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Leases - determining the incremental borrowing rate in practice
In this episode, we will discuss how a lessee determines the incremental borrowing rate for a lease under IFRS 16 in practice.
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.
When a lessee applies IFRS 16, it must determine the discount rate to apply to the lease payments. In this episode, we will discuss how a lessee determines the incremental borrowing rate for a lease under IFRS 16 in practice.
Learning outcomes
Guidance on what to consider to determine the lessee’s incremental borrowing rate for a lease.
For your convenience, full text transcript of this podcast is also available.
Luci Wright
Welcome to the second 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 determines the incremental borrowing rate for a lease under IFRS 16 in practice. 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
Many entities struggle with how to determine the incremental borrowing rate for a lease. What is your advice?
Chan
A lessee may be able to refer to a rate that is readily observable as a starting point when determining the incremental borrowing rate for a lease. For example, an entity may have recently enter into a borrowing facility with a bank and therefore the unsecured borrowing rate may be readily observable. In other cases, a lessee may have recently paid, or would pay, to borrow money to purchase the type of underlying asset being leased. Property yields are also often readily observable. However, in order to determine the incremental borrowing rate as defined in IFRS 16, adjustments to these readily observable rates may be needed.
Wright
What would be the adjustments?
Chan
In the first episode, we talked about the definition of the incremental borrowing rate being 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. Thus, the sources of potential adjustments could include, for example, the credit profile of the lessee, the length of the lease term, and the nature of the underlying asset, etc. Just to illustrate the last point, a piece of leasehold land in a prime location will likely be a more valuable security than a second-hand motor vehicle.
Wright
It seems that there could be many sources of potential adjustments. Can a lessee take materiality into account when identifying these adjustments?
Chan
Yes. Materiality can be taken into account. Having said that, an entity needs to have appropriate analysis before concluding whether a source of potential adjustment is material to the financial statements. It is probably worth mentioning here that the IASB issued Practice Statement No. 2: Making Materiality Judgement in September 2017. The Practice Statement contains non-mandatory guidance to help entities make materiality judgements when preparing for IFRS financial statements. Performing sensitivity analyses might also help determine how material a potential source of adjustment is likely to be.
Wright
And is it correct to say that the magnitude of an adjustment is also lessee specific?
Chan
That’s right. For example, assume two different lessees entering into contracts to lease an identical underlying asset and these two lessees have significantly different credit profiles. Under certain circumstances, the effect of the right-of-use asset as a security to the incremental borrowing rate would be different for those two lessees. Specifically, for the lessee with a stronger credit profile, the effect of the security to the incremental borrowing rate would be less significant than that to the lessee with a weaker credit profile, assuming everything else is the same. Thus the effect of the security to the incremental borrowing rate could be immaterial for one lessee but not for the other.
Wright
Thanks again for sharing your insights with us, Victor. In the next episode, we will consider specific consideration to the incremental borrowing rate for a subsidiary and the application of the portfolio approach.
