Ask any auditor which IFRS 16 input they challenge most and the answer is almost always the same: the discount rate. The lease payments come from a contract. The lease term comes from a documented judgement about options. But the discount rate, for most companies, is an estimate built from scratch, and it moves the lease liability on every lease you have.
This guide explains what the incremental borrowing rate (IBR) is, why most lessees have to use it, and a practical build-up method you can apply and defend. It ends with a sensitivity table showing how much a two-point change in the rate moves the balance sheet.
Quick answer: Under IFRS 16, the incremental borrowing rate is the rate a lessee would have to pay to borrow, over a similar term and with similar security, the funds needed to obtain an asset of similar value to the right-of-use asset, in a similar economic environment (IFRS 16, Appendix A). It is used whenever the interest rate implicit in the lease cannot be readily determined.
Implicit rate or incremental borrowing rate?
IFRS 16 paragraph 26 sets a clear order. First, use the interest rate implicit in the lease: the rate that makes the present value of the lease payments plus the unguaranteed residual value equal to the asset’s fair value plus the lessor’s initial direct costs. Only if that rate cannot be readily determined do you use your incremental borrowing rate.
In practice, the implicit rate is rarely available to a lessee. You would need to know the asset’s fair value, what the lessor expects it to be worth at the end of the lease, and what the lessor spent arranging the deal. A vehicle or equipment lease with a stated finance rate may give you an implicit rate. A property lease almost never does, because nobody can reliably estimate a building’s residual value from the lessor’s point of view. So for most leases, and nearly all property leases, the IBR is the rate you will use.
The four tests inside the definition
The definition is short, but every word matters. Your rate should reflect all four of these:
| Element | What it means in practice |
|---|---|
| Similar term | A 10-year lease needs a 10-year borrowing rate, not your 12-month overdraft rate. Many preparers use the lease’s weighted average life (when, on average, the payments fall) rather than its full term, because a lease is repaid gradually like an amortising loan. |
| Similar security | A lender holding the leased asset as collateral would charge less than an unsecured lender. Property is good security; specialised equipment is weaker. |
| Similar value | The amount borrowed is the value of the right-of-use asset, not the value of the whole building. Small amounts can attract higher rates. |
| Similar economic environment | The rate must be in the lease’s currency and reflect the country and the entity that signs the lease. A US-dollar lease signed by a subsidiary in an emerging market is not priced at the parent’s rate in New York. |
A practical build-up method
The IBR is a hypothetical rate: you are estimating what a lender would charge, not quoting a loan you actually took. The approach most companies and audit firms accept is a build-up in three layers.
Layer 1: Reference rate
Start with a rate that has no credit risk, in the lease currency, for a term that matches the lease. Common choices are government bond yields or interest rate swap rates of the matching maturity. For a five-year US-dollar lease, that is roughly the five-year US Treasury yield or the five-year SOFR swap rate. For a lease in another currency, use that currency’s government curve.
Layer 2: Credit spread for the lessee
Add the extra interest a lender would demand for lending to your entity. Good evidence includes, in rough order of strength:
- The spread on your own recent borrowings of a similar term.
- Indicative quotes from your bankers for a loan like the one in the definition.
- Yields on your listed bonds, if you have any.
- Spreads for companies with a similar credit rating or similar financial ratios.
A subsidiary should start from its own credit standing. A parent guarantee can lower it, but only if the guarantee exists or would realistically be given.
Layer 3: Lease-specific adjustments
Then adjust for the features of this particular lease:
- Security: deduct a margin where the leased asset would be good collateral.
- Term and payment profile: adjust if your evidence is for a different maturity.
- Country risk: add a premium where the lessee operates in a riskier environment than your reference rate reflects, for example a dollar lease in an emerging market.
Worked example of the build-up
A mid-sized company signs a five-year US-dollar property lease. The figures below are illustrative only; use current market data and your own evidence.
| Component | Evidence used | Rate |
|---|---|---|
| Reference rate | Five-year government bond yield in the lease currency | 4.00% |
| Add: credit spread | Spread on the company’s three-year bank loan, adjusted to a five-year term | 3.50% |
| Less: security adjustment | Lender would hold the property lease as collateral | (0.75%) |
| Incremental borrowing rate | 6.75% |
Every line has a source and a reason. That is what an auditor wants to see. The exact number is less important than being able to show how you reached it.
How much does the rate matter? A sensitivity test
Take a lease of US$12,000 a year for five years, paid in arrears, and calculate the liability at three rates. Then repeat it for a longer lease: US$60,000 a year for ten years.
| Discount rate | 5-year lease liability | Change vs 10% | 10-year lease liability | Change vs 10% |
|---|---|---|---|---|
| 8% | 47,912.52 | +5.3% | 402,604.88 | +9.2% |
| 10% | 45,489.44 | — | 368,674.03 | — |
| 12% | 43,257.31 | −4.9% | 339,013.38 | −8.0% |
Three lessons come out of this table:
- A lower rate gives a higher liability. Choosing an optimistic (low) borrowing rate inflates both the lease liability and the right-of-use asset.
- Longer leases are far more sensitive. A two-point change moves the five-year lease by about 5% but the ten-year lease by 8 to 9%. For long property leases, the rate deserves the most work.
- The rate changes the timing, not the total. Over the life of a lease, depreciation plus interest always equals the payments (plus initial direct costs). A higher rate means less depreciation and more interest; a lower rate means the opposite. What changes is the balance sheet and how the cost is spread across years, which in turn affects gearing, EBITDA and loan covenants.
You can run this test on your own lease in seconds: enter it in the IFRS 16 Lease Calculator, then change only the discount rate and compare the results.
Using one rate for many leases
You do not need a separate study for every photocopier. IFRS 16 allows a portfolio approach where applying it would not differ materially from treating each lease separately. Most companies build a small grid of rates, for example by currency and by term band (up to 3 years, 3 to 7 years, over 7 years), with a separate adjustment for property versus vehicles and equipment. Each new lease picks up the rate from the grid at its commencement date.
Refresh the grid regularly. Interest rates move, and a rate set two years ago is not evidence for a lease starting today.
When the discount rate changes
The rate is fixed at the commencement date and is not updated just because market rates move. You determine a revised discount rate only when you remeasure the liability for certain events, including:
- A change in the lease term (for example, you now expect to use an extension option).
- A change in your assessment of a purchase option.
- A lease modification that is not accounted for as a separate lease.
When payments change because of a CPI or other index adjustment, you remeasure using the original rate, unless the change comes from floating interest rates.
What to document for your auditor
- The reason the implicit rate could not be readily determined.
- The reference rate used, its source, date and maturity.
- The evidence for your credit spread (loan agreements, bank quotes or peer data).
- Each adjustment for security, term, currency and country, and why.
- The rate grid, the date it was approved, and how each lease was mapped to it.
- A sensitivity showing the effect of a reasonable change in the rate.
How US GAAP differs
ASC 842 also uses the implicit rate if readily determinable, otherwise the incremental borrowing rate, which US GAAP defines on a collateralised basis. Entities that are not public business entities may instead elect to use a risk-free rate, by class of underlying asset. A risk-free rate is lower, so it produces a higher lease liability. IFRS 16 has no risk-free option.
Test your rate before you book it
The free IFRS 16 Lease Calculator lets you record whether you used the implicit rate or your incremental borrowing rate, then shows the liability, right-of-use asset and first-year charge. The professional report adds a sensitivity to the discount rate and lease term, ready to file with your working papers.
Applying one rate grid across many leases? Load them into the IFRS 16 Lease Portfolio. New to the calculation itself? Start with How to Calculate a Lease Liability Under IFRS 16.
Frequently asked questions
What is the incremental borrowing rate under IFRS 16?
It is the rate of interest a lessee would have to pay to borrow, over a similar term and with similar security, the funds needed to obtain an asset of similar value to the right-of-use asset in a similar economic environment.
Can I use my overdraft or current bank loan rate as the IBR?
Only as a starting point. An overdraft is short-term and usually unsecured, so it rarely matches the term and security of a lease. Adjust it for the lease term, the security the asset would provide, and the lease currency.
Should a subsidiary use the parent company’s borrowing rate?
Not automatically. The rate should reflect the entity that signs the lease and its economic environment. A parent’s rate may be relevant if the parent would guarantee the borrowing or the subsidiary is funded centrally, but the evidence should support that.
Do I update the discount rate when interest rates change?
No. The rate is set at commencement. A revised rate is only used when the liability is remeasured for specific events, such as a change in lease term, a purchase option reassessment or a lease modification.
Does a higher discount rate reduce the total lease expense?
No. A higher rate gives a lower liability and asset, so depreciation falls and interest rises. Over the life of the lease, the total charge to profit or loss is the same.
This article explains the general requirements of IFRS 16 for lessees. The rates in the examples are illustrative, not market data, and the article is not accounting or financial advice for any specific lease. For help setting a discount rate policy, talk to our team.