DETERMINING INCREMENTAL BORROWING RATE UNDER Ind AS 116

BACKGROUND

Ind AS 116 requires a
lessee to discount the lease liability using the interest rate implicit in the
lease if that rate can be readily determined. If the interest rate implicit in
the lease cannot be readily determined, then the lessee should use its incremental
borrowing rate. The interest rate implicit in the lease is likely to be similar
to the lessee’s incremental borrowing rate (IBR) in many cases. This is because
both rates, as they have been defined in Ind AS 116, take into account the
credit standing of the lessee, the length of the lease, the nature and quality
of the collateral provided and the economic environment in which the
transaction occurs. However, the interest rate implicit in the lease is
generally also affected by a lessor’s estimate of the residual value of the
underlying asset at the end of the lease and may be affected by taxes and other
factors known only to the lessor, such as any initial direct costs of the
lessor. It is likely to be difficult for lessees to determine the interest rate
implicit in the lease for many leases, particularly those for which the
underlying asset has a significant residual value at the end of the lease.
Consequently, the standard requires use of the IBR in these situations.

The lessee’s IBR is the rate that the lessee
would have incurred on debt obtained over a similar term for the specific
purpose of acquiring the leased asset. The lessee’s IBR may be equivalent to a
secured borrowing rate if that rate is determinable, reasonable and consistent
with the financing that would have been used in the particular circumstances.
The lessee’s IBR should reflect the effect of any compensating balances or
other requirements present in the lease that would affect the lessee’s
borrowing cost for similar debt. The IBR should also reflect the effect of any
third party guarantees of minimum lease payments obtained by the lessee, to the
extent that similar guarantees of debt payments would have affected the
borrowing costs. However, the lessee’s IBR should not include any component
related to the lessee’s cost of capital (i.e., the IBR should not reflect the
effect of lessee’s use of a combination of debt and equity to finance the
acquisition of the leased asset).

If the lessee’s financial condition is such
that third parties generally would be unwilling to provide debt financing, the
IBR of the lessee might not be readily determinable. In these rare cases, the
lessee should use the interest rate for the lowest grade of debt currently
available in the market place as its IBR.

Three steps are critical in determining the
IBR, namely: (a) the reference rate, (b) the financing spread adjustment, and
(c) lease-specific adjustment. These aspects are discussed below.

REFERENCE RATE

This will generally be the relevant
government bonds or currency swap rates (e.g., LIBOR) reflecting a risk-free
rate. The borrowings should be matched with the currency of the cash outflows
on the lease so that foreign exchange risk is removed. For example, lease cash
flows denominated in USD or GBP (or any other currency) should be matched with
the appropriate risk-free rates, such as those determined from US Treasury
Bills or UK Gilts.

The repayment profile should be considered
when aligning the term of the lease with the term for the source of the reference
rate. Risk-free rates exist for different durations. Therefore, the chosen rate
should be matched with the lease term, as defined by Ind AS 116. The relevant
duration of government bonds to consider is not the total lease term but a
weighted average lease term. While a risk-free rate determined from government
bonds or interest rate yield curves assumes repayment of the capital at
maturity, for an operating lease the repayments are typically spread over the
lease period.

Example: Foreign currency leases

Ez Co, an Indian airline company with INR
functional currency, leases aircrafts; the lease payments are specified in USD
and the interest rate implicit in the lease is not readily determinable. For
making the lease payments, Ez has borrowed in USD and taken a forward contract
to hedge against INR / USD exchange fluctuation risks. The USD loan interest
rate is 4% per annum and the hedge cost is 2% per annum. The currency in which
the lease is determined forms part of the economic environment for which the borrowing
rate is assessed. It is the US dollar incremental borrowing rate that has to be
determined. In this case, the IBR is 4% (subject to any further adjustments
required by the Standard) and not 6%.

FINANCING SPREAD ADJUSTMENT

For determining the spread, lessees should
use credit spreads from debt with the appropriate term. If the same is not
available, it will have to be estimated. The data available to entities to
determine their financing spread adjustment will depend on the type of company
and their financing structures.

For entities with zero debt and / or net
cash balances, consideration should be given to both historical as well as
future debt facilities. The historical position may not be representative of
the current position of the company. It is incorrect to assume that companies
in this situation will have a zero spread, as Ind AS 116 requires the discount
rate to reflect the rate of interest the lessee would have to pay to borrow.
Companies with few data points on their credit spread should seek indicative
pricing from several banks or look to comparable data points available, such as
similar sized companies in a similar industry.

Ind AS 116 is very clear that the IBR is
lessee-specific. Therefore, it is important to evaluate what rate the lessee
would achieve on his own even if theoretically all funding would ultimately be
achieved through a group debt structure. Depending on who is the issuer, and
whether there are written guarantees from the group for the lease payments in
place, it may mean that in some cases a group credit spread that is applicable
to all lessees in a group may be more relevant. In determining an IBR, the
overall level of indebtedness of the entity (i.e., leverage) and whether the
value of the lease results in a change to the leverage ratio such that it
warrants a higher IBR, should be considered.

LEASE SPECIFIC ADJUSTMENT

The key requirement of Ind AS 116 is that the
IBR is directly linked to the asset itself, rather than being a general IBR. To
an extent, the lease is a secured lending arrangement as the lessor can reclaim
the underlying property. The security of the underlying asset should
potentially reduce the credit spread charged by a lender. If there are no data
points with respect to secured borrowing rates the lessee may consider asking
banks or lenders, or use valuation specialists. While all leases will reflect a
secured borrowing position, in practice certain assets may be more valuable to
a lessor and easier to redeploy. For example, the costs of repossessing an
asset of low value (e.g., a Xerox machine) or low duration relative to its cash
flow would be high. Consequently, the security would be largely irrelevant. On
the other hand, in larger value assets with a longer duration (e.g., office
space), the benefit of having security is more valuable because the lessor will
not be at a significant loss in the event of default by the lessee.

PROPERTY YIELDS

In the basis for conclusions of IFRS 16,
property yields are specifically identified as a potential data point for
companies to consider: ‘The IASB noted that, depending on the nature of the
underlying asset and the terms and conditions of the lease, a lessee may be
able to refer to a rate that is readily observable as a starting point when
determining its incremental borrowing rate for a lease (for example, the rate
that a lessee has paid, or would pay, to borrow money to purchase the type of
asset being leased, or the property yield when determining the discount rate to
apply to property leases). Nonetheless, a lessee should adjust such observable
rates as is needed to determine its incremental borrowing rate as defined in
IFRS 16.’

The valuation typically is determined by a
multiplier being applied to the rental income to be received, with the
multiplier representing 1/Yield. Using property yield is more suitable to
valuing commercial property where all likely buyers in the market view the
asset as an investment, for example, valuing
commercial properties. Using property yield is less suitable for owner-occupied
property (e.g., residential properties). Property yields are determined by
assessing the yield profile from recent, comparable sales of similar assets
with similar characteristics. The ‘equivalent yield’ reflected by comparable
sales represents the weighted average of current and future rental income,
smoothing out the effect of rent-free periods or vacancy. In determining the
property yield, the risk to be considered includes location, quality of
property, specification, future rental and capital growth prospects, the
tenants’ credit profile and local supply / demand dynamics. For companies
wanting to use property yields to help them determine lease specific
adjustments, the following assumptions are relevant:

(i)   The currency of property
lease cash flows is aligned with the currency in which the property is valued;

(ii)   The duration of the property
yield data points available are aligned to the weighted average term of the
lease; and

(iii)  The property yields are
aligned to the characteristics of the property lease being assessed (quality,
sector and location of the property).

Practical questions and answers

Query

Ind AS 116 defines the lessee’s incremental
borrowing rate as ‘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.’ What does ‘similar term’ mean in the context of a lease
with a non-cancellable period followed by one or more optional periods? Does
similar term imply:

(a)  A debt for a period equal to the
non-cancellable term?

(b) A debt for a period equal to the maximum term
(including the periods covered by the options to renew)?

(c)  A debt for a period equal to the
non-cancellable term with extension options?

(d) A debt for a period equal to the lease term as
determined in accordance with Ind AS 116 (i.e., taking into account whether or
not it is reasonably certain to exercise the option/s to renew).

Response

The discount rate should be consistent with
the cash flows that are to be discounted and since those cash flows take into
account only the rentals over the lease term as determined according to Ind AS
116, (d) is the right answer.

Query

Ind AS 116
defines the lessee’s incremental borrowing rate as ‘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.’ What does ‘similar
security’ mean in the context of a lease that grants to the lessee the
right-of-use (ROU) for the underlying asset for a period of time? Sometimes,
there could be some guarantees by the parent company or another company in the
group. Can the parent company’s IBR be used?

Response

If parent
provides guarantee on the subsidiary’s debt the pricing of the lease would be
more influenced by the credit risk associated with the parent. The rate used by
the subsidiary should reflect the IBR of the parent, unless the subsidiary is
able to obtain financing on a stand-alone basis without the parent or other
related entities guaranteeing the debt. If that is not the case, the parent’s
IBR would be a more appropriate rate to estimate.

However,
allowing a subsidiary to look up at the parent’s borrowing rate without looking
at anything else, such as the currency exchange rates, may not be appropriate.
Even with a guarantee from the parent company, there are other factors that
could influence the pricing (and the implicit rate) offered by the lessor (such
as tax and other local regulations for example). The lessee should always look
at its own borrowing rate and take into account the impact of any guarantees
provided by the parent company to the lessor. This could be done by soliciting
quotes from local lenders for similar conditions and guarantees. Corporate
borrowing rates may be used as a starting point. However, appropriate
adjustments are usually necessary to take into account specific facts and
circumstances of the lease. The inter-company rate on loans from the parent to
the subsidiary generally should not be used as the lessee’s incremental
borrowing rate.

Query

Ind AS 116
defines the lessee’s incremental borrowing rate as ‘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.’ What does ‘similar
value’ mean?

Response

The
right-of-use (ROU) asset rather than the underlying asset shall be considered
as a security with similar value. The value of the ROU
asset does not include payments that are not lease payments (e.g., variable
payments not based on an index or rate). Similarly, the lease payments relating
to optional periods that are not included in the lease term should also be
excluded.

Query

A company is able to estimate the IBR at
which it would borrow to buy a truck (10 years’ useful life) or property.
Whether the same IBR can be applied if the asset is not the truck but rather a
5-year right of use (ROU) or the asset is not property but an ROU of the
property, or say only two floors of a building are leased?

Response

Whilst there is a practical difficulty in
determining the IBR in the case of an ROU, it is necessary to do so and it will
not be the same as the IBR of the truck or the property.

A lessee should start with the rate it would
incur to purchase the underlying asset, but that rate would require adjustment
to reflect ‘an asset of similar value to the ROU asset’. Adjustments may be
both negative and positive depending on the type of asset and risks associated
with the residual value of the asset.