What recent interest rate increases mean for discount rates used for lease accounting
As noted in our November 2022 Accounting Alert article, the measurement of many assets and liabilities involves the use of fair values or other techniques that include determining the present value of future cash flows. Recent increases in interest rates in New Zealand are likely to have a direct impact on the measurement of many of these items because when interest rates increase, so do the discount rates used in present value calculations.
This also applies to lease accounting.
On 22 February 2023, the Reserve Bank of New Zealand increased the Official Cash Rate (OCR) for the tenth time to 4.75%, the highest level since December 2008. The yields on New Zealand Government bonds have also increased accordingly, which is applying upward pressure on incremental borrowing rates (IBRs).
Assuming the same IBRs as in the past may not be appropriate for new leases, lease modifications and option reassessments going forward and will likely catch your auditor’s attention.
How is the IBR determined?
The IBR is the rate of interest that a 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 to the right-of-use asset in a similar economic environment.
The IBR is made up of three components:
As yields on government bonds have increased as the OCR has increased, so the risk-free rate, or base rate must increase. In addition, due to current economic conditions, many entities may find that their credit spread has also increased. Both these factors will affect the IBR used for new leases, or where there has been a modification to an existing lease, or a reassessment of the lease term on an existing lease.
Please refer to our May 2020 Accounting Alert article or our IFRS in Practice for more guidance on determining IBRs.
Please contact our IFRS Advisory team if you require assistance with any financial reporting matters during 2023.
For more on the above, please contact your local BDO representative.
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