What it means
When your business signs a lease for office space, vehicles, or equipment, accounting standards require you to put that lease on your balance sheet as both an asset and a liability. To calculate the starting value of that liability, you need an interest rate to discount your future lease payments back to today's money.
If the lease agreement does not clearly state the interest rate the lessor is charging you, you must use your incremental borrowing rate instead. This rate reflects what your specific business would be charged by a bank for a loan of a similar size and duration, under similar economic conditions, using the leased asset as collateral.
Determining this rate matters because it directly impacts your financial statements. A higher borrowing rate results in a lower starting lease liability and asset value, which changes your debt-to-equity ratio and influences how your interest and depreciation expenses are recorded over time.
Getting this figure right ensures compliance with international and national financial reporting standards, giving investors and lenders a true picture of your financial commitments. In practice, non-finance managers rarely calculate this number alone.
You will typically work alongside your finance team or external accountants, who will look at current market interest rates, your company's credit rating, the length of the lease, and the currency involved. They will adjust a benchmark rate, such as a base bank rate, to reflect your company's specific risk profile and the specific terms of the lease contract.
In practice
Real-world examples.
Example
TechStart Ltd needs to find its incremental borrowing rate to record a new office lease. Based on recent bank quotes for a five-year loan, they determine they would pay 6.5 percent interest annually to finance similar equipment.
Example
GreenDelivery SME signs a three-year van lease. Without a stated interest rate in the contract, they use an incremental borrowing rate of 7.2 percent, reflecting current commercial vehicle loan rates and their specific business credit score.
Example
BuildCorp, a mid-sized construction firm, leases heavy machinery for four years. Their treasury team establishes an incremental borrowing rate of 8.0 percent by reviewing recent debt issues and secured lending rates for heavy equipment.
Think of it
“Imagine you want to buy a car on finance, but the dealership hides the interest rate and only quotes you a monthly payment. To figure out the true cost, you would call your bank to ask what rate they would charge you for a personal car loan of the exact same amount and term. That bank quote is your incremental borrowing rate.
Formula
Calculation
Present Value = Sum of Lease Payments divided by (1 + Incremental Borrowing Rate)^n
For example, if you pay 10,000 pounds at the end of each year for 3 years, and your incremental borrowing rate is 6 percent:
Year 1: 10,000 / (1.06)^1 = 9,434
Year 2: 10,000 / (1.06)^2 = 8,900
Year 3: 10,000 / (1.06)^3 = 8,396
Total Lease Liability = 26,730 pounds.Case study
Seen in the real world.
Oakwood Retail wanted to expand its store network and signed a five-year property lease requiring annual payments of 50,000 pounds. Under accounting rules, Chief Financial Officer Sarah needed to record this lease on the balance sheet. Because the landlord did not disclose an implicit interest rate, Sarah had to determine Oakwood Retail's incremental borrowing rate. She consulted with their corporate bank, which confirmed that given Oakwood's credit profile and the retail property market, a secured five-year loan would carry an interest rate of 7 percent. Using this 7 percent rate, Sarah discounted the five upcoming payments of 50,000 pounds to a present value of approximately 205,010 pounds. She then recorded this figure as both a right-of-use asset and a lease liability on the balance sheet. This ensured the company complied with reporting standards, providing a transparent view of their long-term financial commitments to potential investors without inflating their asset values.
Watch out
Common mistakes.
- Using the company's average overall cost of capital instead of a rate specific to the lease term and asset type.
- Failing to update the rate when new leases are signed, assuming all leases share the same historical rate.
- Ignoring the impact of collateral, by using an unsecured borrowing rate when the leased asset acts as security.
Questions
People also ask.
Why can I not just use my bank's prime lending rate?
The prime rate is typically reserved for a bank's most creditworthy corporate customers. Your incremental borrowing rate must reflect your specific credit risk, lease term, and collateral.
How often do I need to recalculate my incremental borrowing rate?
You typically determine the rate at the start of a new lease or when a lease is officially modified. Existing leases generally keep the rate assigned at their commencement date.
Do I always need an incremental borrowing rate for every lease?
No. If the lease contract explicitly states the interest rate used by the lessor, and you can readily determine it, you should use that rate instead.
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