Determining what discount rate (or incremental borrowing rate) to use when adopting the new IFRS 16 standard is one of the most important judgments that organisational management will need to make. Ascertaining what discount rate to use is complex and it should be noted that this decision will have the largest qualitative impact on the valuation of the leased assets and lease liabilities, and interest expense. Organisations cannot afford to make this decision lightly.
The new standard requires the calculation of the Right of Use (ROU) value for each lease by discounting the lease payments made to the vendor over the lease term. To achieve this, a discount rate needs to be determined for each lease or portfolio of leases. The standard is very clear on what discount rate or incremental borrowing rate to use and is analysed further below.
Clause IFRS 16.26 stipulates that a lessee discounts the lease payments using the interest rate implicit in the lease if this can be readily determined. For instance, a typical motor vehicle leases may state the interest rate used by the Lessor. However, on initial measurement of Right of Use and Lease Liability, an implicit rate is likely to be not available and the lessee will need to determine an incremental borrowing rate.
The standard also states in IFRS clause 16.A that the lessee’s ‘incremental borrowing rate’ is 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 ROU asset in a similar economic environment. On property leases, we have seen clients determine and apply a different incremental borrowing rate per property lease, whereas other clients have applied a portfolio approach to other leases, such as motor vehicle leases.
The IFRS 16.BC161 clause details that the lessee’s incremental borrowing rate is specific to:
- the lessee: it is a company-specific rate;
- the term of the arrangement: this will typically be the lease term, unless the lease payments are paid up-front;
- the amount of the funds ‘borrowed’;
- the ‘security’ granted to the lessor: i.e. the nature and quality of the underlying asset; and
- the economic environment: i.e. the jurisdiction and the time at which the lease is entered into, and the currency in which the lease payments are denominated.
The impact of the above is that a group incremental borrowing rate cannot be used as doesn’t meet the above criteria. For example, an organisation headquartered in Perth, Australia, with subsidiaries in Canada, Singapore, Vietnam, Mozambique, Namibia, Zimbabwe and Zambia leasing equipment and machinery should not use a group incremental borrowing rate for the offshore operations, but instead, use an incremental borrowing rate specific to the offshore entity and economic environment in which it operates.
Finally, clause IFRS 16.5 stipulates that a lessee is required to identify a discount rate for all leases other than those for which it elects to apply the recognition exemptions for short-term leases (less than <= 12 months) and leases in which the underlying item is of low value.
In determining the discount rate or incremental borrowing rate a Lessees Weighted Average Cost of Capital (WACC) cannot be used as a substitute for the discount or incremental borrowing rate as it incorporates the markets view of how an organisation would structure its financing using both debt and equity optimally over the long term, with each having a different rate of return.
WACC includes all sources of financing (such as overdrafts and bank loans, etc) including equity, whereas the incremental borrowing rate is a rate that considers only borrowings. An organisational WACC rate is specific to the organisation and does take into consideration the term, security or value of the underlying asset in a lease.
Bluleader, having worked across multiple and often complex IRFS 16 compliance projects in varying industries and jurisdictions, has seen that the majority of organisations have adopted a practical approach in determining which incremental borrowing rate to use. Setting a discount rate for every lease permutation (lease type, lease term, economic environment, and underlying asset) is extremely time consuming, specifically for Australian businesses with offshore operations.
Various Bluleader clients have used a portfolio approach. In this instance, they have assigned a single discount rate (or incremental borrowing rate) and applied this rate for all leases such as motor vehicles or office equipment, denominated in the same currency. In situations where the organisation operates in another jurisdiction, for example Singapore, a different discount rate to the Australian operation was used. Furthermore, where leases were denominated in a currency other than the company currency, for example, an Australian company chartering a vessel under a lease denominated in USD, an alternative rate was used.
Other considerations also apply depending on the type of lease involved. For instance, property leases (depending on the industry), have a higher impact on the balance sheet due to the amounts payable and the lease terms. This has meant that clients have determined a discount rate using property yields as a starting point and have adjusted the rate on a range of factors including lease term, repayment profile, currency and location.
In all instances and important to note is that our clients have all consulted with their respective auditors to help determine what discount rate to use by lease type, term, currency and location.
There are many factors to consider when determining an incremental borrowing rate when working towards IFRS 16 compliance. Organisations are documenting methodologies for deciding on incremental borrowing rates and in doing so are identifying early the many complexities and judgements required. Getting the incremental borrowing rate right in the early stages of IFRS 16 journey is imperative in ensuring the integrity of financial data in the long term. Most importantly, organisations must adopt a pragmatic approach in ascertaining an incremental borrowing rate and consider all factors at play, namely the lease type and term, as well as the industry and regions in which they operate.