Demystifying the IFRS 16 Discount Rate

If you’ve spent sleepless nights wrestling with discount rates under IFRS 16, you’re not alone. I’ve seen countless finance teams stare at spreadsheets, wondering: “Are we doing this right?” The good news? You’re asking the right questions. The challenging news? There’s no one-size-fits-all answer.

Let me walk you through this together, the way I wish someone had explained it to me.

Why Does the Discount Rate Matter So Much?

Think of the discount rate as the financial heartbeat of your lease accounting. It transforms future lease payments into today’s values, directly impacting your balance sheet, your ratios, and ultimately, how stakeholders view your company’s financial health.

A difference of just a few percentage points can significantly affect the amounts recognized in your financial statements. For companies with substantial lease portfolios, we’re not talking about minor adjustments—we’re talking about material differences that audit committees and external auditors will scrutinize carefully.

The Two Discount Rates: Understanding Your Options

IFRS 16 offers you a hierarchy for determining the discount rate, and it’s important to understand both options:

Option 1: The Interest Rate Implicit in the Lease

The interest rate implicit in the lease is defined as the rate of interest that causes the present value of the lease payments and the unguaranteed residual value to equal the sum of the fair value of the underlying asset and any initial direct costs of the lessor.

Here’s the catch: this rate reflects the lessor’s economics—their costs, their profit margins, their view of the asset’s residual value. As a lessee, you typically won’t have access to this information unless your lessor is unusually transparent.

Real-world example: Imagine you’re leasing office equipment worth $100,000. To calculate the implicit rate, you’d need to know:

• The lessor’s purchase price (maybe they got a volume discount you don’t know about)
• Their initial costs to set up the lease
• What they expect the equipment to be worth in 5 years
• Their desired profit margin

See the problem? Most lessors guard this information closely. This is why, in practice, most lessees end up using the second option.

What does “readily determinable” really mean?

Here’s a critical point that trips up many finance teams: if you need to hire valuation experts or include significant estimates and assumptions to determine the implicit rate, it’s not “readily determinable.” The threshold is high—if determining the rate requires substantial work, complex modeling, or expert judgment, you should be using your IBR instead.

Some companies spend thousands on consultants to calculate an implicit rate, only to have auditors challenge whether it was truly “readily” determinable. Save yourself the headache: unless the information is straightforward and accessible, move to your incremental borrowing rate.

Additional logical check

One more red flag: if your calculation of the implicit rate produces a negative number or a rate that doesn’t make economic sense—this tells you the implicit rate isn’t appropriate. When the math doesn’t make sense, default to your IBR.

Option 2: Your Incremental Borrowing Rate (IBR) – The Practical Reality

The incremental borrowing rate is defined as the rate of interest that a lessee would have to pay to borrow over a similar term, and with a similar security, the funds necessary to obtain an asset of a similar value to the right-of-use asset in a similar economic environment.

Let me break this down into plain language: If you couldn’t lease this asset and had to borrow money to buy it instead, what interest rate would your bank charge you?

Determining Your Incremental Borrowing Rate: The Five Key Factors

The incremental borrowing rate reflects the credit risk of the lessee, the term of the lease, the nature and quality of the security, the amount borrowed, and the economic environment in which the transaction occurs.

Let’s explore each factor with practical insights:

1. Your Credit Standing

Your company’s creditworthiness is fundamental. For leases entered into by different entities within a group, their incremental credit spreads will need to be factored in. A subsidiary with a weaker balance sheet should use a higher rate than the parent company, even if they’re leasing similar assets.

Practical tip: Don’t assume all your leases can use the same credit spread. If you’re a multinational with operations in various countries, your Brazilian subsidiary likely faces different borrowing costs than your German entity.

2. The Lease Term

A 3-year lease for office space should use a different rate than a 20-year lease for a warehouse. Longer terms typically mean higher rates due to increased uncertainty.

3. The Nature and Quality of Security

It’s important to note that the lessee needs to determine the incremental borrowing rate for the right-of-use asset, not the underlying physical asset. This is subtle but crucial.

Example: Let’s say you’re leasing a building. If you were buying it, you might finance 80% through a secured mortgage and 20% through unsecured borrowing at a higher rate. The lessee should use the rate at which it would finance 100% of the cost of the right-of-use asset, calculated as (80% × secured borrowing rate) + (20% × unsecured borrowing rate). This is your blended rate.

4. The Amount

Larger borrowings often come with better rates due to economies of scale. A $10 million financing might command a better rate than a $100,000 one.

5. The Economic Environment

Consider the currency, country, and timing. Leasing equipment in euros in Germany carries different interest rate implications than leasing in Turkish lira in Istanbul.

Two Approaches to Calculating Your IBR

There are two possible approaches emerging: a top-down approach, which starts with an entity-specific rate like existing bank borrowing, and a bottom-up approach, which starts with a risk-free rate.

The Top-Down Approach (Most Common)

Start with observable rates your company actually pays:

1. Take your existing loan rate (say, 5% on your recent term loan)
2. Adjust for differences in term (add or subtract for longer/shorter leases)
3. Adjust for collateral differences (the loan might have better security)
4. Adjust for currency and country if needed

Example: Your company has a 5-year term loan at 4.5%. You’re accounting for a 3-year equipment lease in the same currency. Your 3-year borrowing rate would likely be slightly lower, perhaps 4.2%, because shorter-term debt typically commands lower rates.

The Bottom-Up Approach

1. Start with a risk-free rate (government bond yield for the lease term)
2. Add your credit spread (based on your credit rating)
3. Add adjustments for the specific lease characteristics

This approach works well for companies with limited debt or those operating in multiple jurisdictions.

Common Pitfalls to Avoid

Don’t Use Your WACC

Using your Weighted Average Cost of Capital will usually be inappropriate as WACC takes into account both debt and equity financing and is not specific to the underlying lease. WACC includes equity costs—leases are debt-like obligations. These are fundamentally different. I’ve seen this mistake more times than I can count.

Don’t Use the Same Rate for Everything

The incremental borrowing rate is not only specific to the lessee but also for the underlying asset, and that’s the reason why you cannot use the same incremental borrowing rate for all of your leases.

Real scenario: A manufacturing company I worked with initially used a single 5% rate for all leases. Their auditors pushed back. The company’s 15-year property leases deserved a different rate than their 3-year IT equipment leases. They ended up segmenting their portfolio into rate bands: 3.8% for short-term equipment, 4.5% for medium-term vehicles, and 5.5% for long-term property.

Don’t Confuse Lessee and Lessor Rates

I once reviewed a client’s calculation where they computed an internal rate of return from their lease payments and called it the “implicit rate.” Auditors were right to refuse the internal rate of return of the lease as the interest rate implicit in the lease, because it was the rate of the lessee, not the lessor. The implicit rate must reflect the lessor’s economics, not yours.

Practical Expedients: Your Secret Weapons

IFRS 16 offers helpful shortcuts:

Portfolio Approach: As a practical expedient, an entity may apply lease accounting to a portfolio of leases with similar characteristics if the effects are reasonably expected to not differ materially from applying the standard to individual leases.

What does this mean for you? You can group similar leases and apply the same discount rate to the entire group. For example:

• All 3-5 year office equipment leases: 4.2%
• All 5-10 year vehicle leases in: 4.8%
• All 10-20 year property leases: 5.5%

This saves enormous amounts of time without sacrificing accuracy.

A Step-by-Step Approach for Your Organization

Here’s how I recommend you tackle this:

Step 1: Inventory Your Leases and group them by:

• Asset type (property, vehicles, equipment, IT)
• Geographic location
• Lease term ranges
• Currency

Step 2: Engage Your Treasury Team They’re your best friends in this process. They understand your borrowing rates, credit spreads, and can access market data.

Step 3: Establish Your Rate Curves Standing data used to calculate IBRs will need to be updated at least annually and in the event of a significant change to company or subsidiary creditworthiness, including a change to credit rating.

Build a framework you can update regularly. Consider:

• Short-term (1-3 years): X%
• Medium-term (3-7 years): Y%
• Long-term (7+ years): Z%

Step 4: Document Your Methodology Your auditors will thank you. Create a clear policy document that explains:

• Your approach (top-down or bottom-up)
• How you determined each rate component
• Why you grouped certain leases together
• How often you’ll update rates

Step 5: Implement and Monitor IFRS 16 states that lease liabilities shall be recalculated if there is a change in an index or rate used to calculate lease payments, and if the recalculation arises because floating interest rates have changed, the lessee should use a revised discount rate based on the new interest rates.

Set calendar reminders to review rates when:

• New leases are signed
• Interest rates change significantly
• Your credit rating changes
• You enter new markets

Transition Considerations

If you’re still transitioning to IFRS 16 or measuring new leases, remember: For entities choosing the modified retrospective approach, lessees are required to determine the lease liability and right-of-use asset using the incremental borrowing rate at the date of initial application.

This means you use the rate as of your transition date for all existing leases, not the rate when each lease originally commenced. This significantly simplifies the exercise.

The Bottom Line

Determining the discount rate under IFRS 16 requires judgment, but it doesn’t have to be overwhelming. Start with what you know—your actual borrowing rates—and adjust methodically for each lease’s specific characteristics.

Remember: perfection isn’t the goal. Reasonable, defensible, well-documented judgment is.

Your auditors aren’t expecting you to pinpoint the rate to multiple decimal places. They’re looking for a logical approach that reflects your company’s economic reality. Build your methodology, document it clearly, and update it regularly.

And here’s my final piece of advice: involve your auditors early. A quick conversation before you finalize your approach can save you weeks of rework later.

You’ve got this. The discount rate may be complex, but with the right framework, it becomes just another element of your lease accounting process.

To check your discounting calculation, download our free template – IFRS 16 Discounting Calculation Example.

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What challenges have you faced in determining discount rates? Feel free to share your experiences—we’re all learning together in this post-IFRS 16 world.

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