If I remeasure a lease, do I need to use a new discount rate?

I have a new lease contract and am not sure whether to discount the lease payments using the IBR (Incremental Borrowing Rate) or the interest rate implicit in the lease?

How do I calculate the interest rate implicit in the lease and my incremental borrowing rate?

When it comes to IFRS 16 discount rates, these are but a few of the questions we hear most frequently. In this guide, we’ll aim to provide clarity on this topic by reviewing the official guidance per the standard and elaborating thereon.

First off, why do we need a discount rate in the first place?

As is the case with any form of financial loan/lending agreement, any outstanding balance of monies owing will accrue interest with the passage of time. This accrual of interest is the cost of borrowing.

If a business requires, for example, a property, vehicle or any other kind of physical asset, there are typically two choices available:

1. The business can apply for a loan from the bank to purchase the asset outright.
2. The business can lease the asset – in other words, they can purchase the right to use that asset from a willing party and compensate them over time for that right of use.

In the case of the latter option, although the lessee isn’t borrowing money, they are borrowing the asset for a fixed term in exchange for set payments to be made at specific dates in the future.

It is these future payments which necessitate the need for a discount rate because, in essence, being allowed to make payments in future is tantamount to receiving a loan; the full asset is made available to you today with repayments only being required in the future. The discount rate therefore encompasses the cost to the business for this financing element of the lease agreement.

So, in summary, to correctly represent the present value of the amounts payable in the future under the lease agreement, we require a discount rate to accurately calculate this present value. The sum of the discounted payments makes up the lease liability and interest is subsequently charged against this liability, representing the cost of the future payments.

Incremental Borrowing Rate or Interest Rate Implicit in the Lease – Which do I use?

The IFRS 16 standard includes two possible options when it comes to determining the discount rate; a lessee will either apply the interest rate implicit in the lease or, if such rate cannot be readily determined they will then apply the incremental borrowing rate (‘IBR’).

IFRS 16(26): “…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.”

In certain circumstances, a discount rate may not need to be determined for a lease if:

• a lessee applies the recognition exemption for either a short-term lease or a low value asset.
• all lease payments are made on or before the commencement date of the lease, or
• all lease payments are variable and not dependent on an index or rate (e.g. if all lease payments vary based on sales or utilisation).

Assuming the above conditions do not apply, a lessee will need to determine the discount rate for every lease that is within the scope of IFRS 16.

Provided it can be readily determined, the standard requires the lessee to use the interest rate implicit in the lease. Therefore, before looking at the Incremental Borrowing Rate, let’s explore what considerations should be made in determining the rate implicit in the lease.

According to IFRS 16, the interest rate implicit in the lease is defined as:

‘The rate of interest that causes the present value of (a) the lease payments and (b) the unguaranteed residual value to equal the sum of (i) the fair value of the underlying asset and (ii) any initial direct costs of the lessor.”

This definition is the same for both the lessee and the lessor.

However, given that the rate needs to consider the initial direct costs incurred by the lessor, determining such rate for the lessee can be problematic, if not impossible.

Nonetheless, depending on the facts and circumstances surrounding the lease, it may be possible to determine the implicit rate without difficulty:

• Depending on the asset being leased, the lease contract may explicitly refer to a specific interest rate.
• The initial fair value of the asset and its residual value may be reliably observable within the market.
• The initial direct costs for such a lease may be immaterial in relation to the overall lease.

These are the kinds of factors which, when applicable, would enable the lessee to more accurately, and more easily calculate the rate implicit in the lease.

Clearly, calculating the implicit rate can be involved and may require technical expertise. Considering this, the standard does say that the lessee is required to apply the interest rate implicit in the lease only when such rate can be readily determined.

Unfortunately, not much is said as to what readily determined means. However, in our experience, the existence of readily observable information which alleviates the lessee of having to make significant estimates and judgements would contribute toward the rate being considered readily determinable.

On the contrary, let’s assume that, in determining the fair value of an asset for a lease, the lessee would require the expertise of an independent valuator. In such cases, the rate would not be regarded as being readily determinable. At this point, the lessee is required to apply the alternative.

On that note, let’s now look at the Incremental Borrowing Rate.

According to IFRS 16, 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.’

As a starting point, the IFRS 16 standard encourages an entity to apply their incremental borrowing rate and make the necessary adjustments thereto for the lease in question.

The Lessee’s Incremental Borrowing Rate would be the rate they obtain for general financing and loans. Then, when adjusting such rate for the lease in question, the lessee should consider the following main factors:

• The credit rating/status of the lessee
• The length of the lease
• The nature and quality of the collateral
• The economic environment in which the lease transaction occurs.

Again, the determination of the IBR will also require judgement, however, the provision of a general borrowing rate as a starting point does make it slightly easier for the lessee to determine a reliable rate.

As a recap, provided it can be readily determined, the lessee should apply the Interest Rate Implicit in the Lease as the discount rate. Where such rate is unavailable, the lessee should then calculate the appropriate Incremental Borrowing Rate instead.

We’ve now covered why a discount rate is necessary, we know why and when we should use the Implicit Rate or the Incremental Borrowing Rate, and, we have a good understanding of the factors we should consider when calculating such rate. The last point we need to address is how we treat the discount rate upon reassessment of the lease liability.

How do I treat the discount rate upon reassessment of my lease liability?

According to IFRS 16, there are two approaches when reassessing the lease liability – the lessee will either need to calculate a revised discount rate or they will leave the discount rate unchanged.

The approach taken is entirely dependent on the reason for the remeasurement. Let’s take a closer look.

Revised Discount Rate

A lessee will remeasure the lease liability by discounting the revised lease payments using a revised discount rate if either:

• there is a change in the lease term because of:
  • a change in the non-cancellable period of the lease, e.g. the lessee exercises an option to extend that was not previously included in the lease term (or the lessee does not exercise such an option that was previously included in the lease term), or
  • a lessee reassessing whether it is reasonably certain to exercise an extension option or not to exercise a termination option, or
• there is a change in the assessment of a lessee’s option to purchase the underlying asset.

If any of the above scenarios apply, the lessee will use a revised discount rate and this rate should be determined by following the same guidance as discussed earlier:

The revised discount rate is the interest rate implicit in the lease for the remainder of the lease term and, where such revised rate cannot be readily determined, the lessee’s incremental borrowing rate at the date of reassessment or effective date of lease modification is used.

Unchanged Discount Rate

According to IFRS 16 (43), unless the change in lease payments arise due to a change in a floating interest rate then, when remeasuring a lease liability because of:

• a change in amounts expected to be paid under a residual value guarantee or,
• a change in future lease payments resulting from a change in an index or rate used to determine those payments.

the lessee shall remeasure the revised lease payments using an unchanged discount rate.

Let’s look at two examples which illustrate when the Discount Rate needs to be revised and when it should remain unchanged:

Revised Rate Example

On the contrary, let’s assume that a lessee has an active vehicle lease whose payments are directly linked to the prime rate of interest. The lessor then revises the lease payments because of a change in the prime rate. Since the lease payments are linked to a floating interest rate, in such case, the lessee will remeasure the lease liability by discounting the revised lease payments at the revised discount rate to reflect the change in interest rate.

Unchanged Rate Example

Let’s assume that, as part of a rent review, the landlord revises the lease payments due on a property lease and that this revision is driven by a change in the market rental rates for such a property. If we apply the guidance then, in such case, the revised lease payments will be discounted at the same discount rate as before. The discount rate remains unchanged.

Conclusion

Whilst the standard provides clear definitions on the different types of rates as well as guidance on the factors to consider in the determination thereof, there is certainly much that is left to interpretation. As a rule of thumb, entities are encouraged to stay up to date on their borrowing rate profile, considering the lending rates they would usually obtain for different classes of assets. Whilst this is only a starting point, it certainly helps when calculating lease-specific discount rates.

We hope this article has been informative and clarified most of your questions relating to IFRS 16 discount rates.

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