Lease accounting looks mechanical once the inputs are set. The incremental borrowing rate and the lease term are where the real work, and the audit questions, sit.
Key takeaways
- The incremental borrowing rate is entity-specific and lease-specific; a group-wide rate is rarely defensible.
- Short Gulf leases with rolling renewals make the lease term judgement more consequential, not less.
- Document both judgements in a policy that applies to new leases and modifications consistently.
Seven years after IFRS 16 became effective, most Gulf entities have a functioning lease register and a schedule that produces the right-of-use asset, the lease liability, depreciation and interest. The mechanics are settled. What continues to generate audit findings are two judgements that the mechanics depend on: the discount rate and the lease term.
The incremental borrowing rate
Where the rate implicit in the lease cannot be readily determined, which is almost always for property leases, the lessee uses its incremental borrowing rate: the rate it would pay to borrow, over a similar term and with similar security, the funds necessary to obtain an asset of similar value in a similar economic environment. Each element of that definition matters.
A defensible derivation starts from a reference rate in the currency of the lease at the lease commencement date. For riyal leases we use Saudi government sukuk yields or SAIBOR-based swap rates; for dinar leases, Bahraini government bonds. To that we add a credit spread that reflects the lessee's own borrowing cost, observable from its existing facilities or benchmarked from comparable borrowers. We then adjust for the term of the lease and for the fact that a lease is secured on the underlying asset, which typically reduces the spread relative to unsecured borrowing. The result is a rate specific to the entity, the currency, the date and the term.
The two errors we see most are a single group-wide rate applied to all leases regardless of currency, term or date, and the use of the group's overall weighted average cost of capital. Neither is an incremental borrowing rate. Both are challenged by auditors and both produce liabilities that can be materially wrong.
The lease term
The lease term is the non-cancellable period plus periods covered by an extension option the lessee is reasonably certain to exercise, and periods covered by a termination option the lessee is reasonably certain not to exercise. Commercial leases in the Gulf are often short, with one to three year terms and rolling renewals, and this makes the judgement more consequential rather than less: the difference between a two-year term and a ten-year term in a head office lease can be the largest single item on the balance sheet.
The assessment should consider the economics: the cost of relocating, the value of leasehold improvements and their remaining life, the importance of the location to the business, the relationship between contract rent and market rent, and the entity's own history of renewals. An entity that has renewed the same premises four times, invested in fit-out and has no relocation plan will find it hard to argue that renewal is not reasonably certain. The assessment is revisited when a significant event within the lessee's control occurs, such as a decision to invest in improvements or to relocate.
Modifications and remeasurements
Rent reductions, extensions and changes in scope are frequent, and each has its own accounting. A change in consideration for the same scope is a modification accounted for by remeasuring the liability with a revised discount rate. A reassessment of the lease term following a triggering event also remeasures with a revised rate. A change in an index-linked payment remeasures with the original rate. Getting the rate right in each case is a direct consequence of having documented the derivation in the first place.
A policy that lasts
We recommend a short lease accounting policy that sets out the discount rate methodology with a worked example, the lease term assessment criteria, the treatment of each type of modification and the review triggers. With that in place, new leases are accounted for consistently, auditors have a single document to test against, and the annual audit stops revisiting settled ground.