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Search Under HKFRS 16 Leases

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.

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