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Use of interest rate implicit in the lease and incremental borrowing rate
This is the first episode of five EY IFRS podcasts on the determination of discount rates by lessees, when applying the new leases standard of IFRS 16 Leases.
This set of five EY IFRS podcasts on the determination of discount rates by lessees, when applying the new leases standard of IFRS 16 Leases is presented by Victor Chan and Luci Wright from EY’s Global IFRS team.
This episode covers how a lessee is required to evaluate the discount rate to be applied to lease payments in a contract. We discuss whether a lessee should use the interest rate implicit in the lease or the incremental borrowing rate as defined in IFRS 16.
Learning outcomes
To apply IFRS 16, entities must determine the discount rate that is applied to the lease payments.
For your convenience, full text transcript of this podcast is also available.
Luci Wright
Welcome to the first episode of this series of EY podcasts on the determination of discount rates by lessees when applying the new leases standard of IFRS 16. I am Luci Wright, an Executive Director with EY Global IFRS Services in London. In this episode, we will discuss how a lessee is required to evaluate the discount rate to be applied to lease payments in a contract under IFRS 16. Today I am joined by Victor Chan, a partner with EY Global IFRS Services and a member of EY Global Subject Matter Group on leases. Victor, welcome to our podcast.
Victor Chan
I am glad to be here.
Wright
The very first question we usually get about the determination of the discount rate under IFRS 16 is which rate a lessee needs to use. Victor, would you please explain more about the requirements under IFRS 16?
Chan
Sure, Luci. A lessee is required to use the interest rate implicit in the lease if that rate is readily determinable to the lessee. The interest rate implicit in the lease is defined in the standard as the rate of interest that causes the present value of the lease payments and the unguaranteed residual value to equal the sum of the fair value of the underlying asset and any initial direct costs of the lessor. If the interest rate implicit in the lease is not readily determinable to the lessee, the lessee is required to use its incremental borrowing rate which is also defined in the standard. The 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 right-of-use asset in a similar economic environment.
Wright
Well, the interest rate implicit in the lease is likely not readily determinable in the contract and the lessee won’t know the unguaranteed residual value of the underlying asset or how much the lessor incurs on initial direct costs. In this situation, can the lessee engage a specialist to make estimates using sophisticated models and assumptions?
Chan
If the interest rate implicit in the lease can only assessed using estimates and assumptions, then it is not considered readily determinable. The objective of the International Accounting Standards Board, or IASB, in this respect is to specify a rate that reflects how the contract is priced [BC160]. Thus the discount rate is lease specific, not market specific.
Wright
But what if the lessor is willing to provide a discount rate to the lessee through other means, say, over the phone or email?
Chan
While many lessors would be unwilling to provide a discount rate, they are likely less willing to provide sufficient information to allow the lessee to verify that such rate is actually the lessor’s rate implicit in the lease. In fact, it is expected that the interest rate implicit in the lease is not usually readily determinable to the lessee and thus a lessee would generally need to determine its incremental borrowing rate for the lease.
Wright
This is helpful. The incremental borrowing rate is also referred to under the existing leases standard of IAS 17. What are the differences between the two standards on the definition of the incremental borrowing rate?
Chan
The definitions are quite similar. One of the main differences is that, under the existing leases standard of IAS 17, the definition refers to the funds necessary to purchase the asset. Whereas under the new leases standard of IFRS 16, the definition specifically refers to the funds necessary to obtain an asset of a similar value to the right-of-use asset. Another difference is that under IAS 17, the incremental borrowing rate is determined at inception of the lease while under IFRS 16, the incremental borrowing rate is generally determined on the commencement date of the lease which is the date on which a lessor makes the underlying asset available for use by a lessee and is generally later than the inception of the lease.
Wright
Thank you for sharing your insights with us, Victor. In the next episode, we will consider how the incremental borrowing rate is determined in practice.
