Key Takeaways
- Use the rate implicit in the lease if readily determinable; otherwise use the incremental borrowing rate (IBR)
- The IBR is the rate a lessee would pay to borrow funds for a similar asset, term, and security
- IBR should reflect the lessee's credit risk, lease term, currency, and the nature of the underlying asset
- The discount rate is locked at commencement and only changes for specific remeasurement events
- A portfolio approach can simplify rate determination for entities with many leases
Why the Discount Rate Matters
The discount rate is fundamental to IFRS 16 lease accounting. It directly affects both the lease liability and right-of-use asset recognised on the balance sheet, as well as the interest expense and depreciation charges in the income statement.
A higher discount rate results in a lower lease liability (and vice versa), which is why the standard provides clear guidance on rate determination and limits when rates can be changed.
IFRS 16 Requirement
"The lease payments shall be discounted using the interest rate implicit in the lease, if that rate can be readily determined. If that rate cannot be readily determined, the lessee shall use the lessee's incremental borrowing rate."
- IFRS 16.26
The Discount Rate Hierarchy
IFRS 16 establishes a clear hierarchy for determining the discount rate:
Interest Rate Implicit in the Lease
This is the preferred rate if it can be "readily determined." It's the rate that causes the present value of lease payments plus the unguaranteed residual value to equal the fair value of the underlying asset plus the lessor's initial direct costs.
Incremental Borrowing Rate (IBR)
If the implicit rate cannot be readily determined (which is usually the case), use the lessee's incremental borrowing rate - the rate the lessee would pay to borrow funds necessary to obtain an asset of similar value in a similar economic environment over a similar term with similar security.
Interest Rate Implicit in the Lease
The rate implicit in the lease is the internal rate of return for the lessor. It can be calculated if you know:
- Fair value of the underlying asset
- Lessor's initial direct costs
- Expected residual value (guaranteed and unguaranteed)
- All lease payments to be made by the lessee
When is the Implicit Rate Available?
The implicit rate is typically only readily determinable when:
- The lessor discloses it (common in motor vehicle finance leases)
- The lease is structured as a finance lease with purchase option at a nominal price
- The lessee can reliably estimate the asset's fair value and the lessor's costs
In practice, most operating-style leases require the IBR because lessees don't have access to the information needed to calculate the implicit rate.
Incremental Borrowing Rate (IBR)
The IBR is the rate most lessees use. It must be determined entity by entity and should reflect specific characteristics of the lease.
Components of the IBR
The IBR is typically built up from several components:
| Component | Description | Typical Source |
|---|---|---|
| Risk-free rate | The base rate for the relevant currency and term | Government bond yields, swap rates |
| Credit spread | Adjustment for the lessee's creditworthiness | Corporate bond spreads, bank loan margins |
| Lease-specific adjustments | Adjustments for the nature of security and asset type | Secured vs unsecured differentials |
Factors Affecting the IBR
The standard requires the IBR to reflect borrowing with:
Methods for Determining the IBR
There are several approaches to determining the IBR, depending on the entity's circumstances:
1. Use Existing Borrowing Rates
If the entity has existing secured debt with a similar term, this provides a starting point. Adjustments may be needed for differences in:
- Loan term vs lease term
- Type of security (real property vs equipment)
- Date of the borrowing vs lease commencement
2. Build-Up Approach
Construct the rate from components:
3. Third-Party Quotes
Obtain indicative quotes from banks for secured borrowing of the relevant amount, term, and currency. This is often the most practical approach for entities without existing debt:
- Ask your bank for an indicative rate on a secured term loan matching the lease term and approximate value
- Use the quoted rate directly as the IBR, or decompose it into a base rate and credit spread for use across different lease terms
- A single bank quote can anchor your entire rate methodology. Apply the implied credit spread to the relevant risk-free rate curve for different maturities
4. Yield Curve Analysis
Use publicly available yield curves for corporate debt of similar credit quality and interpolate for the specific lease term.
5. Financial Ratio Benchmarks
For entities without a credit rating, existing debt, or bank relationship, financial ratios can be mapped to an implied credit rating to estimate the credit spread. Key ratios include interest coverage, debt-to-equity, and EBITDA margin. This approach requires more judgement but provides a reasonable starting point when other methods aren't available.
Documentation is Critical
Whatever method is used, the approach and inputs should be documented. Auditors will challenge IBR determinations, so maintaining clear records of the methodology, data sources, and any judgements applied is essential.
Portfolio Approach
IFRS 16 permits applying a single discount rate to a portfolio of leases with similar characteristics, provided it wouldn't result in a materially different outcome from applying rates individually.
When to Use Portfolio Rates
This practical expedient is particularly useful for:
- Large fleets of similar vehicles
- Multiple equipment leases with similar terms
- Property leases with similar remaining terms in the same jurisdiction
Defining Portfolio Characteristics
Portfolios should be defined based on characteristics that affect the discount rate:
| Characteristic | Rationale |
|---|---|
| Asset class | Different asset types may have different security values |
| Lease term bands | Term structure affects the risk-free rate component |
| Currency | Different currencies have different interest rate environments |
| Geography | Economic environment and country risk may differ |
| Entity | Different group entities may have different credit profiles |
Worked Example: IBR Determination
Scenario
A UK-based company with a BBB credit rating enters into a 5-year property lease. The company needs to determine its IBR at the lease commencement date of 1 January 2025.
Build-Up Calculation
| Component | Rate | Source |
|---|---|---|
| 5-year UK gilt rate (risk-free) | 4.00% | Bank of England data |
| BBB corporate credit spread | 1.50% | Market data for 5-year BBB bonds |
| Secured borrowing adjustment | (0.50%) | Estimate based on secured vs unsecured differential |
| Incremental Borrowing Rate | 5.00% |
Validation
The company validates this rate against:
- Its existing bank facility margin (SONIA + 1.75% = approximately 6.5% unsecured)
- Indicative quote from bank for 5-year secured property loan (4.8%)
- Rates used by similar companies disclosed in financial statements
The 5.00% IBR is considered reasonable given these reference points.
When to Update the Discount Rate
The discount rate is generally locked at commencement. However, it must be revised in certain circumstances:
| Event | Revised Rate Required? |
|---|---|
| Change in lease term assessment (option exercise) | Yes - revised rate at remeasurement date |
| Change in purchase option assessment | Yes - revised rate at remeasurement date |
| Lease modification (not a separate lease) | Yes - revised rate at modification date |
| Change in index-linked payments | No - use original rate |
| Change in residual value guarantee amounts | No - use original rate |
| Floating interest rate lease (variable not linked to index) | Yes - revised rate when payments change |
For detailed guidance on remeasurements, see our Remeasurement guide.
Common Challenges
Entities Without External Debt
Private companies or subsidiaries without their own borrowing facilities may struggle to determine an IBR. Options include:
- Using parent company rates with adjustments for different credit profiles
- Obtaining indicative bank quotes (see Method 3 above)
- Using financial ratio benchmarks to estimate an implied credit rating (see Method 5 above)
- Using industry benchmarks from peer company disclosures
For a detailed walkthrough of these approaches with worked examples and benchmark tables, see our FRS 102 discount rates guide. The methodology applies equally to IFRS 16 entities.
Long-Term Leases
For very long leases (e.g., 20+ years), market data for equivalent borrowing terms may be limited. Extrapolation from available yield curve data may be necessary.
Foreign Currency Leases
For leases denominated in foreign currencies, the IBR should be determined in that currency, reflecting local interest rate environments.
For detailed guidance, see our Foreign Currency Leases guide.
Applying the Discount Rate
Once determined, the discount rate is used to calculate the present value of lease payments. There are several methods, all following the same discounting principle:
| Method | Excel Formula | Best For |
|---|---|---|
| PV | =PV(rate, nper, pmt) |
Simple leases with equal payments |
| NPV | =NPV(rate, values) |
Varying payments at regular intervals |
| XNPV | =XNPV(rate, values, dates) |
Any payment structure (most accurate) |
The XNPV method provides the most accurate calculation as it accounts for the exact timing of each payment, including months with different days and leap years.
For detailed calculation guidance, see our Lease Liability guide.
This article is provided for general informational purposes only and does not constitute accounting, legal or professional advice.