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.