IFRS 16: Discount rate - How to calculate it correctly

Q: How do I handle leases in foreign currency?

For leases in foreign currency , the discount rate should reflect interest rates in that currency. You cannot use a rate based on another currency and then convert it – the rate must be in the same currency as the lease payments from the start. This often means setting separate yield curves for each relevant currency (EUR, NOK, SEK, etc.).

The discount rate reflects the time value of money – the principle that money today is worth more than the same amount in the future, because of factors such as inflation, risk and alternative investment opportunities.

IFRS 16 can be a demanding process for companies with many leases. When you set the discount rate under IFRS 16, you need to understand how this key component affects the lease liabilities recognised in the balance sheet. This guide covers what the discount rate is, why it matters, how it is calculated and the practical challenges companies face.

What is the discount rate under IFRS 16?

Discounting future cash flows is a fundamental principle in financial analysis. The choice of discount rate often has a large impact on the assessment of investments and projects, especially for long-term obligations. The discount rate is therefore a critical factor in decisions for both companies and investors.

The discount rate under IFRS 16 is a key component in measuring lease liabilities in the balance sheet. When a company enters into a lease, the IFRS 16 standards requires it to recognise both a right-of-use asset and a lease liability,.

The discount rate is used to calculate the present value of future lease payments and therefore determines the size of both the lease liability and the right-of-use asset.

Two approaches to the discount rate

Under IFRS 16, there are two ways to determine the discount rate for a lease: the interest rate implicit in the lease and the lessee’s incremental borrowing rate.

A higher discount rate reduces the lease liability and the right-of-use asset that are recognised, while a lower rate leads to higher amounts in the balance sheet.

This also affects key ratios such as gearing, asset turnover and earnings before interest and taxes (EBIT).

Interest rate implicit in the lease: the rate 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. It can be calculated if all the necessary information is available.

Incremental borrowing rate: the rate of interest the 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.

Models such as the Weighted Average Cost of Capital (WACC) and the Capital Asset Pricing Model (CAPM) are used in investment analysis, but they are not a basis for the IFRS 16 discount rate. The incremental borrowing rate is a borrowing rate: in practice a reference rate plus a credit spread, adjusted for the lease term, security and currency.

Besides affecting the amounts in the balance sheet, the discount rate affects the profile of the lease expense over time. A higher rate gives higher interest expense early in the lease term, while depreciation of the right-of-use asset is spread evenly over the period. This creates a front-loading effect, where the total lease expense is higher early in the lease term.

Read ShareControl IFRS 16 vs Excel – these are the benefits

How is the discount rate calculated?

Calculating and discounting future cash flows under IFRS 16 is a critical part of measuring lease liabilities in the balance sheet. Setting the right discount rate requires a careful assessment of several factors.

Here is an overview of the two main methods for determining the discount rate under IFRS 16:

Interest rate implicit in the lease

The interest rate implicit in the lease is used if it can be readily determined (IFRS 16.26).

It reflects the lessor’s expected return on its investment in the asset, adjusted for risk and time, and follows from this relationship:

Present value of the lease payments + present value of the unguaranteed residual value = fair value of the underlying asset + initial direct costs of the lessor

In other words, the implicit rate is the rate at which the present value of the future lease payments and the unguaranteed residual value equals the fair value of the asset plus the lessor’s initial direct costs.

Example: calculating the interest rate implicit in the lease

A lessor leases out a machine with a fair value of EUR 500,000. The lessee pays EUR 100,000 at the end of each year for five years. The lessor expects the machine to have an unguaranteed residual value of EUR 50,000 at the end of the lease term.

Calculating the implicit rate

Present value of the five annual lease payments of EUR 100,000 + present value of the residual value of EUR 50,000 = fair value of EUR 500,000.

By iteration (or with a financial calculator or Excel), the implicit rate is approximately 3%.

Check

Present value of the lease payments: EUR 100,000 × 4.5797* = EUR 457,970
Present value of the residual value: EUR 50,000 × 0.8626** = EUR 43,130
Total: EUR 501,100 ≈ EUR 500,000

* Annuity factor for 5 years at 3%

** Discount factor for a single amount in year 5 at 3%

Recognition in the balance sheet:

At the commencement date, the lessee recognises:

Right-of-use asset: EUR 457,970
Lease liability: EUR 457,970

(Note: the residual value is not included, as it belongs to the lessor.)

Incremental borrowing rate

If the interest rate implicit in the lease cannot be readily determined, the lessee uses its incremental borrowing rate. This is the rate the lessee would have to pay to borrow the funds needed to obtain an asset of a similar value to the right-of-use asset, with a similar security and over a similar term, in a similar economic environment.

Factors that affect the incremental borrowing rate:

Credit standing of the lessee: the company’s borrowing capacity and credit rating affect the rate it can obtain.
Risk profile: market risk, credit risk and uncertainty about future cash flows affect the rate a lender requires.
Lease term: a longer term normally means a higher rate, because the lender’s risk increases.
Security: the type and quality of the security offered (often the right to use the asset) affect the rate.
Economic environment: interest rates in the environment the lease is entered into (country, currency, timing) also play a part.

Example: calculating the incremental borrowing rate:

Assume the lessee in the example above has no access to information about the machine’s fair value or the lessor’s expected residual value. The lessee therefore cannot calculate the implicit rate.

Instead, the lessee determines its incremental borrowing rate. Based on its credit standing, security and economic conditions, it finds that it could borrow a similar amount at 5% over five years.

Calculation with an incremental borrowing rate of 5%

Present value of the lease payments: EUR 100,000 × 4.3295* = EUR 432,950
Lease liability at the commencement date: EUR 432,950

* Annuity factor for 5 years at 5%

Comparing the two methods

	Implicit rate (3%)	Incremental borrowing rate (5%)	Difference
Lease liability	EUR 457,970	EUR 432,950	EUR 25,020
Right-of-use asset	EUR 457,970	EUR 432,950	EUR 25,020
Present value of cash flows	Higher	Lower	Reflects the risk adjustment

As the table shows, a higher discount rate gives a lower lease liability in the balance sheet. This also affects:

Gearing: lower with a higher rate
EBIT: slightly higher with a higher rate, because a lower right-of-use asset gives lower depreciation. Interest expense is recognised below EBIT.
Profit: the front-loading effect is stronger with a higher rate

Effect of the discount rate over the lease term

To show how the choice of discount rate affects the accounts over time, here are the first two years of the machine example.

With an incremental borrowing rate of 5%:

Year	Lease liability, opening	Rentekostnad (5%)	Lease payment	Lease liability, closing
1	EUR 432,950	EUR 21,648	EUR 100,000	EUR 354,598
2	EUR 354,598	EUR 17,730	EUR 100,000	EUR 272,328

With an implicit rate of 3%:

Year	Lease liability, opening	Interest expense (3%)	Lease payment	Lease liability, closing
1	EUR 457,970	EUR 13,739	EUR 100,000	EUR 371,709
2	EUR 371,709	EUR 11,151	EUR 100,000	EUR 282,860

As the tables show, a higher discount rate gives higher interest expense early in the lease term, which affects profit or loss. The right-of-use asset is depreciated on a straight-line basis over the lease term, which reinforces the front-loading effect at higher rates.

Choice of discount rate and the importance of documentation

The choice between the implicit rate and the incremental borrowing rate depends on the information available. It is often difficult for the lessee to obtain all the information needed to calculate the implicit rate, especially when the fair value of the asset or the lessor’s costs are unknown. In such cases, the incremental borrowing rate is the practical alternative.

Whichever method is used, the company must document the basis for the calculations carefully. This makes the accounts verifiable and in line with IFRS 16, and gives auditors and other stakeholders insight into the judgements made.

Les mer om Fordeler med IFRS 16 og sentralisert leieregnskap

Practical challenges for lessees

Lessees face several challenges when calculating the discount rate under IFRS 16, particularly in setting the most accurate rate for measuring lease liabilities. One of the biggest is the lack of information needed to calculate the interest rate implicit in the lease. Lessors often do not disclose the fair value of the asset, their initial direct costs or the expected residual value of the asset at the end of the lease term. This often makes it hard for lessees to determine the implicit rate reliably.

When the implicit rate cannot be determined, lessees must use their incremental borrowing rate. Setting this rate is not straightforward either. Lessees must take several factors into account, including their credit standing, the term of the lease and the security linked to the leased asset. Each of these factors can vary from lease to lease, which makes the process time-consuming and complex.

Lessees must also adjust for economic conditions such as inflation, interest rate changes and currency risk, which can affect the value of future cash flows and the economic environment of the lease. This uncertainty makes it complex for companies to set correct discount rates.

Another challenge is that audit and regulatory requirements oblige lessees to document all judgements and calculations under IFRS 16. This often requires new systems and processes for data collection and reporting. Lessees must also update the discount rate in the event of lease modifications or reassessments, which adds complexity to the ongoing accounting.

These challenges make the standard demanding, especially for companies with many and varied leases.

ShareControl IFRS 16 – the complete system for lease accounting

Calculating the discount rate under IFRS 16 can be a demanding process that requires careful assessment of contract terms and economic conditions. It can have a large impact on the company’s balance sheet and key ratios, and must therefore be handled with precision and thorough documentation. A dedicated IFRS 16 system lets you automate and streamline large parts of the accounting process.

ShareControl IFRS 16 helps companies automate and streamline their IFRS 16 processes. The system lets you upload, manage and calculate lease data through integrations with SharePoint and Excel. ShareControl IFRS 16 also covers finance leases.

The discount rate in ShareControl IFRS 16 is set and adjusted per lease or per portfolio, including bulk updates of the rates used for new leases when the yield curve is updated. This gives accurate and reliable calculations in line with IFRS 16.

Do you have questions about ShareControl IFRS 16?

Get answers to your questions or a quick walkthrough of how ShareControl IFRS 16 works and integrates with your Microsoft 365 environment.

Kontakt oss

+47 24 02 21 00

FAQ – IFRS 16 DIscount Rate

What is the discount rate in an IFRS 16 context?

The discount rate under IFRS 16 is the rate used to calculate the present value of future lease payments. It directly determines the size of both the lease liability and the right-of-use asset recognised in the balance sheet. Choosing the right discount rate is essential for correct accounting and has a significant impact on the company’s financial ratios.

Why is the discount rate so important for IFRS 16 accounting?

The discount rate matters because it:
1. Determines the size of the lease liability and the right-of-use asset in the balance sheet
2. Affects ratios such as gearing and equity ratio
3. Determines the profile of the lease expense over time (front-loading effect)
4. Affects EBIT and finance costs
5. Must be documented thoroughly for audit purposes

A difference of just 1–2 percentage points in the discount rate can have a significant effect on the amounts in the balance sheet, especially for long-term leases.

Which discount rate should I use – the implicit rate or the incremental borrowing rate?

Under IFRS 16, you use the interest rate implicit in the lease if it can be readily determined. If it cannot (which is often the case), you use the incremental borrowing rate. In practice, most lessees use the incremental borrowing rate, because lessors rarely share the information needed to calculate the implicit rate.

How do I determine the incremental borrowing rate for my company?

The incremental borrowing rate should reflect the rate the company would have to pay to borrow a similar amount, with a similar security, over a similar term, in a similar economic environment. To determine it, you can:

1. Ask the company’s bank for current lending rates
2. Look at existing loans with a similar term and security
3. Adjust for differences in term, security and currency
4. Document all assumptions and judgements

Many companies prepare a yield curve for different terms that is updated regularly.

Can I use the same discount rate for all leases?

No. As a starting point, the discount rate is determined for each lease, based on:

– The lease term
– Type of asset and security
– Currency
– Economic conditions at the commencement date

However, IFRS 16 allows a portfolio approach as a practical expedient: leases with similar characteristics can be grouped and given the same discount rate, provided the effect does not differ materially from applying the standard to each lease (IFRS 16.B1). For example, all office leases with a five-year term in the same currency can be treated alike.

How do I handle leases in foreign currency?

For leases in foreign currency, the discount rate should reflect interest rates in that currency. You cannot use a rate based on another currency and then convert it – the rate must be in the same currency as the lease payments from the start. This often means setting separate yield curves for each relevant currency (EUR, NOK, SEK, etc.).

How often must I update the discount rate?

The discount rate is set at the commencement date and is normally not changed during the lease term. You must, however, reassess it and use a revised discount rate in the event of:

– Lease modifications that are not accounted for as a separate lease
– A change in the lease term (when extension or termination options are reassessed)
– A change in the assessment of whether a purchase option will be exercised
– A change in lease payments resulting from a change in floating interest rates

Other changes in market interest rates after the commencement date do not change the discount rate for existing leases.

What documentation does the auditor require for the discount rate?

The auditor will typically require documentation of:

– The method used to set the discount rate (implicit rate or incremental borrowing rate)
– The calculations and assumptions behind it
– The source of the interest rates (for example bank confirmations or loan terms)
– Any adjustments for term, security or currency
– Decisions on the portfolio approach and groupings
– The process for updating yield curves
– A log of changes to the discount rate on lease modifications

We recommend a written policy for setting the discount rate.

How do I document that the incremental borrowing rate is correctly set?

Good practice includes:

– Obtaining lending rates from the bank for different terms (building a yield curve)
– Documenting comparisons with the existing loan portfolio
– Preparing a yield curve approved by the CFO or management
– Setting up a routine for periodic updates (for example quarterly)
– Documenting any adjustments for special circumstances
– Keeping all correspondence with banks and financial institutions

We have hundreds of leases – how do we handle this in practice?

For companies with many leases, we recommend:
– Setting standardised yield curves for different terms
– Grouping similar leases into portfolios
– Using a dedicated IFRS 16 system (such as ShareControl IFRS 16) that automates the calculations
– Setting fixed routines for updates and documentation
– Delegating responsibility for different categories of leases

A good IFRS 16 system can handle bulk changes, for example when the yield curve used for new leases is updated each year.

What is an acceptable difference between the implicit rate and the incremental borrowing rate?

There is no fixed answer, but material differences should be analysed and understood. Typically:
– The implicit rate is often somewhat lower than the incremental borrowing rate (the lessor may have better purchasing terms and includes the residual value)
– Differences of 1–3 percentage points can be normal
– Larger differences may indicate that one of the rates is wrong or that the lease has special terms

If you have access to both rates, document the comparison and the reasons for your choice.

How does a zero or negative interest rate environment affect the discount rate?

Periods of very low or negative market rates can be challenging. IFRS 16 does not prohibit a negative discount rate if the incremental borrowing rate is actually negative. In practice, however, most companies have a positive borrowing rate even in low-rate environments because of the credit spread. The key is to be consistent and to document why your incremental borrowing rate differs from risk-free rates.
In such an environment, it can be useful to distinguish between the risk-free rate (which may be negative) and the company’s actual borrowing rate (which includes a credit spread and will normally be positive).

What if we have leases with variable interest rates?

For leases where the payments depend on a floating interest rate:
– Measure the lease liability at the commencement date using the discount rate at that date
– Measure the lease payments using the floating rate at the measurement date
– When the floating rate changes, remeasure the lease liability using a revised discount rate that reflects the change in the interest rate (IFRS 16.43)
– Variable lease payments that depend on an index (for example a consumer price index) are remeasured using an unchanged discount rate

Do covenants or pledges affect the discount rate?

Yes. Security and covenants should be reflected in the incremental borrowing rate. If the lease has better security than a standard loan, this can justify a lower rate. Conversely, if the company has to provide additional security or has strict covenants in its loan agreements, this can affect the incremental borrowing rate. All such adjustments must be documented.

How does the timing of the commencement date affect the discount rate?

The discount rate is set at the commencement date and reflects the economic conditions at that date, including market rates, inflation and risk profile. Two identical leases that commence at different times can therefore have different discount rates. This is important to understand, especially in periods of volatile interest rates or changes in the company’s credit standing.

How does the choice of discount rate affect our key ratios?

The discount rate affects:

– Balance sheet: a higher rate gives a lower lease liability and a lower right-of-use asset
– Gearing: a lower lease liability gives a lower debt ratio
– EBIT: slightly higher with a higher rate, because depreciation is lower; interest expense is recognised below EBIT
– Interest expense: a higher rate gives higher interest expense early in the lease term
– Profit after tax: the front-loading effect means higher expenses early and lower expenses later

A sensitivity analysis is recommended to understand the effect on your company.

What is the front-loading effect and how is it affected by the discount rate?

Front-loading means that the total lease expense (interest + depreciation) is higher early in the lease term and lower later. This happens because:

– Interest expense is highest at the start, when the lease liability is largest
– Depreciation is straight-line over the whole period
– A higher discount rate reinforces the effect

This can affect profit development and bonus schemes, so it is important to be aware of the effect.

Should we choose a high or low discount rate to “optimise” the accounts?

No. The discount rate must be set on the basis of the principles in IFRS 16 and actual economic conditions – not chosen to achieve a desired accounting effect. The auditor will review this closely, and artificially high or low rates will be rejected. Focus instead on:
– Correct and consistent methodology
– Thorough documentation
– A fair reflection of the company’s borrowing terms

Articles on IFRS 16

About The Author

Ragnar Bryne

administrator

Ragnar Bryne er partner og gründer i Share Control. Ragnar har mer enn 35 års allsidig erfaring fra ulike lederstillinger i en rekke større nasjonale og internasjonale foretak, samt fra konsulentvirksomhet og gründer av IT-selskap. Erfaring også fra KPMG og EY.

Siden 2014 har han vært gründer og eier av Share Control og har vært en sterk støttespiller til selskapets virksomhet, produkter og kunder.

See author's posts

IFRS 16: Discount rate – How to calculate it correctly