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Determining your periodic IFRS 16 discount rates

IFRS discount rates

How to determine your periodic IFRS discount rates

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KPMG Nederland

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IFRS 16 Leases requires lessees to recognise the right-of-use assets and lease liabilities for all leases except for short-term and low value leases. The new lease liability is initially measured at the present value of the future lease payments. The measurement of the right-of-use asset on transition depends on the choice of transition approach.

The determination of the discount rate PDF (1.5 MB) is an important step in determining the present value of the lease payments. The lease payments shall be discounted either using:

  • the interest rate implicit in the lease (if readily determinable); or
  • the lessee's incremental borrowing rate ("IBR")

The interest rate implicit in the lease is often difficult to determine as it is a measure that the lessor determines specifically for the lessee. Most lessors are not willing to disclose the rate implicit in the lease, as this would disclose their profit margin for that specific lease. 

IBRs, on the other hand, can be calculated with data available from public sources. The key considerations for determining the IBR are given below, as the IBR is the rate specific to:

  • the lessee - i.e. it is a company-specific rate that reflects the creditworthiness of the company;
  • the term of the arrangement;
  • the amount of the funds `borrowed';
  • the `security'- i.e. the nature and quality of the underlying asset; and
  • the economic environment, encompassing the jurisdiction, the currency and the date at which the lease is entered into.

The above elements can be captured by using a 'build-up' approach to the IBR. This approach develops from a risk-free rate to a lessee specific IBR rate.

The first step is to capture the term, the currency and the economic environment of the lease by applying the appropriate country-specific risk free rate. A proxy for this risk-free rate is often considered to be the return on the local government bonds. When applying the return on the local government bond, care should be taken that a weighted average term is applied for the appropriate lease term. This 'duration' element should be taken into account as there is a mismatch between the duration of lease payments and the duration of government bond.

The second step is to capture the lessee-specific financing spread that would reflect the credit worthiness of the Group or Operating Company. To factor in the credit risk, a corporate bond spread should be applied which is: above the risk free rate, based on observed bond yields for similarly rated companies, in the same industry and with terms corresponding to the lease length and currency.

The last and final step would be to apply the lease specific adjustment(s) in a balanced way. Companies should, on the one hand consider discounts over the credit spread due to the securitized nature of the financing and on the other hand contemplate certain asset specific premiums or discounts based on the specialized or general nature of asset.

Most of the parameters required for the above steps are typically based on readily available market data. Thus, once a proper framework is set-up, to carry out the above steps, companies can properly manage their discount rates for leases.

What can KPMG do for you?

KPMG has developed an IBR model that provides a ready-to-use output matrix for IBRs. We will assist in identifying which discount rates are required based on the portfolio of leases. Similar characteristics, such as lease term, class and economic environment will be taken into account to determine whether it is possible to apply the portfolio approach. The collected information will be processed and calculated based on accepted methodologies in our standardized in-house IBR model. The output of the in-house model will be displayed in the form of an IBR matrix with a supporting report explaining all the steps taken. For an efficient process KPMG will keep your auditors updated at each stage of the IBR determination process

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