If you have worked with IFRS 16 for any length of time, you already know that the discount rate is one of the most important numbers in the entire lease calculation. Get it wrong, and your lease liability, right of use asset, interest expense, and depreciation will all be off. Yet many accountants still find the concept of the incremental borrowing rate confusing, especially when it is not clearly stated in the lease agreement.
Let’s walk through what the incremental borrowing rate actually is, when to use it, and how to determine it in a way that holds up under audit scrutiny.
Two Options for the Discount Rate
IFRS 16 gives you two possible options for discounting lease payments. The first is the interest rate implicit in the lease, which is the rate that makes the present value of lease payments and the unguaranteed residual value equal to the fair value of the asset plus any initial direct costs of the lessor.
The problem is that lessees rarely have access to the information needed to calculate this rate, since it depends on details the lessor holds, such as the residual value assumptions. That is why most businesses end up using the second option: the incremental borrowing rate.
What the Incremental Borrowing Rate Really Means
The incremental borrowing rate is defined as the rate 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 in a similar economic environment.
In simple terms, it is the interest rate your business would be charged if it borrowed money to buy the leased asset outright instead of leasing it. This rate reflects your company’s own credit standing, the length of the lease, and the currency and economic environment the lease operates in.
Why This Rate Cannot Just Be a Guess
Some businesses are tempted to apply a single standard rate across all their leases for simplicity. While this might seem easier, it does not reflect the actual requirements of IFRS 16 and can lead to inaccurate lease liabilities, especially when leases differ significantly in term or currency.
For example, a five year lease and a two year lease should not necessarily use the same discount rate, since the borrowing cost associated with longer terms often differs from shorter ones. Similarly, leases denominated in different currencies may carry different borrowing costs depending on local interest rate environments.
Factors That Influence the Rate
When determining an appropriate incremental borrowing rate, consider the following factors:
- The lease term, since rates typically vary by duration
- The currency in which lease payments are made
- The economic environment of the country or region where the lease is based
- Your company’s own credit risk, based on its borrowing history and financial position
- Whether the lease is secured or unsecured, since this affects the rate a lender would offer
Larger companies with strong credit ratings often have lower incremental borrowing rates than smaller businesses with limited borrowing history, which is why one size fits all approaches rarely work well.
Practical Approaches to Estimating the Rate
Many businesses start with their actual cost of borrowing, such as recent loan agreements or credit facilities, and adjust it based on the specific lease term and currency. Others work with external advisors or use published yield curves and credit spread data to build a more defensible rate.
Whatever approach you take, documentation matters. Auditors will want to see the reasoning behind your chosen rate, not just the final number. Keep records of the assumptions, data sources, and adjustments used to arrive at each rate.
Revisiting the Rate Over Time
The incremental borrowing rate is generally locked in at the commencement of the lease and does not need to be updated for the remainder of the lease term, unless there is a lease modification or reassessment event. However, it is worth reviewing your methodology periodically to ensure it still reflects current market conditions for new leases being signed.
FAQs
1. What is the difference between the interest rate implicit in the lease and the incremental borrowing rate?
The implicit rate is based on the lessor’s assumptions, such as residual asset value, and is often not available to the lessee. The incremental borrowing rate is based on what the lessee would pay to borrow funds for a similar asset, and is the rate most businesses use in practice.
2. Can a business use the same incremental borrowing rate for all its leases?
Generally, no. The rate should reflect factors like lease term, currency, and economic environment, so different leases may require different rates depending on these variables.
3. Does the incremental borrowing rate change after the lease begins?
Usually not. It is typically fixed at lease commencement, unless there is a lease modification or specific reassessment event that requires recalculation.
Final Thoughts
Choosing the right incremental borrowing rate is not just a technical box to check. It directly shapes how accurately your financial statements reflect your lease obligations. Taking the time to build a consistent, well documented approach to determining this rate will save you headaches during audits and give you more confidence in your reported numbers.
