Lease accounting has undergone significant changes with the amendments to FRS 102, the financial reporting standard applicable for organisations in Ireland and the UK. Specifically, Section 20, Leases, introduces a single on-balance sheet model for lessees, requiring capitalization of most lessee leases through the recognition of a lease liability and corresponding Right-of-Use (ROU) asset.
FRS 102 states that at initial measurement of the lease liability, the lessee shall measure the liability at the present value of the lease payments, discounted using the rate implicit in the lease if that rate can be readily determined.
If that rate is not readily determinable, then the lessee can choose to apply with the lessee’s incremental borrowing rate, IBR, or the lessee’s obtainable borrowing rate, OBR. In this article, we will discuss the difference between the implicit rate, the incremental borrowing rate and the obtainable borrowing rate along with further discount rate simplifications and considerations for FRS 102.
Implicit rate
Per FRS 102, the implicit interest rate is defined as the rate of interest that causes the present value of:
- (a) the lease payments; and
- (b) the unguaranteed residual value
to equal the sum of:
- (i) the fair value of the underlying asset; and
- (ii) any initial direct costs of the lessor
This formula is presented below:
If the inputs are available, a lessee can use the IRR function in Excel, or use our implicit rate calculator tool, to come up with the implicit interest rate in a lease.
The implicit interest rate should be used by the lessee to calculate the initial lease liability under FRS 102 if the rate is readily determinable. However, this rate is often not readily determinable because, as shown above, it requires inputs and assumptions that the lessee would not be privy to.
Incremental borrowing rate
If the interest rate implicit in the lease is not readily determinable, the lessee may choose, on a lease-by-lease basis, to apply either the lessee’s incremental borrowing rate or the lessee’s obtainable borrowing rate.
The lessee’s incremental borrowing rate (IBR) is the interest rate the 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.
Determining the IBR often requires a sophisticated process, as it requires a process involving organization specific factors such as credit risk, collateral, etc. and lease specific factors. In order to alleviate some of the burden of FRS 102 application, a new interest rate election was introduced, called the obtainable borrowing rate (OBR).
Obtainable borrowing rate
FRS 102 introduces an additional option for when the implicit rate is not readily determinable by the lessee. This rate is called the “obtainable borrowing rate” (OBR), which FRS 102 defines as “the rate of interest that a lessee would have to pay to borrow, over a similar term, an amount similar to the total undiscounted value of lease payments to be included in the measurement of the lease liability.”
While a similar concept to the IBR, the OBR is significantly easier to determine than the IBR since it relies on readily available inputs to the lessee, such as the value of the lease payments and lease terms, making it a practical alternative to simplify adoption of FRS 102.
Further discount rate simplifications and considerations
In addition to the introduction of the OBR, FRS 102 also permits organizations to apply a single discount rate to a portfolio of leases with reasonably similar characteristics (for example, a similar remaining lease term for a similar class of underlying asset in a similar economic environment).
Additionally, for public benefit entities, on the basis that some of them may not borrow and therefore would not be able to readily determine the implicit interest rate, the IBR, or the OBR, they can use the rate of interest otherwise obtainable by the entity on deposits held with financial institutions.
To further simplify discount rate application, FRS 102 introduces scenarios that allow a lessee to not update the discount rate when a lease change occurs. Under other lease accounting standards such as IFRS 16 and ASC 842, lessees have to reassess the discount rate at the point a modification occurs. These exemptions allow for easier maintenance of ongoing compliance with FRS 102.
The three modification scenarios that permit a lessee to use an unchanged discount rate under FRS 102 are:
- the additional consideration from the lease modification is insignificant relative to the total consideration of the original lease,
- the lease modification decreases the scope of the lease by removing the right to use one or more underlying assets, and the consideration for the lease decreases by an amount commensurate with the stand-alone price for the decrease in scope, or
- the lease modification decreases the consideration payable for the remaining term of the lease but does not decrease the scope of the lease by removing the right to use one or more underlying assets.
If an unchanged discount rate is used for a lease modification, organizations should include this the FRS 102 lease disclosures along with the carrying value of the remeasured lease liabilities.
Summary
FRS 102’s single lessee accounting model places significant emphasis on the accurate determination of the discount rate to measure the lessee’s lease liability. Lessees must first use the interest rate implicit in the lease if readily determinable. If that rate is not readily determinable, the lessee has the option to use either the Incremental Borrowing Rate (IBR) or the simplified Obtainable Borrowing Rate (OBR). Correct application of the discount rate is critical in ensuring financial statements accurately reflect the correct balances for compliance with the lease requirements in FRS 102.
Regardless of the rate applied, documentation of the methodology and key inputs is crucial, and organizations should provide support for any judgments made in discount rate evaluation and application and should be prepared to disclose this information in their FRS 102 disclosures.
