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HKFRS 16 Leases

Leases discount rate

The Questions and Answers (Q&As) below were developed by the Financial Reporting Standards Committee ("FRSC") of the Hong Kong Institute of Certified Public Accountants (the HKICPA) and are for general reference only. The HKICPA, FRSC and their staff do not accept any responsibility or liability in respect of the Q&As and any consequences that may arise from any person acting or refraining from action as a result of any materials in the Q&As. Members of the HKICPA and other users of these Q&As should also read the original text of HKFRS 16 Leases, as found in the HKICPA Members’ Handbook for further reference and seek professional advice where necessary when applying the references contained in these Q&As.

The HKICPA's Standard Setting Department welcomes your comments and feedback on this paper, which should be sent to commentletters@hkicpa.org.hk.

Hong Kong Financial Reporting Standard (HKFRS) 16 Leases, which becomes effective for accounting periods beginning on or after 1 January 2019, introduces changes to lessee accounting, and replaces Hong Kong Accounting Standard (HKAS) 17 Leases.

Currently, under HKAS 17, the majority of leases are classified as operating leases and do not appear on the lessee’s balance sheet. That will change when lessees apply HKFRS 16, with the new standard eliminating the classification of leases by lessees as either operating leases or finance leases. Instead, a lessee will account for almost all leases in a manner similar to today’s finance leases. This means that a lessee will recognize both an asset and a liability on the balance sheet. The asset represents the lessee’s right to use the asset underlying the lease for the duration of the lease term. The liability reflects the lessee’s contractual obligation to make payments to the lessor throughout the lease term.

When the standard becomes effective, a lessee will be required to measure the lease liability at the present value of the lease payments payable over the lease term. A key input into the present value calculation is the discount rate. However, lease agreements do not usually state an interest rate and, even if they do, it may not be the rate as required by HKFRS 16. This means lessees need to determine what discount rate to use to calculate the carrying value of the lease liability. HKFRS 16 also requires the discount rate to be reassessed in certain circumstances.

This article outlines some of the practical tips and considerations in determining an appropriate discount rate for leases.

What the standard says

Paragraph 26 of HKFRS 16 requires lease payments to be discounted using the interest rate implicit in the lease, if that rate can be readily determined. If not, a lessee is required to use its incremental borrowing rate. Both methods have the same objective – to reflect the actual pricing of the lease contract (HKFRS 16.BC160).

The concept of the interest rate implicit in a lease and the lessee’s incremental borrowing rate is elaborated in table 1.

Table 1

	Interest rate implicit in the lease	Lessee's incremental borrowing rate
Definition (HKFRS 16 Appendix A)	The rate of interest that causes the present value of the lease payments and the unguaranteed residual value to equal the sum of the fair value of the underlying asset and any initial direct costs of the lessor.	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.
Commentary	It is a rate that the lessor uses to price the lease. Essentially, it takes into account the minimum return that the lessor expects to earn on the lease.	It is a rate at which the lessee would borrow to finance an asset of a similar value to the right-of-use asset. Essentially, it takes into account the term of the lease and the security guaranteed on the lease.

For the lessee to use the interest rate implicit in the lease, that rate needs to be readily determinable. In its Basis for Conclusions on the new standard, the International Accounting Standards Board (IASB) acknowledges that because the rate implicit in the lease takes into account the 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 initial direct costs of the lessor), it may be difficult for lessees to determine the rate implicit in the lease for many leases (International Financial Reporting Standard (IFRS) 16.BC161). If an implicit rate is not readily determinable, the lessee should use its incremental borrowing rate as the discount rate.

There is a common misconception that a company that has never borrowed funds does not have an incremental borrowing rate – for example, when an entity has sufficient cash or is restricted by law from raising debt. In fact an incremental borrowing rate is the rate that a lessee would have to pay to borrow funds to obtain an asset of a similar value to the right-of-use asset rather than a general corporate borrowing rate. How an entity finances its operations does not directly affect the determination of its incremental borrowing rate under HKFRS 16. The sections below provide more discussions on the determination of incremental borrowing rate.

Have the discount rate requirements changed from HKAS 17?

The definitions “interest rate implicit in a lease” and “incremental borrowing rate” under HKFRS 16 are broadly unchanged from HKAS 17.

HKAS 17.20 requires finance-leased assets and liabilities to be measured at the fair value of the leased assets or, if lower, the present value of the minimum lease payments. The discount rate used in calculating the present value of the minimum lease payments is the interest rate implicit in the lease if it is practicable to determine, otherwise, the lessee’s incremental borrowing rate shall be used.

Under HKFRS 16, the discount rate will become important to more companies than before as almost all leases are required to be recognized on the balance sheet.

The following are some practical matters that are commonly encountered by entities when determining the appropriate discount rates for leases.

Q1.	Can a lessee use a single discount rate for all leases?

No. HKFRS 16 specifies that individual leases should be considered separately (HKFRS 16.B1). An incremental borrowing rate is the rate that takes into account the term of the lease, the security guaranteed on the lease, the value of the underlying asset in the lease and the economic environment in which the lease is entered into (HKFRS 16 Appendix A).

Having said that, a lessee is permitted to use a single discount rate for a portfolio of leases with similar characteristics if the lessee reasonably expects that the effects on the financial statements of applying HKFRS 16 to the portfolio would not differ materially from applying it to individual leases within the portfolio (HKFRS 16.B1).

Q2.	What should be considered when determining a lessee’s incremental borrowing rate?

A 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 a similar value to the right-of-use asset in a similar economic environment” (HKFRS 16 Appendix A). Paragraph BC161 of HKFRS 16 explains that the incremental borrowing rate is essentially a rate that takes 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.

In theory, a lease is similar to a secured lending arrangement as a lessor has the right to reclaim the underlying asset itself. Therefore, the discount rate for a lease should reflect a rate that a lessee would borrow on a collateralized basis.

In addition, as the incremental borrowing rate is the rate that a lessee would have to pay to borrow the funds; it appears that the incremental borrowing rate should consider only borrowings, not other sources of finance (e.g. equity). Therefore, the discount rate for a lease should reflect a rate that a lessee would face if 100 percent of the cost of an asset was funded with finance.

In an article published by members of the IASB Leases One Year On - Putting IFRS 16 Into Practice, one of the board members noted that, to arrive at an appropriate incremental borrowing rate for the lease, lessees need to think about the factors a lender would typically consider. If lessees have difficulties in identifying a rate for a similar borrowing to use as a starting point, the author suggested that a lessee should consider how the price of the lease was assessed at contract inception. Alternatively, lessees could make use of other observable rates such as relevant property yields as a starting point, and then consider how those observable rates might need to be adjusted in order to meet the definition of incremental borrowing rate in IFRS 16.

Q3.	Can a lessee simply use its general borrowing rate or property yields for discounting lease liabilities?

No. Incremental borrowing rates are lessee-specific and directly linked to the leased asset itself (HKFRS 16 Appendix A). As mentioned in Q2, it is possible for a lessee to refer to a rate that is readily observable as a starting point when determining its incremental rate for a lease. We outline below the factors that are commonly applied in practice to derive the discount rate for a lease from a general borrowing rate and a property yield.

General borrowing rates

To derive the discount rate, an entity adjusts its general borrowing rate to reflect the features specific to the lease. Based on its own facts and circumstances, an entity may consider applying the following adjustments to its general borrowing rate as needed:

Align the duration of the loan to the length of the lease;
Reflect the loan with a collateral similar to the nature and quality of the leased asset;
Reflect the loan amount similar to the value to the right-of-use asset; and
Align the currency of the loan with the currency of the lease payments.

In practice, some entities may simply ask banks to quote an incremental borrowing rate based on the terms of the lease contract. It is important to note that even if a bank does provide a rate, an entity should exercise appropriate professional judgment when evaluating the information.

Property yields

A property yield can be used as an input when determining the incremental borrowing rate for property leases. Property yields reflect the annual return expected on a property. However, property yields do not reflect lessee-specific features that would affect the incremental borrowing rate – e.g. the length of the lease, the lessee’s credit rating etc. Like a general borrowing rate, an entity adjusts the property yield to reflect the features specific to the lease in order to derive the discount rate.

Q4.	Can a subsidiary use its parent’s or group's incremental borrowing rate as the discount rate for its leases?

It depends. In principle, a subsidiary that is a lessee should not use its parent’s or group's incremental borrowing rate as its discount rate, even if all the debt financing is obtained centrally by its parent company. That is because incremental borrowing rates under HKFRS 16 are lessee specific and should reflect the rate a lessor charges the subsidiary.

Nonetheless, it may be the case that the rate charged by the lessor has been influenced by the credit standing of the parent or group. For example, negotiations with a lessor may require the parent entity to guarantee the lease payments, in which case, the pricing of the lease may be influenced by the credit standing of the parent, rather than the subsidiary. If so, it might be reasonable for the subsidiary to use its parent’s discount rate as an input in determining the lessee’s borrowing rate in the lease contract.

Q5.	When is a lessee required to revise discount rates used in calculating lease liabilities?

A lessee is not required to reassess its discount rate during the lease term unless the economics of the lease change (HKFRS 16.BC194). For example:

When the original lease term or assessment of a purchase option changes (HKFRS 16.40); or
When floating interest rates change, resulting in a change in future lease payments (HKFRS 16.43).

If the economics of a lease change, the revised discount rate is the implicit interest rate for the remaining lease term, unless it cannot be readily determined. If the implicit rate cannot be readily determined, the revised discount rate is the lessee’s incremental borrowing rate at the date of reassessment (HKFRS 16.41).

Other considerations

Entities should not underestimate the time it will take to determine appropriate discount rates. Additional data may be needed from third parties. Depending on the information available to an entity, estimates will need to be used according to an entity’s particular circumstances. Entities should document the basis for these determinations. Entities also need to disclose how discount rates have been derived and the sensitivities around them if they represent a significant judgment or estimate under HKAS 1 Presentation of Financial Statements.

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HKFRS 16 Leases

Leases discount rate