Discount rate – Leases -IFRS 16

IFRS says that the incremental borrowing rate is the rate of interest that a lessee would have to pay to borrow the funds to obtain:

• An asset of a similar value to the underlying asset,
• Over a similar term,
• With similar security,
• In a similar economic environment.

This definition implies that the incremental borrowing rate is not only specific for the lessee but also the underlying asset and that’s the reason why the same incremental borrowing rate cannot be used for all of the leases.

In other words, the incremental borrowing rate (IBR) is the interest rate a lessee would have to pay to borrow funds to finance an asset similar to the lease’s ROU asset in value, over a similar term, and in a similar economic environment.

Why is IBR so important in lease accounting? 

The incremental borrowing rate is used to discount future cash flows to reflect the impact of time on the remaining lease obligation. 

For instance, on a lease with payments of $1,000 a month for five years, the organization’s lease accounting needs to recognize not only current payments but also what will be paid in the future, using the IBR to reflect the timing of individual cash flows. 

How is the incremental borrowing rate determined? 

An organization’s incremental borrowing rate is generally a reflection of its creditworthiness based on two components: 

• The risk-free rate, determined by the current rate on Treasury bills (T-bills) 
• The individual organization’s specific credit rating

Ideally, the IBR should also consider an organization’s current credit rating, including its debt structure and capital. This is especially true with real estate and other high-value leases. 

For instance, a small start-up company may pose more credit risk and therefore pay a higher IBR on real estate leases compared to a larger and more established company.

In addition, determining the incremental borrowing rate is often more difficult for a private organization than for a public company. 

How is IBR different for public and private companies? 

Public companies typically know what their IBR is, due to the ongoing financial tracking and reporting required from publicly traded companies. By necessity, these organizations usually know their average cost to capital, borrowing interest rates, and other factors that affect their credit.

Private companies are less likely to know those factors and may not have up-to-date credit information readily available. Instead, they may have to pick a theoretical IBR based on a wide range of issues such as: 

• The interest rate paid the last time they borrowed money 
• How much above the risk-free rate they are likely to pay 
• The type of asset — for example, the interest on financing a vehicle vs. financing a building 
• Whether the asset will depreciate or appreciate 
• The length of time over which payments will be made 
• The organization’s borrowing activity and credit risk 
• Market conditions and borrowing costs 

Therefore, for simplicity, private companies often opt to use the risk-free rate as their IBR — for example, basing the IBR for a five-year lease on the rate at which five-year T-bills are currently trading.  

What is the impact of using the risk-free rate as your IBR? 

Looking up the risk-free rate and using it as an organization’s incremental borrowing rate is certainly easy. However, it will inflate the organization’s liabilities. 

The risk-free rate is always the lowest borrowing rate, minus the inflation expectation. But when factored over time, the lower the interest rate is, the higher the NPV will be. That means the risk-free rate has a larger impact on the balance sheet. 

Therefore, while it is less work to use the risk-free rate, it may not be as advantageous as determining your actual incremental borrowing rate. 

Discount rates under IFRS 16 Leases

Under IFRS 16 the lessee should discount the lease payments using:

• The interest rate implicit in the lease, or
• The lessee’s incremental borrowing rate if the interest rate implicit in the lease cannot be determined.

The interest rate implicit in the lease

The interest rate implicit in the lease is very hard to determine for all the lessees as the rate is specific for the lessor, not the lessee.

IFRS 16 defines the rate implicit in the lease as the discount rate at which:

• the sum of the present value of the lease payments and unguaranteed residual value equals to
• the sum of the fair value of the underlying asset and any initial direct costs of the lessor.

Therefore, if you are a lessee, you should find out the unguaranteed residual value and the lessor’s initial direct cost.

The trouble is that not many lessors would tell you this information as they might consider it confidential and sensitive.

This is the reason why most lessees will simply use the incremental borrowing rate.

I believe that auditors from this question were right when they refused the internal rate of return of the lease as the interest rate implicit in the lease because it was the rate of the lessee, not the lessor.

How to determine the incremental borrowing rate

1. Observable rate.

Observable rates can be said, the rate on past similar borrowings, or the actual offers from a bank for the loans with a similar amount, security, and term.

• Adjustments.

An adjustment might be needed exactly because observable rates might not precisely reflect the lease.