New lease standard – determining (i.e. not just guessing) the incremental borrowing rate

Issues arising in identifying the incremental borrowing rate under IFRS 16.

As we discussed here, this is what the standard has to say about initially measuring the lease liability:

  • “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.

You’ll recall that the 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.”).

We looked at various matters relating to the lease liability, but didn’t dwell on issues relating to the discount rate. The IASB acknowledges in the basis for conclusions that this will often come from the incremental borrowing rate:

  • The interest rate implicit in the lease is likely to be similar to the lessee’s incremental borrowing rate in many cases. This is because both rates, as they have been defined in IFRS 16, take 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 occurs. However, the interest rate implicit in the lease is generally also affected by a 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 any initial direct costs of the lessor. Consequently, the IASB noted that it is likely to be difficult for lessees to determine the interest rate implicit in the lease for many leases, particularly those for which the underlying asset has a significant residual value at the end of the lease.

CPA Canada’s IFRS Discussion Group recently discussed  a few issues that might arise. First, can a lessee use the rate on its existing borrowings as its incremental borrowing rate? This certainly seems like a relevant starting point in most cases, but it’s easy to see why it might not provide the final answer. Most obviously, the very act of entering into the lease might change the lessee’s indebtedness profile to a sufficient extent to increase its cost of borrowing. The rate of existing borrowings might be affected by asset security arrangements, or by embedded put or call or options, that won’t apply under the terms of the lease. In many cases then, adjustments will be necessary to existing borrowing rates.

The group then considered whether a subsidiary can use its parent’s incremental borrowing rate. The factors noted above all apply again to indicate why this might not work. In addition, a group of entities may have a centralized treasury function maintained by the parent. The subsidiary can’t simply default to using the parent’s incremental borrowing rate, if that rate wouldn’t be available to the subsidiary based on its own credit profile. The group commented that discussions with the treasury department may be appropriate, to come up with a rate that is supportable and auditable. Among other considerations, a foreign subsidiary needs to consider its economic environment, including whether its leases are denominated in a different currency.

The group then focused on the phrase “pay to borrow over a similar term” within the definition. Again, if the entity doesn’t have any other borrowings with terms that in any way resemble those of the lease, then some judgment may be required in making this determination. But in broad terms, it’s evident that risks associated with an arrangement with frequent periodic payments of principal and interest are different from those with a single principal payment at maturity, and all other things being equal, the rate attaching to the latter will often be higher. So the challenge is to devise a theoretical borrowing rate that reflects the duration and frequency of payments under the lease.

The group made the following broad point:

  • Although IFRS 16 is clear that the lessee’s incremental borrowing rate must take into account the terms and conditions of the specific lease contract, a level of aggregation may be required to practically implement the standard. An analogy was made to determining different depreciation rates for categories of property, plant and equipment. Also, depending on the magnitude of the leases, there could be significant judgments involved in deciding the appropriate adjustments to a lessee’s existing borrowing rate. As a result, an entity should consider whether it has provided adequate disclosures for financial statement users to understand the significant judgments applied in coming up with a reasonable incremental borrowing rate that is specific to a material lease, or group of material leases.

The group acknowledged that some issuers, perhaps smaller ones, may not have other borrowings available even to provide a starting point of reference. Presumably the related disclosures will be all the more significant in that kind of situation….

The opinions expressed are solely those of the author

4 thoughts on “New lease standard – determining (i.e. not just guessing) the incremental borrowing rate

  1. Hi John, Again you brought the relevant issue that would be debated in forthcoming reporting cycle when actual implementation of Standard will take effect. Until now many have undermined the implication of determination of discount rate, whether incremental or implicit rate in lease. Perhaps biggest concern that would be relevant for Asian countries is to come discount rate for long term lease of land (which economically termed as equivalent to outright purchase by many owing to option of extending term to another long term with nominal payment or paying then market rate of lease payment). The debate would be around determining rate having such long duration which is non existence. Perhaps it all boil down to choosing transition approach that grand father existing leases on adoption. Many suggesting using expert to come up with rate to support calculation. It is interesting to see how practice evolve. Further another interesting debate is around dismantling provision calculation which many arguing that on netting with residual value of scrap it would be immaterial. It is another interesting debate that will emerge. Looking forward to have your comment

    • Hi Muhammad. Those are all interesting areas you have flagged but I’m not sure I have anything useful to add on them as I think the correct answers will be heavily dependent on the specific circumstances and environment. I suppose companies always have the option of engaging an expert for anything, but it does seem to me that this issue should be something on which management can generally make a balanced determination, providing sufficient disclosure for users of the judgments they made…

  2. Hi John, The other area that gaining traction in implementation of IFRS 16 is inclusion of site restoration/dismantling cost. At present many held the view that since the underlying lease they hold will continue in perpetuity or at least for considerable / longer period of time. Hence the restoration cost; if any, on present value basis would be negligible. Consequently they are arguing inclusion of such cost in the ROU with recording of corresponding liability in their books. Even they try to present an argument that the scrap that would be generated on dismantling would fetch some value and hence on net basis the amount that Company would be paying for restoration would not that be material at all. I am not sure if you have come across such matter in any of your discussion with companies implementing IFRS 16.

    IFRS 16 on its face appear to be simple but devils are always in detail…………………

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