How to determine the discount rate for lessees under IFRS 16?
“We are implementing IFRS 16 Leases. We have a lot of operating leases for which we need to calculate right-of-use asset.
And, we need to determine the right discount rate.
We simply calculated the internal rate of return of our cash flows from operating leases and this is our interest rate implicit in the lease, but auditors told us it was not OK.
So, we wanted to use the incremental borrowing rate. Currently, we have medium-term loan for about 3% p.a., but our auditors are not happy either.
Please, how to determine the appropriate discount rate for our leases?”
Answer: IRR vs Incremental Borrowing Rate
This is a very broad question, but please let me give you a few hints and explain why your auditor was not happy with your discount rates – at least, that’s what I think why.
Discount rates under IFRS 16 Leases
The standard IFRS 16 says that 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.
Let me shortly break this down.
Interest rate implicit in the lease
Interest rate implicit in the lease is very hard to determine for all the lessees.
The reason is that this rate is specific for the lessor, not for the lessee.
Why?
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.
Incremental borrowing rate
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 a similar security,
- In a similar economic environment.
This definition implies that the incremental borrowing rate is not only a specific for the lessee, but also for the underlying asset and that’s the reason why you cannot use the same incremental borrowing rate for all of your leases.
Let me give a few illustrations:
- Imagine you want to lease the valuable land in a high-level area – that’s really a great value collateral and it affects your incremental borrowing rate.
But, if you would like to lease a car, that’s not so valuable collateral as the land.In other words, the security is not the same and you would need to apply different incremental borrowing rate when leasing a car and when leasing a land.
- Imagine you want to lease a land for 1 mil. CU and a car for 20 000 CU – not the same level of risk for the bank as not the same amount of funds necessary to borrow.
- Imagine your car leases are for 3 years, but the office lease is for 10 years. I am quite sure that the interest rate offered by the bank for 3-year loans would be different from the rate offered for 10-year loans.
- Imagine you want to lease an office space in the capital city center and a warehouse in a cheap area of your country. Again, not the same value, strength and environment.
- Imagine you entered one lease on 1 January 2017 and the second one is planned on 1 January 2019 – not the same economic environment, since it is 2 years apart, and you must take all the changes into account.
Again, auditors were right when they refused to accept the same incremental borrowing rate for all the leases that you have.
How to determine the incremental borrowing rate
There are 2 basic steps:
- Take some observable rate.
Observable rates can be for example the rate on your past similar borrowings, or the actual offers from your bank for the loans with similar amount, security and term.
Or, if you are renting the property, then the property yields could be a great start.
- Make adjustments.
Adjustment might be needed exactly because your observable rates might not precisely reflect the lease.
For example, when you take the rates for unsecured loans, then you need to adjust the rates for the collateral – which is your underlying asset.
Or, maybe you took the rates offered to companies with low credit risk, but your credit profile is worse – then you need to adjust.
Finally, let me point out the materiality.
It can happen that you have just a few leases and thus the impact of these adjustments to observable rates would not be material.
In this case, just take the observable rates and don’t bother with adjustments – they would be costly, judgmental and immaterial. But, you need to make absolutely sure that you are below your materiality level.
Any comments or questions? Please write me below – thank you!
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Hello,
I want to ask a question from the lessee’s perspective. In the lease agreement, no interest rate implicit in the lease is mentioned. If I use the incremental rate to calculate the present value, then the present value of the lease payment is double the fair value of the asset. Kindly guide me on which rate I should use to calculate the present value?
Hi silvia,
I have a doubt.My client is leasing out his yard for another company.They have been leasing it from 2019 but they do not have any idea about the borrowing.,In such cases what can we do.If the company has vehicle loan and term loan can we use that rates.But each one has different rates.So how can we take that rate?
Hi sharon,
well, try asking the client’s bank for the quote. The banks would indicate the rate for the similar loan. Or just look to the market loans for the similar companies, similar terms, etc. I would not take the vehicle loan and term loan (which was not specified), because they might not mirror the conditions of the lease. All the best, S.
hi silvia,
In our company there is a warehouse rental agreement with local authority for 2 years (01.01.2019-31.12.2020). payment are made annually (like total rent agreement 200,000 then each year we paid 100,000 through cheque and they gave us every time same amount invoice.) and problem is this we didn’t consider this as a lease and our 2019 year audit finished without above transaction treated as lease. instead of IFRS 16 provisions, we did following entries in our books:-
Warehouse rental a/c Dr. 100,000 (each year)
To Bank a/c 100,000
now what should I do please guide me. can I make the adjustment entry like Modified retrospective approach in 2020 like (1) Bank a/c Dr. 100,000 (2) ROU A/c Dr. (with PV of lease liability amount)
To Retained Earning 100,000 To Lease libility a/c
(3) Retained Earning a/c Dr. (with 2019 dep. amount) (4) Retained earning Dr.( with 2019 Intt. part)
To ROU Lease liabl. a/c Dr. (with 2019 principal part)
To bank a/c ( installment 100,000)
please guide can i make above adjustment entry to incorporate IFRS 16 impact in our books of a/c. or some other adjustment required.
We have some other rent agreement also which contract period is 12 months. can we take exemption to follow IFRS 16 for those 12 months rent agreement.
Hi Silvia
In our company, there are a lot of vehicle hiring agreements entered into for 2 year period since the outright purchase has been restricted at the time. Vehicles are to be supplied with fuel and driver. The monthly charge consist of running cost plus fixed rental. The annual fixed rental slightly exceeds the Company’s minimum threshold set to for recognition of leases. During this two year period, vehicle should be available 12hrs daily and hirer is not allowed to use the vehicle for any other businesses during this 2 year period. The company allows 2-3 days monthly for R&M of the vehicle. Further, the company with one month notice, can discontinue these agreements. And also, the extensions beyond two years of the agreements will not occur. According to IFRS16, should these agreements to be treated as lease agreements ? If so, what’s the interest rate to be used?
Hi Sylvia,
Can you provide any guidance on the Interest Rate Benchmark Reform? Specifically do I need to recalculate the IBR for our Operating Leases (and if so at what date) and then revise my Lease Liability and ROU Asset values?
Many thanks
Hi Silvia – Hope you are doing well. We entered into a 2 year office lease and required to reinstate the office back to original condition at the end of the lease (the lease is renewable). Our office incurred some renovations and hence already capitalised as lease improvement. The same renovation contractor has given us a fee quote of 50,000 to tear down the office to original condition. Can you guide us the process to determine the FV and accounting entry – initial and subsequent entry? Understand that we need to calculated the NPV. How do we determine the discount rate for a Singapore lease?
Hello Sylvia
Our company leases a property for 20 years, with a yearly payment of usd 50,000 paid in advance. How should I calculate the IBR? Thanks for the reply.
Hello Silvia,
We have group company based out at US and subsidiary company in India. Group company computes the IBR rates for India to discount local leases based on US treasury rates and adjusted with country specific currency risk. We use those rates for discounting leases in India under Ind AS (equivalent IFRS), but my auditors are not happy with this process. They says instead we should be taking IBR with reference to local rates from local Banks. Problem is we are debt free company, but have intercompany loans only that too from outside India and no bank shares quotes for the rates infact this is highly confidential as this is negotiable and based on various parameters. We believe this is very impractical for the company to arrange IBR that too periodically from Bank.
Hello Silvia,
Hope your day is going well? The article is on target and helpful. Can you give an example of how to adjust for the observable rate. This would most appreciated.
Hi Silvia!
I have a question, is it reasonable to create an incremental borrowing rate by interpolation? comparing the lease term with the free-risk rate of the country where the asset is? and then, apply a credit risk adjustment?.
I’m not really sure how to do the credit risk adjustment (counterparty risk), should I use CDS (Credit Default Swap) data or other? such as the Transition and Default study by Fitch?
Hi Silvia .
I want to know while remeasuring :The recognition of Lease Liability calculated with period ”0” ?
For example if we have a change in Index rate in 20×5 and lease starts from 20×3 .So while calculation the new Lease liability on 20×5 do we use discount factor with n =0,n=1 or n=1,n=2
Hi Silvia. As being mentioned in the passage above regarding the observable rate, can i just divide the monthly property yield (rental income of $780) with the monthly lease payment (rental expenses of $3424) and getting the discount rate of lease? As for my case, there is no past similar borrowings. Hence, i have no idea on how to determine the discount rate.
Hi Silvia, its been enjoyable to see your share knowledge. I need your kind help on how to define IBR as per auditor’s inquiry. We have 5 years contract for office building rent, paid yearly in advance. On 3rd year, the lessor increase 7.5% rental charge which mention initially in the contract. Can we use this rate (7.5%) to provide to our auditor? Many thanks in advance to your favorable reply
Hi Silvia
If let’s say the leased asset was happened between the intercompany/related party (for example a Parent company “P” as a lessor to lease out a warehouse to the subsidiary company “S”) and the company S intend to use the interest rate given from the company P as the discount rate used instead from external party, would it be an a significant issue regarding these?
Hi Liew, well if that would cause a material error, then yes. If your auditors notice. Anyway – only in a separate financial statements, because it does not matter on consolidation (the lease is eliminated as intragroup transaction).
Hi Sylvia (apologies for calling you Connie)
Great discussion thread. Just to clarify the understanding on the IBR
1. If Company A leases property in different geographical locations, can a blanket rate be used across all leases?
2. If Company A leases different properties on different lease periods (ie 5yrs and 10yrs), can a blanket rate be used across all leases?
3. Confirm the interest rate must be based on the period of the lease only, generally unsecured. Therefore generally a mortgage rate would not be applicable.
Many Thanks
Jeeten
Hi Jeeten, I am on a vacation right now, so just quick replies: 1) No, 2) No, 3) No. For the same reasons as described above, I would only be repeating my own words.
Hi Connie
Great discussion thread. Just to clarify the understanding on the IBR
1. If Company A leases property in different geographical locations, can a blanket rate be used across all leases?
2. If Company A leases different properties on different lease periods (ie 5yrs and 10yrs), can a blanket rate be used across all leases?
3. Confirm the interest rate must be based on the period of the lease only, generally unsecured. Therefore generally a mortgage rate would not be applicable.
Many Thanks
Jeeten
Hi Silvia,
May I get your email address, I have a question on IFRS 16 and its not any of the issues discussed above.
Hi Connie, well for this purpose we offer our online advisory service. Thanks for your understanding!
Hi Silvia, thanks for doing this Podcast. It really helps people like me, who has little experience about IFRS 16, to understand the IBR. I have a question, and would really appreciate your help.
Once the IBR is decided for a certain lease, do we need to review that rate for this specific lease annually (hence would have to recal the lease liability), or we keep using this rate until the lease expires unless the lease is modified?
Many thanks,
Sandy
Hi, Silvia. Thanks for your broad explanations. It really matters. Could you, please, advise me on some issues too.
In our Group statements we have a lot of lease agreements for offices. Some of the are material for us whether some are not. For those that immatereial – could we just recognise ROU and liabilities at the reporting date using our credit portfolio wacc? For those that material – should we extimate the IBR? Which suggestions you could advise on how to do it? I’m really exhausted, because when we analysed in different countries similar amounts of loans from different banks that could provide you with the amount relative to material lease agreements ROU cost and liabilities amount, our auditors said that itsn’t correct. How should we then try to determine IBR?
Thanks in advance. Mikhail.
Hi Mikhail,
well, I would say that if the aggregate of “immaterial” leases is still immaterial, then it is acceptable to use some approximation as the interest rate, although not really WACC. But if the aggregate is immaterial, then I as your auditor don’t care.
For material leases yes, you should estimate incremental borrowing rate as I have already described above. If auditors say it is not right, then I would ask them what is acceptable for them – because it seems your method is acceptable in line with IFRS 16.
Silvia, thanks for a fast reply. One point to clear – in you above explanations your talk about “observable rates”. Does is mean that f.e. if we have an office say in US, we could try to request from bank info about how much interest rate they would give for the credit with the same amount and term as we have for our office in US due to its schedule in the appropriate agreement?
Thanks in advance.
Yes, that would be very good method and that’s what the companies usually do – if they have their account manager in the bank, then the bank can provide them with this supporting documentation.
Thanks a lot, Silvia. BTW, what do your recommend if i want to see all materials from you site? What kind a subscription will be suitable for me if I would like to receive consulting issues, read about application features of particular IFRSs, read guides etc. I am currently working in IFRS as well. Thanks.
HI Silvia,
I am Thishan. One of my client has entered into an agreement for 75 years’ lease term. In this case, how they can determine the interest rate as there are no similar comparable loans for 75 years term. Thanks
Suppose the lease is in Country A and the currency is BDT and the parent company is in country B and the currency is EURO. And the parent gives it’s subsidiary loan at 1.5% interest rate. Can country A use that rate of parent company?
Hi,
If lease payments are CPI-linked then should a discount rate be real (not nominal)?
Thank you.
Dear Silvia,
My name is Michael, pls I have the same question as Olufolake. I work in a Bank also and I have been wondering how to implement IFRs 16 since we currently have our rental in prepaid rent account.
I saw your response to her question, but pls can you expatiate. if there is no lease liability, how do we now account for this and what entries do we raise to.
Also, my additional question is that, at what value do we bring in the already existing prepaid rent on the books.
I will appreciate your urgent response. thank you.
Hi Silvia,
I appreciate you effort and your work regarding IFRS.
I have a question regarding IFRS 16. For example,
A office building lease was classified as operating lease previously, there were simple lease rental shown as expense in P/L under IAS 17.
Moving forward under IFRS 16, under new lease agreement, there is split between rental and building service charges. My question is that would sevices charges be part of right of use asset or expensed out in P/L ?
Hi Aamir,
if you are a lessee – then I would like to remind you that there is a practical expedient. Lessees do NOT have to separate lease components from non-lease and they can account for all the contract as for the lease. In this case, yes – these service charges would be simply a part of your lease payments and enter into ROU. If you decide to separate, then not. S.
Hi Silvia
Mary Christmas
I have same question with “Olufolake Adeyinka” and
other my question is : we have lease contract for 3 year but our payment is monthly (end of each month) what should we do with this kind contract?
Happy new year in advance
Ops, I responded to Olufolake by e-mail. So my answer is – there is no lease liability.
To your second question: that seems like a normal lease contract with 36 future lease payments (3 years monthly). You would discount these future payments by your monthly incremental borrowing rate (or lessor’s interest rate implicit in the lease).
Hi Silvia,
I need some help on how best to implement IFRS 16 in a Bank that I work for. Most of our branches are on long term lease contracts, however the lease payments are fully paid in advance. Essentially there are no Lease liabilities. Under IAS 17, we DR Prepayments with the advance payments and release to the P or L on a monthly basis. The challenge now is, how do we treat this prepayment (fully paid amounts for the lease term) under IFRS 16. What is our Lease liability going to be? when in reality, we don’t have any.
Your prompt response will be appreciated.
I think you need to calculate what would be the lease liability then adjust for the amount paid as advance
Hi Silvia, many thanks for your clear explanation. It is very useful.
I have a question about the borrowing rate. If the terms of rental agreement of a property are for 2 years at monthly rental of CU10,000 i.e. CU240,000 in total. The fair value of the property is CU1,000,000 at the inception of agreement. What terms shall I show to bank for quoting the rate of loan? Is it for 2-year mortgage loan of CU240,000 or CU1,000,000? Usually mortgage loan will be last over 10 years. Please clarify
Hi Ko, you need to take the ROU asset into account, not the underlying asset when taking security into account – in this case, it is a big difference, because your ROU asset relates only to 2-years of use of the property. Therefore, logically, you cannot take mortgage rates into account, because you can acquire underlying asset (property) with the help of mortgage, but not 2 years of using the offices (ROU asset). Mortgage involves completely different level of security similar to outright ownership – not applicable in this case.
Instead, you should maybe look to consumer loans for 2 years to acquire asset with value close to 200 – 240 thousand CU. S.
Dear Silvia
Thanks for your reply. Do you mean that when determine the incremental borrowing rate, the “funds necessary to obtain an asset of similar value” represent the similar amount for the value of the right, ie. total lease payment of the lease? And the “similar term” represent the duration of the lease. Right?
Many thanks.
Yes, right.
Million thanks