Determining The Appropriate Lease Discount Rate Under IFRS 16
With upcoming changes to compliance standards being implemented with IFRS 16, companies will be expected to bring all leases onto their balance sheets.
While some provisions and recognition exemptions are included in this new standard – for example leases under $5000 in value, leases that are fully prepaid, leases that have variable payments based on sales or usage, or small-ticket leases tied up in larger leases – the challenges associated with determining lease payment discount rates and the ramifications of these decisions should not be underestimated. After all, deciding on discount rates has a drastic and far-reaching effect on several key financial ratios extending across the entirety of your business’s balance sheets.
Although IFRS 16 maintains the current definitions of discount rates used in existing lease accounting standards, unfortunately however, it is not as easy as copy-pasting all the information from your books and continuing older accounting strategies as the new protocols are ushered in. To comply, companies will not only need to bring existing leases into their statements, but also determine discount rates for most leases including those that in the past have been classified as operating leases - this will affect your statements’ lease liability and therefore an array of financial ratios. Your lease liability is based on current payment values, but companies may mitigate their lease liability by introducing lease discount rates - and depending on the type of lease or asset, deciding on that discount rate can be a taxing endeavour.
Deciding The Road Ahead For Lease Accounting Discount Rates
When it comes to picking a strategy to relieve or reduce your lease liability, there are two broad avenues to consider. The first is using a single discount rate for groups of similar leases, as IFRS 16 contains clauses that allow lessees to apply a single discount rate to groups of leases or lease agreements that share similar characteristics. Essentially, leases that have similar security, terms or lease periods, or economic environments may fall under one ‘catch-all’ discount rate; this is especially useful to ease the pain of transition, particularly in companies that hold gigantic portfolios of leases. Such a strategy of collective measurement might well provide large companies with considerable “cost “relief and simplicity when switching to the new compliance standards.
The second is the use of hindsight when considering the intricacies of past lease determinations and their subsequent lease discount rates. However, this modified retrospective approach has its own set of challenges, the foremost of these being the fact that a lessee cannot use the interest rate implicit in the lease. Thus, a lessee will need to consider each lease agreement to determine the incremental borrowing rate applicable at the date of initial application – and that can be much more difficult than it sounds. Such a determination often relies on information about the assets being leased; companies might not wish to disclose sensitive commercial or financial information, and where such disclosure is made, it might be based on unknown or company-specific expectations or valuations that should be treated with professional scepticism.
Calculating the incremental borrowing rate of leases can be tricky, but in general this rate is affected by the quality of security, the amount borrowed, and the borrowing term, with the amount borrowed having the greatest impact on the IBR.
In any case, IFRS 16 outlines that lessees should discount lease payments using the interest rate implicit in the lease if this figure is readily determined. This interest rate depends on the current value of lease payments, the unguaranteed residual value of the asset, the sum of the fair value of the underlying asset and all initial direct costs to the lessor. Otherwise, the lessee uses its incremental borrowing rate.
However, determining these figures or rates is not so clear-cut, and so due diligence needs to be exercised when deciding what discount rate to practice. Many leases do not disclose specific information about the assets and their recorded valuation or have an implied interest rate that is company specific or is based on in-house valuation that uses unclear or partial criteria with little in the way of clear and transparent information (as with IBR, this often involves sensitive commercial data or financial information a company may not be comfortable imparting).
At the very least you should scrutinise the implied interest rate with the professional scepticism you would have in most financial dealings.
The Far-reaching Implications Of Deciding Your Lease Payment Discount Rates
The effects of deciding discount rates for lease liabilities has pervasive effects and depends on specific lease items, but in general lessees should remember that higher discount rates ‘front load’ the balance statements and affect the initial measurement of the lease liability. As the following list shows, higher discount rates on leases can have far-reaching effects:
- Interest cover – interest cover will be lower, as the interest expense will be higher
- Operating profit/Earnings before Tax and Interest - EBTI and all operating profits will be higher than normal, because depreciation will be reduced
- Current Ratio – this will be higher, as the current portion of the company’s lease liability will be lower
- Gearing/Leverage – lower due to the decrease in lease liabilities
- Asset turnover – turnover of assets will be increased, because right-to-use assets and therefore total assets in company financial reports will be lower
- Earnings before Interest, Tax, Depreciation and Amortisation - EBITDA will be unaffected, as depreciation and interest are excluded in this calculation
Determining the discount rate for lease payments can be a time-consuming and complex task that requires full scrutiny of details of leased assets, terms and security, and with IFRS 16 looming large your business should already be taking steps to ensure that you’re ready to meet all the coming changes in good time. This includes taking inventory of all leases and their terms and conditions, determining what strategies you will use to transition into the new accounting standards, identifying which leases require a group or specific discount rates, and documenting all calculations, decision making and policy decisions in this period.
With not long left before IFRS 16 is put into effect, you should not underestimate the work necessary to prepare for the sweeping changes to accounting standards. For more useful advice and information in streamlining the transition process and implementing solutions for compliance sign up to receive our helpful e-book, 7 Steps to Lease Accounting Compliance - Access your copy but clicking on the link below.
Are you ready for the upcoming compliance changes and the brave new world of IFRS 16?
Disclaimer: this article contains general information about the new lease accounting standards only, and should NOT be viewed in any way as professional advice or service. The Publisher will not be responsible for any losses or damages of any kind incurred by the reader whether directly or indirectly arising from the use of the information found within this article.