IFRS 16 Leases requires lessees to bring most leases onto the balance sheet. The new assets and liabilities are initially measured at the present value of the lease payments. But discounted at what rate?
The discount rate affects the amount of the lessee’s lease liabilities – and a host of key financial ratios.
Our publication will help you to determine the appropriate discount rate and to assess how this will affect your financial statements.
A key transition challenge for lessees
IFRS 16 brings forward definitions of discount rates from the previous leases standard, but applying these old definitions in the new world of on-balance sheet lease accounting will be tough, especially for lessees. They now need to determine discount rates for most leases previously classified as operating leases.
New systems and processes
Systems and process changes may be required to capture and assess the data necessary to comply with the new discount rate requirements. New calculations and review processes will be needed to determine the discount rate and the judgements and assumptions applied will need to be documented.
Ongoing monitoring will be required as estimates may be revised – e.g. if the lease is modified.
A lessor uses the interest rate implicit in the lease for purposes of lease classification and to measure the net investment in a finance lease.
The interest rate “implicit” in the lease is the discount rate at which:
- the sum of the present value of (i) the lease payments and (ii) the unguaranteed residual value equals
- the sum of (i) the fair value of the underlying asset and (ii) any initial direct costs of the lessor.
A lessee discounts the lease payments using the interest rate implicit in the lease if this can be readily determined. Otherwise, the lessee uses its incremental borrowing rate.
The lessee’s 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 similar value to the right-of-use asset in a similar economic environment.
That is, the lessee’s incremental borrowing rate is specific to:
- the lessee: it is a company-specific rate;
- the term of the arrangement: this will typically be the lease term, unless the lease payments are paid up-front;
- the amount of the funds “borrowed”;
- the “security” granted to the lessor: i.e. the nature and quality of the underlying asset; and
- the economic environment: i.e. the jurisdiction and the time at which the lease is entered into, and the currency in which the lease payments are denominated.
A lessee is required to identify a discount rate for all leases other than those for which it elects to apply the recognition exemption for short-term leases and leases in which the underlying item is of low value.
Find out more
Read our full Leases: Discount rates publication, which analyses the key considerations when determining the correct discount rate for leases. It includes KPMG’s insight and examples illustrating practical application of the new requirements.