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Lease classification

The standard does not dictate the nature of the assets collateralizing the borrowing. We believe any
form of collateral can be used to determine the incremental borrowing rate as long as the lessee has
the right to pledge the collateral. For example, assume an entity enters into a lease of a building. We do
not believe the lessee may use the building as collateral when determining the incremental borrowing
rate because the lessee does not own the building and therefore does not have the right to pledge the
building. However, the lessee could use its leasehold interest in the building if a lender would accept
that as collateral and it would be enough to fully secure the borrowing. Alternatively, the lessee could
use other assets unrelated to the leased asset if the lessee has the right to pledge the asset as collateral.
An observable interest rate for an existing secured line of credit could also be an acceptable
incremental borrowing rate.

Regardless of the nature of the collateral, a lessee must assume its borrowing (i.e., the lease payments)
is fully collateralized. However, a lessee may not assume its borrowing is over collateralized. For
example, if a lessee enters into a lease of an asset that requires total lease payments of $1,000,000
throughout the term of the lease, and the lessee owns other assets valued at $5,000,000 that it may
pledge as collateral, the lessee may not consider assets valued in excess of $1,000,000 when
determining the incremental borrowing rate.

The incremental borrowing rate is based on a borrowing with a term that is similar to the term of the
associated lease. However, when a lease includes renewal, termination, or purchase options, it is not
clear whether options that are not determined to be reasonably certain of exercise (i.e., options not
included in the lease term at the lease commencement date) should be considered.

We believe a lessee may make an accounting policy election to either include or exclude options that
are not reasonably certain of exercise when determining the term of the borrowing. While the lease
term determined at lease commencement (i.e., exclusive of any options not reasonably certain of
exercise) is an acceptable term to consider when determining the incremental borrowing rate, we
believe the existence of options to renew or terminate a borrowing arrangement would affect the rate a
lender would charge irrespective of whether or not the options are reasonably certain of exercise.
Accordingly, we believe the consideration of all options in an arrangement, whether reasonably certain
of exercise or not, is appropriate when determining the incremental borrowing rate and consistent
with the definition and principal of the rate.

Question 3-16

Is a lessee limited by a loan-to-value ratio when determining the incremental borrowing rate?

PwC response
No. The loan-to-value ratio would be relevant if the collateral was limited to the right-of-use asset.
However, since we believe the standard permits the use of any collateral for determining the
incremental borrowing rate and the lessee must assume its borrowing is 100% collateralized (and only
100% collateralized), the loan-to-value ratio is irrelevant.

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