Time and again, warnings have been launched that the standard is ill-conceived, lacks proper field work and is not fit for application.

The following detailed examples show why IFRS will cause problems and it is important that any negative comments or publicity about the new standard is the full responsibility of the standard setter, the International Accounting Standards Board (IASB).

The International Financial Reporting Standard about Leases, IFRS16, mentions using the * interest rate implicit in the lease* for calculating the start or initial value (initial measurement) of the lease for the lessee.

The basic calculation of initial measurement for leases only requires three variables:

- the number of future payments with indication of interval (month, quarter, etc.);
- the amount to be paid per payment (in its simplest form one equal amount for each payment period);
- an interest rate to be applied for discounting the future lease payments to arrive at the net present value which is the initial value of the lease to the lessee.

The first two variables are explicitly available in the lease contract.

The third is an unknown variable to the lessee and for good reason therefore is called the 'implicit' interest rate.

Many believe - and thus far have applied - * the contractual rate*, if disclosed by the lessor, to be the implicit interest rate.

In the following case study, it is shown that in fact, the contractual and the implicit interest rate are different.

The contractual rate can be used as a rate within an acceptable bandwidth for the lessee, though. However, such ‘acceptable’ usage applies more to current finance leases than to operating leases.

In the below case study, we will be looking at a really simple lease transaction and show that IFRS 16, all leases being treated equal, is based on an incorrect assumption - an operating lease should not be treated like a finance.

**Case study**

The investment amount is €210,000 and the estimated market value after 4 years is €60,000.

A lease transaction is concluded for a 4-year period with annual payments at the end of each annual period.

The market of interest rates is fully transparent and interest surcharges (margins for the lender) applied by banks/financiers to both lessee and lessor happen to be the same as well (in this case study).

The respective interest rates to lessee and lessor for 1 to 4 years are: 2.25%, 2.90%, 3.20% and 3.35% per annum.

The lessee calculates the interest rate, based on a linear redemption profile, to be (2.25+2.90+3.20+3.35)/4=2.92500% ( see table

However, is this the implicit interest rate?

**Table 1 - Calculation of average interest percentage rate, unweighted and weighted with years and residual value**

Simple lease

Years | Interest % | Linear value | Redemption | ||
---|---|---|---|---|---|

0 | 210,000.00 | 0.00 | |||

1 | 2.25% | 172,500.00 | 37,500.00 | ||

2 | 2.90% | 135,000.00 | 37,500.00 | ||

3 | 3.20% | 97,500.00 | 37,500.00 | ||

4 | 3.35% | 60,000.00 | 37,500.00 | ||

150,000.00 | Redemption | ||||

4 | 3.35% | 60,000.00 | Residual value | ||

210,000.00 |

*Average interest percentages:*

*4-years 2.92500% Average interest %, unweighted linearly*

* 3.20061% Average interest %, weighted years, RV.*

The lessor will be using a weighted percentage, taking consideration of the financing of the residual value of the asset. The lessee, due to market transparency, can calculate this interest percentage, too. The percentage calculated can be used as the rate implicit in the lease.

For an example of the calculation in year 3, see table 2. The ‘somproduct’ is 4466.25, being 37,500*3.2% + 37,500*3.35% + 60,000*3.35%, etc.

**Table 2 - Calculation of average interest percentage rate, weighted with years and residual value**

Simple lease

*Simple stack-graph*

2.25% | 37,500 | ||||

2.90% | 37,500 | 37,500 | |||

3.20% | 37,500 | 37,500 | 37,500 | ||

3.35% | 37,500 | 37,500 | 37,500 | 37,500 | |

3.35% | 60,000 | 60,000 | 60,000 | 60,000 | |

Years | 1 | 2 | 3 | 4 | |

Value start of yr | 210,000 | 172,500 | 135,000 | 97,500 | 615,000 |

(somproduct) | 6397.50 | 5553.75 | 4466.25 | 3266.25 | 19683.75 |

Avg % | 3.04643% | 3.21957% | 3.30833% | 3.35000% | 3.20061% |

Based on the interest percentage of 3.20061%, the annual instalment is €42,468.19. Based on the interest percentage of 3.20061%, the annual instalment is €42,468.19.

Using the variables, the Net Present Value (NPV), being the initial value of the lease for the lessee, is € 157,104.08, resulting in 4 annual linear depreciation amounts of €39,276.02.

Total cash out (interest + redemption) for the lessee is 4 * €42,468.19 = € 169,872.76.

Total lease expense (interest + linear depreciation) varies per year, because of the linear depreciation.

There is no longer a match between cash out and total expense to the lessee. This is one of the effects due to IFRS 16. (see table 3).

**Table 3 – Net present value, linear depreciation and interest expense for the lessee, based on the contractual rate**

IFRS 16 | 3.20061% | 42,468.19 | 4 | |
---|---|---|---|---|

Remaining Periods | Net Present Value | Redemption per period | Interest amount per period | Linear Depreciation per period |

4 | 157,104.08 | 37,439.90 | 5,028.29 | 39,276.02 |

3 | 119,664.18 | 38,638.21 | 3,829.98 | 39,276.02 |

2 | 81,025.97 | 39,874.87 | 2,593.32 | 39,276.02 |

1 | 41,151.10 | 41,151.10 | 1,317.09 | 39,276.02 |

**Contractual versus implicit interest rates**

Everybody understands, that the lessor is applying a weighted interest method as compensation for financing the residual value, resulting in an interest rate in the contract of 3.20061%.

Lessors may even be willing to disclose the contractual interest rate, as long as the lessee is not, onerously, misusing the information to negotiate a lower interest rate.

At the same time, the question arises whether the lessee is helped with a contractual interest rate.

In this case study, the contractual rate was easy to calculate and can be considered the rate implicit in the lease.

Lessees may want to apply their own calculated ‘implicit’ interest rate.

This is not for ‘manipulative’ reasons. The calculation of the implicit interest rate requires a ‘readily’ available (future) residual value amount.

Sometimes, this information is available in the market; think of cars. A lot of times, think of vessels or premises, there simply is no contractual interest rate and there also is no known or reliably estimated future residual value of the asset.

And then there is the ‘logic’ of the lessee: it’s not lessee’s profession to monitor residual values for cars, vessels, etc.

Furthermore, it may be assumed that a proper compensation for financing the residual value is included in the four equal annual lease payments.

So why bother trying to apply an interest rate that cannot be supported by facts?

In addition, in the end, it still comes down to paying 4 * € 42,468.19.

If we apply lessee’s number of payments (4), the annual payment amount (€42,468.19) and lessees unweighted interest rate (2.9250%), the outcome is shown in table 4.

The initial value is up by €1,037.89, compared to table 3, due to discounting the same lease payments at a lower interest percentage.

This same difference, of course, will show over time in the P&L components of interest and linear depreciation; depreciation up and interest down with the mentioned amount, compared to the contractual rate.

The choice to apply a low discount rate = a higher annual depreciation, may coincide with management's intent to show high depreciation and low interest expense.

Also, banks and analysts may be pleased, too, as they will be most critical on performance of the company’s interest coverage ratio.

**Table 4 – Net present value, linear depreciation and interest expense for the lessee, based on lessee’s interest rate**

IFRS 16 | 2.92500% | 42,468.19 | 4 | |
---|---|---|---|---|

Remaining Periods | Net Present Value | Redemption per period | Interest amount per period | Linear Depreciation per period |

4 | 158,141.97 | 37,842.54 | 4,625.65 | 39,535.49 |

3 | 120,299.43 | 38,949.43 | 3,518.76 | 39,535.49 |

2 | 81,350.00 | 40,088.70 | 2,379.49 | 39,535.49 |

1 | 41,261.30 | 41,261.30 | 1,206.89 | 39,535.49 |

**Operating leases**

In the reality of operating leases, there are more effects to consider.

Numerous operating leases stipulate the up-front payment of rentals.

Thus, instead of redemption and interest on a loan or a finance lease at the end of the lease period (in-arrears), payment is required at the start (in advance) of the lease period.

The lessor, when using an in-advance method for the lease payment, calculates a lower (annual) payment of €41,210.66 or a total (4*) of €164,842.64.

This compares to the total cash out in the in-arrears situation (table 4) of €169,872.76; a difference of €5,030.12.

The results of the in-advance payments for the lessee, using the same interest percentage as before, is shown in table 5.

**Table 5 – Net Present Value, linear depreciation and interest expense for the lessee, based on lessee’s interest rate for an in-advance calculation**

IFRS 16 | 2.92500% | 41,210.66 | 4 | |
---|---|---|---|---|

Remaining Periods | Net Present Value | Redemption per period | Interest amount per period | Linear Depreciation per period |

4 | 153,459.22 | 36,721.98 | 4,488.68 | 38,364.80 |

3 | 116,737.24 | 37,796.10 | 3,414.56 | 38,364.80 |

2 | 78,941.14 | 38,901.63 | 2,309.03 | 38,364.80 |

1 | 40,039.51 | 40,039.51 | 1,171.15 | 38,364.80 |

There is more to consider:

With the first payment made in advance of the start date of the lease, the lessee might argue to only have 3 payments left to discount at the start of the lease. As table 5 shows, the initial value for 3 periods remaining is €116,737.24.

It makes the difference between an asset bought and an asset leased, in this case, of around 45% (€116,737 versus € 210,000), without having a residual value risk on the books of the lessee.

How do you account for the first payment? Is it a down payment?

Obviously, the lessee is not calculating any interest on this payment. Perhaps, the wording of a lease (any lease) contract needs adjustment to make it work.

The benefit is a lower initial value, thus lower balance sheet totals. Will all future leases, including current finance leases, become in-advance leases?

When we take a closer look at the average (unweighted) interest rate, the outcome would be a 3.15% average interest rate.

This is higher than the original calculated unweighted interest rate (see table 6).

However, this is while taking the original interest percentages for an in-arrears lease.

As the next payment is due in one year, the applicable interest rates for 1, 2 and 3 years should apply, not those for 2, 3 and 4 years.

The impact is striking. The average rate drops from 3.15% to just 2.783%, as table 6 shows.

**Table 6 - Calculation of average interest percentage rate, unweighted; remaining three payments at original rates, respectively at rates for first 3 years**

Simple lease

Years | Interest % | Interest % |
---|---|---|

1 | 2.25% | 2.25% |

2 | 2.90% | 2.90% |

3 | 3.20% | 3.20% |

4 | 3.35% | 3.35% |

Average interest rate, unweighted linearly | 3.15000% | 2.78333% |

If we apply the rate of 2.78333%, in combination with three unchanged lease payments of €41,210.66 to calculate the lessee’s reporting requirements, the lower interest rate causes a small increase (compared to table 5) of the initial value to €117,056.24 and thus a higher depreciation expense of €38,495.27.

In fact, the three-years linear depreciation will become €117,056/3 = € 39,018.75.

This outcome, again, may please management, banks and analysts.

**Table 7 – Net Present Value, linear depreciation and interest expense for the lessee, based on lessee’s remaining 3-years interest rate**

IFRS 16 | 2.78333% | 41,210.66 | 4 | |
---|---|---|---|---|

Remaining Periods | Net Present Value | Redemption per period | Interest amount per period | Linear Depreciation per period |

4 | 153,981.40 | 36,924.86 | 4,285.80 | 38,495.27 |

3 | 117,056.24 | 37,952.60 | 3,258.06 | 38,495.27 |

2 | 79,103.64 | 39,008.95 | 2,201.71 | 38,495.27 |

1 | 40,094.69 | 40,094.69 | 1,115.97 | 38,495.27 |

In conclusion, the lessee is best helped applying its* own implicit interest rate*.

As there is a **disconnect** between lessor and lessee accounting (accepted by IASB in IFRS 16), there is no need to take the position of having the same starting points.

The length of the contract to the lessee is not automatically similar to that of the lessor, nor are the interest rates applied. It will all become a question of wording in the lease contract.

It is important to note that in the example, we have been looking at a lease with an annual payment profile which therefore generates an explicit impact.

Using monthly payments, the impact would of course be more limited, but the case study still is indicative of a quite random initial value outcome, hence a random depreciation amount. This makes it difficult to achieve comparability between companies.

The conclusion is clear.

Even the same leases are not equal (dependant on the lessee or lessor perspective) and therefore equal footing in calculations is not required.

A second conclusion might be that in future leases, all should be regarded as in-advance leases with the first payment at the inception of a lease.

That way, a huge reduction in balance sheet totals is made compared to an in-arrears lease transaction and with the added benefit of lower interest rates to apply for discounting, hence higher depreciation amounts and lower interest amounts, which is shown in the comparison of tables 5, 6 and 7.

**The incremental borrowing rate**

The above conclusions about operating leases are not the only disturbing elements in trying to apply IFRS 16 by the book.

IFRS 16, incorrectly, considers the financing part of a lease transaction, on the liability side of lessee's balance sheet, comparable with a loan.

That only happens to be partly true.

Any lessee wanting to secure a 100% loan for a specific asset-investment will acknowledge that a bank is not providing 100% of the needed funding.

As a result, a lessee has to resort to supplier credit, debit balances on current accounts or its own equity for finance.

What this is doing for the credit standing depends on the choices made, with the application of equity as the most expensive sort of funding. Yet, own funds is what it comes down to in the end.

It is hard to judge or analyse whether own funds are applied to the financing of the first instalment or the last or would be attributable to financing the residual value element in the lease.

This is a decision for management that so far has been ignored in analysis of IFRS 16.

And thus, the incremental borrowing rate, mentioned in IFRS 16 as an alternative to the interest rate implicit in the lease, is another hard nut to crack.

Suppose the implicit rate in the lease is not readily available; then the company may resort to the incremental borrowing rate.

It was thought by the IASB that the incremental borrowing rate was rather easy to derive as the rate to be paid for similar assets in similar situations, etc.

However, there is simply no similar situation for financing the residual value of a lease; it may be the similar period for a bullit-loan, but it isn’t the same risk as there actually is no asset in the control of the company (funding the residual asset that in an operating lease automatically at end of lease returns to the provider of the asset).

Funding should be far more expensive from a bank point of view, so applying the company’s return-on-equity rate might be a serious alternative (at least for a percentage of it, linked to the pro-rata part of the asset, covering the residual value estimate as a percentage of investment amount.

What if in the disclosure to the annual accounts on leases, it is said: "*Management is of the opinion that financing the estimated market (residual) value is best represented by applying the company's return on equity (roe).*

“*Management is not considering to run ongoing discussions with analysts, auditors and banks, each formulating their own reasons why an alternative interest rate would best be fitting the individual lease transaction. As a result, it therefore has decided to apply to operating leases, as in accordance with classification criteria for lessors under IFRS 16, the roe criterion as interest percentage for the residual value element in leases, if observable to the company, on a pro-rata basis, or 2/3 of the roe criterion as incremental borrowing rate to the full lease transaction, if the residual value is not observable to the company."*

With potentially random outcomes of initial values, a direct relation to the investment alternatives and their financing costs may be a welcome simplification.