The discount rate determines how large a lease liability appears on the balance sheet. Move it by two percentage points on a ten-year lease and the reported liability shifts materially — with no change whatsoever to the underlying contract. This is why auditors spend disproportionate time on a number that looks like a footnote.
The Rate Hierarchy
Ind AS 116 requires lease payments to be discounted using:
- The interest rate implicit in the lease, if that rate can be readily determined
- The lessee’s incremental borrowing rate, otherwise
The hierarchy is not a free choice. If the implicit rate is readily determinable, it must be used.
Why the Implicit Rate Is Rarely Used
The interest rate implicit in the lease is 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.
To compute it a lessee would need to know:
- The fair value of the underlying asset
- The lessor’s estimate of the residual value at the end of the lease
- The lessor’s initial direct costs
Lessors do not typically share the second and third. So for most property and equipment leases the implicit rate is not readily determinable, and the lessee falls to the incremental borrowing rate.
What the Incremental Borrowing Rate Is
The incremental borrowing rate (IBR) is the rate of interest 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 to the right-of-use asset in a similar economic environment.
Each of those four qualifiers does work:
| Qualifier | Implication |
|---|---|
| Similar term | A 10-year lease uses a 10-year rate, not the entity’s short-term working capital rate |
| Similar security | The borrowing is notionally secured on a similar asset, which usually lowers the rate |
| Similar value | Rate reflects borrowing the ROU asset’s value, not the entity’s total debt |
| Similar economic environment | A lease in a different country uses that country’s rate environment |
How the IBR Is Built Up
A common approach constructs the rate in layers:
| Component | Source |
|---|---|
| Risk-free rate for the lease term | Government security yield of matching tenor |
| + Credit spread | Entity’s own credit standing, from actual borrowings or a rating-based spread |
| − Security adjustment | Reflects collateralisation by the underlying asset |
| ± Country and currency adjustment | Where the lease is in another jurisdiction or currency |
| = Incremental borrowing rate |
Where an entity has recently borrowed on comparable terms, that observed rate is strong evidence and usually the starting point.
Common Errors
- Using one rate for all leases. A single group-wide rate ignores the term-matching requirement. A two-year lease and a fifteen-year lease should not share a discount rate.
- Using the weighted average cost of capital. WACC includes an equity return component. The IBR is a borrowing rate, and using WACC understates the liability.
- Using the entity’s existing average borrowing cost. Existing debt has a different maturity profile and security position than the notional lease borrowing.
- Ignoring the security adjustment. An unsecured borrowing rate overstates the IBR, since a lease is effectively secured on the asset.
- Using the parent’s rate for a subsidiary. The IBR is the rate the lessee entity would pay, which may differ from the group’s.
Why the Rate Matters So Much
Consider a ten-year lease at ₹50 lakh per year, discounted at different rates:
| Discount rate | Approximate lease liability |
|---|---|
| 7% | ₹3.51 crore |
| 9% | ₹3.21 crore |
| 11% | ₹2.94 crore |
| 13% | ₹2.71 crore |
The same contract produces liabilities ranging across roughly ₹80 lakh depending purely on the rate selected. A lower rate produces a larger liability and a larger ROU asset — and more depreciation but less interest.
This is why the rate affects debt-to-equity, and why it is disclosed. Ind AS 116 requires disclosure of the weighted average incremental borrowing rate applied.
When the Rate Is Revisited
The IBR is determined at commencement and is not routinely updated. It is revised only on specific remeasurement events:
| Event | Revised rate? |
|---|---|
| Change in lease term | Yes |
| Change in purchase option assessment | Yes |
| Lease modification treated as a separate lease | Yes — new rate for the new lease |
| Change in an index or rate affecting payments | No — original rate retained |
| Change in residual value guarantee estimate | No |
| General movement in market interest rates | No |
That last row is worth noting. Rising market rates do not cause existing lease liabilities to be remeasured — the original rate stays until a qualifying event occurs.
Key Takeaways
- Discount at the implicit rate if readily determinable, otherwise the IBR
- The implicit rate is rarely determinable because lessors do not disclose residual value assumptions
- IBR reflects similar term, similar security, similar value, similar economic environment
- Typically built as risk-free rate + credit spread − security adjustment
- Do not use WACC — it includes an equity component and understates the liability
- Term-matching matters: different lease lengths need different rates
- A lower rate produces a larger liability and a larger ROU asset
- The rate is not updated for general market movements — only on specified remeasurement events
Frequently Asked Questions (FAQ)
Q: What is the incremental borrowing rate under Ind AS 116?
The rate a lessee would 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. It is used when the interest rate implicit in the lease cannot be readily determined.
Q: Why is the interest rate implicit in the lease usually not used?
Computing it requires the lessor’s estimate of residual value and its initial direct costs, which lessors do not typically disclose. Without those inputs the rate cannot be readily determined, so lessees fall back on the incremental borrowing rate.
Q: Can I use WACC as the incremental borrowing rate?
No. WACC includes a cost of equity component and is not a borrowing rate. Using it would generally understate the lease liability. The IBR must reflect what the entity would actually pay to borrow on comparable terms.
Q: Can one discount rate be used for all leases?
Generally not. The rate must reflect a similar term to each lease, so a two-year lease and a fifteen-year lease should use different rates. A portfolio approach may be acceptable for leases with genuinely similar characteristics, applied consistently.
Q: How does the discount rate affect the lease liability?
Inversely. A lower rate produces a larger present value and therefore a larger liability and right-of-use asset. On a long lease, a couple of percentage points can change the reported liability substantially without any change to the contract.
Q: Is the incremental borrowing rate updated when market rates change?
No. The rate is set at commencement and revised only on specified events such as a change in lease term or purchase option assessment. General movements in market interest rates do not trigger remeasurement of existing leases.
Q: Does the IBR need to be disclosed?
Ind AS 116 requires disclosure of the weighted average incremental borrowing rate applied to lease liabilities, which allows users to assess the reasonableness of the rate and compare across entities.
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