Introduction
The incremental borrowing rate is the rate 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.
It is the fallback discount rate under IFRS 16, used where the interest rate implicit in the lease cannot be readily determined — and in practice the rate most lessees apply, since the implicit rate is computed from the lessor's position. It sets the lease liability, and through it the right-of-use asset, and it fixes how much of the total charge lands in finance cost rather than depreciation in each period.
When the Incremental Borrowing Rate Applies
IFRS 16.26 sets a hierarchy. Lease payments are discounted using the interest rate implicit in the lease if that rate can be readily determined; if it cannot, the lessee uses its incremental borrowing rate.
The implicit rate depends on lessor inputs — the fair value of the underlying asset, its initial direct costs and the unguaranteed residual value — and one unavailable input is enough, because the rate solves for all of them at once. The incremental borrowing rate is then determined at the commencement date, on the market conditions at that date: not at the reporting date, and not revisited each period.
What the Definition Requires
The definition is doing more work than it appears to. Each phrase in it is a condition the rate must satisfy, and each one is a place where a plausible-looking rate goes wrong.
| The definition says | What that requires |
|---|---|
| over a similar term | Match the tenor to the lease term, including option periods that are reasonably certain to be exercised — not the asset's useful life. A lease amortises, so the profile is an instalment facility rather than a bullet loan repaid in full at maturity. |
| with a similar security | A secured rate. The lessor retains recourse to the underlying asset, so the comparable borrowing is collateralised, not the entity's unsecured cost of debt. |
| an asset of a similar value to the right-of-use asset | Price a borrowing of the value of the right of use, not the fair value of the underlying asset. The two diverge sharply on short leases of long-lived assets. |
| in a similar economic environment | Match the currency of the lease payments and the jurisdiction of the entity that is the lessee, not those of the group's funding centre. |
The reference to the right-of-use asset rather than the underlying asset is the one most often missed. A five-year lease of a building worth 30,000,000 with a forty-year remaining life does not call for the rate on a 30,000,000 property loan, but for the rate on a borrowing of roughly the present value of five years of rentals, secured on a right that expires with the lease.
Building the Rate
Few entities can observe a borrowing that matches a lease on all four conditions, so the rate is normally constructed. It is a borrowing rate throughout — the weighted average cost of capital does not serve, because it blends in a return on equity.
- Reference rate. A currency-matched, term-matched observable rate — typically a government bond yield or a swap rate at the tenor of the lease.
- Credit spread. The spread applicable to the entity that is the lessee, based on its own rating or on a rating estimated from its financial profile. Where the obligation is guaranteed by a parent, the spread reflects the terms on which the lessee could actually borrow with that guarantee in place.
- Security and asset adjustment. A downward adjustment for the collateral the arrangement provides. Its size depends on how readily the asset can be recovered and resold: property supports a larger reduction than specialised plant with a thin second-hand market.
Where a lessee holds many similar leases, IFRS 16.B1 allows one rate across a portfolio of leases with similar characteristics — grouped on currency, term, asset class and credit standing — provided the effect is not expected to differ materially from rating each lease individually.
Worked Example
A retailer leases a store for five years from 1 January 2026, with payments of 500,000 annually in arrears. The property is worth 30,000,000 and has a remaining useful life of forty years. The retailer cannot obtain the landlord's residual value assumption, so the implicit rate is not readily determinable.
| Component | Rate | Basis |
|---|---|---|
| Five-year government bond yield | 9.00% | Same currency as the lease payments, tenor matched to the lease term |
| Credit spread | +2.50% | Spread for the lessee entity's estimated credit rating at commencement |
| Security adjustment | -0.75% | Recourse to the leased premises on default |
| Incremental borrowing rate | 10.75% |
The amount priced is the borrowing needed to obtain the right of use, around 1,900,000, not the 30,000,000 property. Discounting five payments of 500,000 at 10.75% gives an annuity factor of 3.719258 and a lease liability of 1,859,629.
What the Rate Actually Moves
Holding the same lease and varying only the rate:
| Discount rate | Lease liability | Year 1 finance cost | Year 1 depreciation | Year 1 total expense |
|---|---|---|---|---|
| 8.50% | 1,970,321 | 167,477 | 394,064 | 561,541 |
| 10.75% | 1,859,629 | 199,910 | 371,926 | 571,836 |
| 13.00% | 1,758,616 | 228,620 | 351,723 | 580,343 |
A 4.5 percentage point range moves the liability by 211,705, close to 11% of its value, and moves reported debt and gearing with it. What it does not move is the total: over the five years the charge to profit or loss is 2,500,000 at every rate, because depreciation totals the cost of the right-of-use asset and finance cost totals the difference between that cost and the payments. A higher rate simply front-loads the expense. The rate is a question of measurement and timing, not of what the lease ultimately costs.
When the Rate Must Be Revised
The commencement rate is replaced only on specified events, and IFRS 16 is deliberate about which ones.
| Event | Discount rate |
|---|---|
| Change in the lease term | Revised rate |
| Change in the assessment of a purchase option | Revised rate |
| Change in payments arising from a floating interest rate | Revised rate, reflecting the change in the interest rate |
| Modification not accounted for as a separate lease | Revised rate at the effective date of the modification |
| Change in amounts expected to be payable under a residual value guarantee | Original rate |
| Change in payments linked to an index or rate, other than a floating interest rate | Original rate |
The logic is consistent: where the shape of the borrowing changes — its term, or whether it ends in a purchase — the pricing is redetermined; where only the amount of a payment changes within the existing term, the original pricing stands. A revised rate is a fresh incremental borrowing rate for the remaining term, on conditions at that date.
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Conclusion
The incremental borrowing rate is an estimate, but a structured one. Matching the currency, the term, the security and the value of the right of use narrows the range of defensible answers considerably, and a rate built from an observable reference rate, a credit spread and a security adjustment leaves an audit trail that a single quoted rate never does — on the number that sets the liability, the right-of-use asset and the profile of the expense for the whole of the lease term.
For clarification, guidance, or feedback on our article, please reach out to us at insight@leash.co.za.