need to consider taking out specialist subscriptions in order to get access to more detailed benchmark data, in order to address or minimise some of the above challenges.
Yields for secondary assets are much more difficult to determine, since there are much greater degrees of variance in respect of asset characteristics. Property yields can be used to value leasehold, as well as freehold interests, but leaseholds are rarely sold as investments, so these yields are especially difficult to determine and subject to a high degree of valuer judgement.
Below one potential example is provided of how companies could use property yield data in this context.
|
Example 6: Property yields providing additional data to determine lease specific adjustments to IBR Assume a company has a mixed portfolio of properties in 3 UK cities, consisting of offices, industrial warehouse and retail locations. Assume relevant prime “best in class” benchmark property yields are as follows:
Some themes that could be drawn from this data and used to adjust other data points to determine a more asset-specific IBR include:
|
Timing considerations
All of the data points discussed so far are specific to a certain point in time, namely when the debt financing arrangement was entered into.
Typically this will not align with the date when a lease is entered into, so companies therefore need to consider whether adjustments to data points are required.
Reference rate
Data points for publicly listed government bonds, and interest rate yields are generally available on a daily basis, so companies should be able to align these with lease start dates. Certain currencies or duration of government bonds with fewer data points may require assessment at a weekly or monthly time period. Data is typically readily available for historical periods.
Financing spread adjustment
For debt arrangements which are publicly traded, daily, weekly or monthly credit spreads can be obtained depending on how actively the debt is traded. Otherwise there needs to be consideration as to whether the credit spread determined by the lender at the date the debt arrangement was entered into is still appropriate for use at the date of lease inception. Historical spreads may require adjustment changes since the date of debt issuance, as outlined in the diagram below.
Transition considerations
Economic impact of the transition
In addition to publishing the new lease accounting standard, the IASB published an effects analysis, highlighting the expected impacts of IFRS 16. This analysis states the following:
“The change to lease accounting does not affect a company’s economic position or commitments to pay cash, which are typically already considered by lenders.”
Based on this principle, companies need to be careful not to make adjustments which are not relevant to determining discount rates on transition. Specifically, the “level of indebtedness” adjustment discussed in Step 2 may not be required on transition, depending on transition approach taken and the relevant facts and circumstances, as it could be assumed that the outstanding borrowings were issued after having given due consideration of the pre-existing operating lease commitments. Following transition, the renewal of a lease may also not require assessment of certain factors, if the underlying economics have not changed from when the lease was originally entered into.
|
Retrospective implementation approach |
Modified retrospective implementation approaches |
|
Issuers choosing the full retrospective implementation approach are required to determine discount rates as of the date of lease inception. This adds another layer of complexity to the factors discussed on the previous page in that different discount rates will need to be determined for leases that commenced at different times. For large issuers with a significant number of historical debt agreements, this may involve obtaining multiple data points at different periods in time. For companies with significantly less information available, the process to determine an IFRS 16 IBR may involve applying constant credit spreads to historical changes in reference rates, only taking into account significant changes in credit standing when data is available. Careful consideration and analysis will need to be applied to ensure the determined lease liability valuations are not materially misstated through the use of too broad or simplistic discount rate assumptions. |
Those using one of the modified implementation approaches will be required to calculate all incremental borrowing rates as of the date of initial application, rather than as of the date of lease inception. We would therefore expect that the remaining term of each lease is considered, rather than the original lease term. Similar to the issues for the retrospective approach, issuers will need to consider timing differences and make appropriate adjustments to historical spreads that are no longer reflective of the credit standing or economic environment as of the transition date. 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 |
|
Example 7: Adjusting data points: Retrospective approach Assume two leases exist at the initial application date of IFRS 16, entered into as follows, along with a debt issuance as indicated. The table below outlines how, based on the transition approaches available, the various data points would be considered for use in determining an IBR.
|
Financial reporting and disclosure considerations
While IFRS 16 does not require disclosure of the actual discount rates used, it may be that market practice dictates disclosure where lease liabilities are highly material for public companies.
In general, there are several places in an annual report or financial statements where the discount rate assumptions may be discussed, specifically:
Companies who record a material liability in their financial statements are likely to consider the discount rate assumption as a significant assumption and source of estimation uncertainty, based on the requirements of IAS 1 Presentation of Financial Statements:
“An entity shall disclose, along with its significant accounting policies or other notes, the judgements […] that management has made in the process of applying the entity’s accounting policies and that have the most significant effect on the amounts recognised in the financial statements.”
The necessary audit committee and external auditor commentary on this significant accounting estimate will potentially require discussion of the year on year change in discount rates and the driving factors behind these changes, even if the absolute amount or range of the discount rates is not disclosed. This will be an area to watch closely, especially if regulators start to scrutinise discount rate methodologies and judgements used by companies.
Given indebtedness ratios such as net debt to EBITDA can be key performance indicators or covenant compliance metrics for listed companies and private companies, it is expected that the change brought about by IFRS 16 to result in significant focus on the discount rate assumption from shareholders, debt-holders, banks, regulators and external analysts:
-
Senior management will need to ensure they have a robust process and controls in place for determining this assumption, using appropriate inputs, and for those public companies with audit committees, that appropriate oversight of this assumption occurs.
-
Public reporting from audit committees and external auditors are also both likely to need to include commentary on this assumption, including how both parties have each satisfied themselves that the discount rate assumptions used are appropriate. For some companies this disclosure may only happen at transition, but for others this may continue in future periods.
A careful balance is needed in the level of precision used to determine the inputs to the incremental borrowing rate and the degree to which the final rate is set as if it could have a material impact.
See also our friends: IFRS Community – Discount rate
Determining a leases discount rate
IFRS 16 Incremental borrowing rate IFRS 16 Incremental borrowing rate IFRS 16 Incremental borrowing rate IFRS 16 Incremental borrowing rate
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.