AASB16: Incremental Borrowing rate Key considerations

One of the key challenges for implementing AASB16 – Leases is the determination of the incremental borrowing rate. This is a new concept that aligns well with the spirit of what AASB16 is attempting to achieve. The standard defines the incremental borrowing rate as 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. If leases are to be brought back on balance sheet as an interest-bearing liability then determining an appropriate rate to borrow the corresponding asset for the term is more than reasonable. 

The first instinct most people have is to use their current cost of debt as their incremental borrowing rate. Clearly, this is unlikely to be correct – particularly if your current debt facilities are unsecured or are secured with assets that do not resemble your leased assets or the terms are significantly different. The incremental borrowing rate can have a material impact on the asset and liability you recognise at the outset of your lease, so it is worth at least attempting to determine an incremental borrowing rate that approximates what the standard requires.

One challenge that must simply be acknowledged is that the rate will inevitably have some level of fantasy in it. This is a necessity due to the nature of the lending market, particularly (but not peculiarly) in Australia. No bank will lend money for 25 years to a corporate entity, secured or not. It’s simply not how the market works. However this could quite possibly be what is required for a 15+5+5 property lease, depending on your expectations at the outset. So it is not realistic to determine a precise rate, but it is at least worth attempting to determine an incremental borrowing rate that approximates what the standard requires. 

Per the definition, there are three characteristics of the incremental borrowing rate under AASB16 that need to be considered to determine an appropriate incremental borrowing rate – your cost of credit, the security being offered, and the term over which the money is being “borrowed”.

Your cost of credit

Your cost of funds should be the starting point for your determination of your incremental borrowing rate. However, you should give some consideration to how long ago you agreed that rate, whether any security was provided, and also whether the borrowing is fixed or floating. 

If you are 3 years into a 5 year borrowing, the margin on your borrowings is unlikely to be the same now as it was when you agreed it with the bank. You should consider prevailing interest rate and borrowing conditions when determining your incremental borrowing rate. Furthermore, the incremental borrowing rate, where you determine it, is just one rate. This implies that you really need to be considering a fixed rate proxy – in a normal curve environment this will result in a higher fixed rate than the floating rate. 

The “security” of the borrowing

Security is an important contributor to a company’s cost of funds as it provides a way for the bank to mitigate its risk. The faster an asset depreciates, the less security it provides and therefore the higher rate it will attract. All else being equal, the interest rate on kitchen equipment will be higher than for a motor vehicle which will be higher than yellow machinery that will be higher than property. So if you have different assets leased, an incremental borrowing rate attached to each of those asset classes would be appropriate.

Time

The term of the borrowing is the one area of determining your incremental borrowing rate that will require the most judgement and has the potential to have the largest impact on the rate. Leases, particularly on property, often extend well beyond the term that banks are willing to lend money in Australia. So in that circumstance there is little you can do but guesstimate – a rule of thumb observed in the past was for the increase in margin to be 15 basis points increment for each year increment. This works out to about 7 years, but likely reduces from there.

Conclusion

In conclusion, precision in determining your incremental borrowing rate for your leases is unlikely but that does not mean that you should just adopt you current borrowing rate – that may result in a materially incorrect asset and liability recognised. Rather, you should start with your current borrowing cost and make the following adjustments:

  1. Adjust for market movements from your most recent refinance.
  2. Adjust for floating to fixed base rate.
  3. Adjust for the security being offered. Different security will result in different adjustments to the original rate.
  4. Adjust for the term.

Your banker is likely to be the most appropriate person to speak to regarding these adjustments. If you make them you will have a much more defensible position when you speak to your auditors than if you simply attempt to use your current borrowing cost.