At commencement of a lease, a lessee must discount the future lease payments to measure its lease liability. Under IFRS 16, which discount rate should the lessee use?
- The interest rate implicit in the lease, if that rate can be readily determined; otherwise, the lessee's incremental borrowing rate
- The lessee's weighted-average cost of capital, applied consistently to every lease regardless of whether the implicit rate can be determined
- The risk-free government bond rate matching the lease term, since IFRS 16 requires a rate free of the lessee's own credit risk
- Whichever rate produces the lowest initial lease liability, since IFRS 16 gives the lessee discretion to select the discount rate for balance-sheet purposes
Why A? And why not the others?
Correct answer: A. The interest rate implicit in the lease, if that rate can be readily determined; otherwise, the lessee's incremental borrowing rate
IFRS 16 paragraph 26 requires a lessee to discount lease payments using the interest rate implicit in the lease if that rate can be readily determined; if it cannot, the lessee uses its incremental borrowing rate instead. The option specifying weighted-average cost of capital is wrong because IFRS 16 does not reference a general corporate cost-of-capital figure at all — it specifies only the two rates above. The option specifying a risk-free government bond rate is wrong because the incremental borrowing rate is explicitly not risk-free: it is defined as the rate the lessee would have to pay to borrow, over a similar term and with similar security, the funds necessary to obtain an asset of similar value, so it reflects the lessee's own credit standing and the transaction's specific terms. The option allowing the lessee to pick whichever rate minimizes the liability is wrong because IFRS 16 does not grant that discretion; using an artificially low rate to shrink the reported liability would undermine faithful representation, which the standard's hierarchy of rates is specifically designed to prevent.
Source: IFRS 16 Leases, paragraph 26 and Appendix A (definition of the lessee's incremental borrowing rate)