Thelessee’s incremental borrowing rateis defined inIFRS 16 as ‘the rate of interest that a lessee would have topay to borrow over a similar term, and with a similar security,the funds necessary to obtain an asset of a similar value tothe right-of-use asset in a similar economic environment’.
The incremental borrowing rate is determined on thecommencement date of the lease. As a result, it will incorporatethe impact of significant economic events and other changesin circ*mstances arising between lease inception andcommencement.
A lessee will need to determine a discount rate for virtuallyevery lease to which it applies the lessee accounting modelin IFRS 16. However, a discount rate may not need to bedetermined for a lease if:
- a lessee applies the recognition exemption for either a shorttermor a low-value asset lease
- all lease payments are made on (or prior to) the commencement date of the lease, or
- all lease payments are variable and not dependent on an index or rate (eg, all lease payments vary based on sales or usage).
The interest rate implicit in the lease may be similar to the lessee’s incremental borrowing rate in many cases. Both rates consider the credit risk of the lessee, the term of the lease, the security and the economic environment in which the transaction occurs.
Interest rate implicit in the lease
The definition of interest rate implicit in the lease is the samefor both a lessee and a lessor. Because it is based in part uponthe initial direct costs of the lessor, it will often be difficult and inmany cases impossible for the lessee to readily determine theinterest rate implicit in the lease.
For some leases, including most property leases, a lack ofdetailed information about the fair value of the underlyingasset, the expected residual value of the asset at the end of thelease term and any initial direct costs of the lessor will makeit difficult or impossible for the lessee to readily determine theinterest rate implicit in the lease.
In other cases, the lessee may be able to obtain the relevantinformation from the lessor during the lease negotiationprocess. The initial fair value of the underlying assetand residual value of the underlying asset may also bedeterminable from a reliable external source. The lessee may beable to reasonably determine that the lessor’s initial direct costswould not be significant to the overall arrangement. In leasingtransactions between related parties, it is likely that most or allof the relevant information can be obtained by the lessee.
While it is relatively common for some traditional equipmentfinance leases to make explicit reference to an interest rate inthe lease documentation, caution is warranted. This rate willnot represent the interest rate implicit in the lease if it doesn’tinclude an estimate of residual value for the underlying asset ortake the lessor’s initial direct costs into account.
What is readily determinable?
The interest rate implicit in the lease must be used only if that rate can be readily determined. The meaning of the term‘readily determinable’ is open to some interpretation.
Sometimes, particularly in relation to leases of real estate, thelessee uses a valuation expert to determine the interest rateimplicit in the lease. In our view, rates determined by expertswould not qualify as readily determinable and the lesseeshould be using its incremental borrowing rate instead.
Similarly, where the interest rate implicit in the lease canonly be determined by including significant estimates andassumptions, a lessee would likely conclude that the interestrate implicit in the lease is not readily determinable.
The impact of variable lease payments on the interestrate implicit in the lease
Variable lease payments can impact the calculation of theinterest rate implicit in the lease. Only variable payments basedon an index or rate should be included in the calculation ofthe interest rate implicit in the lease (ie. variable paymentsthat are included in the definition of lease payments). Truevariable payments, such as those based on sales or usage,must be excluded. Unfortunately, this can result in rates that arepotentially misleading if the lease agreement is structured in away that most payments are variable. If the calculated interestrate implicit in the lease is negative or otherwise doesn’t makesense, in our view the incremental borrowing rate should be used.
Lessee’s incremental borrowing rate
Where the lessee is unable to readily determine the interestrate implicit in the lease, the discount rate will be the lessee’sincremental borrowing rate. The incremental borrowing rate isan interest rate specific to the lessee that reflects:
- the credit risk of the lessee
- the term of the lease
- the nature and quality of the security
- the amount ‘borrowed’ by the lessee, and
- the economic environment (the country, the currency and the date that the lease is entered into) in which the transaction occurs.
With significant judgement required to assess many of thefactors noted above, we expect this to be a challenging area inpractice.
It is important to note that the lessee needs to determine theincremental borrowing rate for the right-of-use asset, not theunderlying physical asset.
In most cases, the lessee will need to determine its incrementalborrowing rate separately for each lease. Exceptions are where:
- as a practical expedient, the entity applies lease accounting to a portfolio of leases that have similar characteristics. IFRS 16 allows this practical expedient if the effect is reasonably expected to be materially the same as a lease-by-lease approach, or
- on transition, using the modified retrospective approach, a lessee applies 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).
It would not be appropriate for a lessee to use its weightedaverage cost of capital (WACC), which includes equity as wellas borrowings. An entity’s weighted average cost of capital isnot specific to the term, security and amount of the lease.
It would also not be appropriate for a lessee to use its parent’sincremental borrowing rate instead of calculating anddetermining its own rate.
If a lessee has direct borrowings, the effective interest rate on those borrowings may serve as a helpful starting point for determining the incremental borrowing rate. However, it is important to appreciate this is a starting point and adjustments are likely to be necessary. The interest rate on the direct borrowings may have been determined at a date when market conditions and the credit risk of the lessee were different than they are on the commencement date of the lease, or the borrowing may have been based on a different term or included different security. Substantial adjustment may be required (in either direction) to the interest rate on direct borrowings to determine an appropriate incremental borrowing rate and significant judgement will be involved in making these adjustments.
The interest rate implicit in a lease often incorporates an ‘assetrisk premium’ reflecting the lessor’s exposure to the residualvalue of the asset at the end of the lease term. As thesepremiums reflect the risks and circ*mstances of the lessor, theyshould be ignored when estimating the lessee’s incrementalborrowing rate.
There is an additional complexity involving the way in which a loan’s principal will be repaid. For example, a lender charging 8% for a fully amortising loan (ie, blended payments of principal and interest over the loan term) may charge adifferent rate for a ‘bullet-style’ loan where the principal is repaid all at once at the end of the loan’s term. Unfortunately, the Standard has no guidance on whether the lessee is required to base its analysis on rates applicable to fully amortising loans, or whether rates for bullet-style loans might also provide a meaningful starting point in assessing incremental borrowing rate. While most leases are likely to involve payment streams similar to an amortising loan, lessees will need to exercise careful judgement and consider all facts and circ*mstances relevant to their situation.
