Athens, January 2019

Chris Ragkavas, BA, MA, FCCA, CGMA
IFRS technical expert, financial consultant.

Which rate to use?

This issue deserves some clarification.

The rate implicit in the lease

This is in fact the IRR, the effective rate, discounting the sum of the total lease payments to the fair value of the asset leased.

Admittedly, in theory this sounds clear, but to what extent is this practically possible to be calculated?

Assume Burberry enter into a lease agreement as follows:

  • Commencement date of the lease: 1/1/2020.
  • Annual lease payments in arrears:  GBP 100,000.
  • Lease term: 10 years.
  • No end-of-lease-term purchase options.

The property is new, and its expected useful life is 40 years.

Clearly, Burberry enter into this lease agreement, with no intention to purchase the property. There is no real “asset” whose fair value is readily available, to compare its value with the total sum of the lease payments, i.e. GBP 1,000,000.

The lessee’s incremental borrowing rate

On the contrary, it is safe to assume that Burberry can easily obtain their incremental borrowing rate. That is, the rate that would discount the GBP 1,000,000 to the amount that Burberry would manage to borrow on 1/1/2020, over a similar term, and with a similar security, security being, for example the total expected net proceeds from selling apparel over the lease period, in the leased property.

Assume Burberry would borrow under these terms on 1/1/2020, say, GBP 811,090. By performing some very simple calculations beyond the scope of this article, we arrive at an incremental borrowing rate of 4%, which is the rate that discounts the sum of GBP 1,000,000 to be paid during the lease period, into being equal to GBP 811,090, on 1/1/2020.

Alternatively, assume Burberry can establish that they would borrow on 1/1/2020 for a period of 10 years, at a rate of 4%, as evidenced by communicating with their financiers. The present value on 1/1/2020, of 10 annual payments of GBP 100,000 incurred in arrears, at a rate of 4%, is indeed GBP 811,090.

It is rather more suitable and straightforward to use this rate when control of the property is not transferred at the end of the lease term, or in any case the lessee does not lease the asset for the major part of its useful life. In other words, it is more suitable to use this rate, unless there is an actual tangible asset to compare its fair value at the commencement of the lease, with the present value of the lease payments. More on the differences between the leased asset and the tangible asset leased itself, in Part IV of this series.

Queries, comments, are welcome at [email protected]