One of the issues currently facing clients when implementing AASB 16 is the determination of a discount rate. Most leases are discounted using the incremental borrowing rate (IBR). This is the rate of interest that a lessee would have to pay to borrow the funds necessary to acquire an asset of a similar value. Determining the incremental borrowing rate will therefore often involve significant judgment and will most likely be a practical challenge as most of our clients do not have direct borrowings with banks or financial institutions.
As a guide, the most appropriate source to consider when determining the discount rate is the current interest rate on borrowings. This information is readily available. Other sources of data that can be used include government or corporate bond rates and also property yields for property leases. These would need to be quantitatively adjusted to arrive at an appropriate IBR that satisfies the requirements of AASB 16.
Factors to consider when considering an appropriate IBR includes:
- The length of the lease: the longer the lease, the higher the rate
- The underlying value of the asset being leased: the better the security, the lower the rate
- The entity’s existing debt: the higher the current cost of borrowing, the higher the incremental cost of borrowing
- The quality of the asset being leased: the better quality of asset, the lower the rate.
The following would also need to be considered:
- where the lessee chooses to apply the practical expedient that allows for lease accounting on a portfolio basis, AASB 16 allows this if the effect is expected to be materially the same as a lease-by-lease approach
- What risk premium to attach to any rate being considered
- on transition where the lessee uses the modified retrospective approach and applies a single discount rate to a portfolio of leases with reasonably similar characteristics (eg. Leases with a similar remaining lease term for a similar class of underlying asset in a similar economic environment).
An entity entered into a 5-year lease contract for a photocopier machine. The entity has no current borrowings with a financial institution and therefore could not obtain the incremental borrowing rate. As such, a good place to start would be the Indicator Lending Rate which is published on the RBA website.
From the schedule, the appropriate rate to use would be the “Small business-Variable-Overdraft” as indicated in column C. The published rate for July 2020 is 6.57%.
To read more about AASB 16 Leasing Standard, read Bentleys article: New leases accounting standard: how different will your balance sheet look? Alternatively, please contact your Bentleys Advisor to discuss AASB 16 and how it applies to your business.
Disclaimer: This information is general in nature and should not be relied on as advice. It does not take into account the objectives, financial situation or needs of any particular person. You need to consider your financial situation and needs and seek professional advice before making any decisions based on this information.