Incremental borrowing rate for leases: how to determine the ASC 842 discount rate
The incremental borrowing rate is the rate of interest a lessee would have to pay to borrow, on a collateralized basis, over a similar term, an amount equal to the lease payments, in a similar economic environment. Under ASC 842 you reach for it only when the rate implicit in the lease is not readily determinable, which for real estate is nearly always. It is not your revolver rate and it is not a lender quote. It is a rate you build and document.
Last updated August 2026
THE PROBLEM
Built for controllers, technical accounting teams, and CPA firms setting ASC 842 discount rate policy
The rate is the one ASC 842 input with no document to point at. Every other measurement input is written in the lease. The discount rate has to be constructed from credit, collateral, term and economic environment, then defended to an auditor who will ask why a seven year lease was discounted at a rate quoted for a one year revolver.
Pull the term, payments and dates the rate has to match
A discount rate is only right if it matches the lease term and the payment stream it discounts. Upload the lease and the AI returns the commencement date, the term including options reasonably certain of exercise, the full payment schedule and any escalation basis, each linked to the clause it came from, so the rate you build is matched to the right tenor and the right amount.
Find the leases where an implicit rate actually is determinable
Equipment and vehicle schedules often state the asset fair value, the payment stream and a purchase option, which is enough to solve for the implicit rate. Real estate almost never does. Abstracting the population tells you which bucket each lease falls in before you commit to a policy.
Give the auditor the inputs behind the rate, not the lease file
Discount rate testing starts with a sample and a request to support the term, the payments and the classification behind each rate. When every value carries a page and clause reference, that support is a link rather than an afternoon of rereading.
What is the incremental borrowing rate?
The ASC Master Glossary defines the incremental borrowing rate as the rate of interest that a lessee would have to pay to borrow on a collateralized basis over a similar term an amount equal to the lease payments in a similar economic environment. Four conditions sit inside that one sentence, and a rate that fails any of them is the wrong rate.
| Condition | What it requires | How it is commonly failed |
|---|---|---|
| Collateralized basis | A secured rate. The lessee can pledge assets if it defaults, so the rate sits below the unsecured rate for the same credit. | Using an unsecured bond yield or a corporate credit spread with no security adjustment |
| Similar term | Tenor matched to the lease term, including options reasonably certain of exercise. A one year lease and a ten year lease get different rates. | Applying one company-wide rate taken from a revolving facility to every lease regardless of length |
| An amount equal to the lease payments | Sized to the lease. If the obligation is large enough to change the capital structure, the credit profile it implies changes with it. | Ignoring the size of the obligation entirely |
| Similar economic environment | The currency and country the lease sits in, including sovereign risk for foreign subsidiaries. | Discounting a foreign currency payment stream at a US dollar rate |
RSM makes the practical point plainly in its guidance for lessees: conclusions based on a lender quote or an existing borrowing facility are typically not appropriate on their own. Those are data points that feed the rate. They are not the rate.
What discount rate should be used for ASC 842?
ASC 842-20-30-3 sets a hierarchy, and it is short. Use the rate implicit in the lease whenever that rate is readily determinable. If it is not readily determinable, use the incremental borrowing rate. A lessee that is not a public business entity may instead elect a risk-free rate, by class of underlying asset. ASC 842-20-30-2 adds the timing rule: the rate is set on information available at the commencement date.
| Tier | Rate | When it applies | Who can use it |
|---|---|---|---|
| 1 | Rate implicit in the lease | Whenever it is readily determinable. This is mandatory, not optional. | Every lessee |
| 2 | Incremental borrowing rate | When the implicit rate is not readily determinable | Every lessee |
| 3 | Risk-free rate | Policy election, by class of underlying asset, and only where the implicit rate is not readily determinable | Lessees that are not public business entities |
The tier that trips people up is the first one. The risk-free election is not a way out of the hierarchy. ASU 2021-09 was explicit that if the rate implicit in the lease is readily determinable for an individual lease, a nonpublic lessee must use that rate, whether or not it has made the risk-free election. The election replaces the incremental borrowing rate. It never replaces the implicit rate.
Why the rate implicit in the lease is almost never readily determinable
The rate implicit in the lease is the rate that makes the present value of the lease payments plus the amount the lessor expects to derive from the asset at the end of the term equal the fair value of the asset less any investment tax credit retained by the lessor, plus the lessor deferred initial direct costs. Read the inputs again and the problem is obvious.
| Input to the implicit rate | Does the lessee normally have it? |
|---|---|
| The lease payments | Yes, they are in the lease |
| Fair value of the underlying asset | Sometimes for equipment, rarely for a floor of a building |
| The residual value the lessor expects at the end of the term | No. This is a lessor estimate that is not disclosed to the tenant |
| The lessor deferred initial direct costs | No. Broker commissions and lessor legal costs are not shared |
Two of the four inputs live only inside the lessor accounting records. That is why the implicit rate is readily determinable on a stated equipment schedule with a purchase option and a listed asset price, and effectively never on an office or retail lease. Readily determinable means all of the inputs are available without estimating the ones you cannot see. Assuming a residual value in order to solve for a rate does not make it determinable.
How to determine the incremental borrowing rate
The workable method is a build-up: start from a risk-free base at the lease tenor, add a credit spread for the lessee, then adjust for security. RSM sets out the components a lessee has to consider and document: lessee specific credit risk, the amount of the lease payments, the collateralized nature of the lease, the quality of the collateral, alignment of borrowing term with lease term, and the economic environment including currency.
| Step | Component | Illustrative |
|---|---|---|
| 1 | Risk-free base at the 7 year tenor | 4.20% |
| 2 | Credit spread for the lessee at that tenor | plus 2.90% |
| 3 | Indicated unsecured borrowing rate | 7.10% |
| 4 | Adjustment for secured, collateralized borrowing | less 0.55% |
| 5 | Incremental borrowing rate for a 7 year lease | 6.55% |
Those figures are illustrative, not current market data. Pull your own base curve and spread as of each commencement date. The method is what carries over.
Step 2 is where most of the judgment sits. If the lessee has a rating from a major agency, start there. If it does not, and most private companies do not, a synthetic rating is developed from liquidity and solvency ratios or from a regression of the company financial metrics against a peer group of public debt issuers. Parent guarantees matter here: where a corporate parent guarantees its subsidiaries leases, the parent credit profile drives the rate and you do not need to build a separate profile for each subsidiary.
Step 4 is the step most often skipped. Observable market rates for a given credit are generally unsecured. The definition requires a secured rate, so an adjustment down is needed. RSM notes that the secured adjustment is generally not specific to the leased asset but reflects the aggregate collateral the lessee could pledge, and that its size depends on credit quality: for a strong credit, default and recovery are remote and the adjustment is small; for a weak credit, collateral quality does real work and the adjustment is larger.
Incremental borrowing rate vs implicit rate vs risk-free rate
The three rates answer three different questions and produce three different balance sheets from the same lease.
| Implicit rate | Incremental borrowing rate | Risk-free rate | |
|---|---|---|---|
| Whose economics | The lessor | The lessee | Neither, it is a market benchmark |
| Typical source | Solved from the lease and asset fair value | Built up from credit, term and collateral | US Treasury yield at a comparable period |
| Reflects lessee credit | Indirectly | Yes | No |
| Relative level | Varies | Higher than risk-free | Lowest of the three |
| Effect on liability | Varies | Baseline | Largest liability and ROU asset |
| Cost to produce | Low where inputs exist, impossible where they do not | High, usually a valuation exercise | Low, a published yield |
| Available to | All lessees | All lessees | Nonpublic lessees only, by asset class |
The risk-free rate is lower than a real borrowing rate, and a lower discount rate produces a larger present value. That is the trade: the cheapest rate to produce is also the one that grosses up the balance sheet the most. The risk-free rate election under ASC 842 works through when that trade is worth taking and when it is not.
What the discount rate does to the balance sheet
Take a seven year office lease at $200,000 a year, paid annually in arrears, commencing 1/1/2026, classified operating. Total undiscounted payments are $1,400,000 in every case. Only the rate changes.
| Rate used | Rate | Initial liability and ROU asset | Imputed interest | Difference vs IBR |
|---|---|---|---|---|
| Incremental borrowing rate, term matched | 6.55% | $1,094,976 | $305,024 | baseline |
| Risk-free rate at a comparable period | 4.20% | $1,191,589 | $208,411 | $96,613 higher |
| Short tenor rate taken from a revolver | 5.10% | $1,153,092 | $246,908 | $58,116 higher |
| Unsecured rate, no collateral adjustment | 7.10% | $1,074,110 | $325,890 | $20,866 lower |
Each liability plus its imputed interest equals the $1,400,000 of undiscounted payments, which is the check the maturity analysis in the footnote has to pass. The spread between the defensible rate and the two common errors is roughly $58,000 and $21,000 on a single mid-size lease. Across a portfolio that is what a covenant test turns on.
One point worth being precise about, because it is widely stated wrongly. For an operating lease the discount rate does not change total annual expense. Single lease cost is the total lease payments spread straight line over the term, $200,000 a year here, at every rate in the table. The rate changes the balance sheet, the split between interest accretion and ROU amortization, and the weighted average discount rate you disclose. For a finance lease the rate does change expense, because interest and amortization are presented separately and the pattern is front loaded. See operating lease vs finance lease for the classification test that decides which one you are in.
When does the discount rate have to be reassessed?
The rate is set at commencement and is not refreshed because market rates moved. It is reassessed when a specific event requires remeasurement: a modification that is not accounted for as a separate contract, a change in the lease term or in the assessment of a purchase option, and for finance leases a change in the amounts probable of being owed under a residual value guarantee. A change in the assessment of an option to extend is the common one, and it resets the tenor, which means it resets the rate.
Practically this means the rate build-up is not a one time adoption exercise. Every new lease signed after adoption needs a rate as of its own commencement date, and every modification needs a rate as of the modification date. Companies that treated the rate as a transition project and never rebuilt the curve end up discounting 2026 leases at 2022 rates. The ASC 842 implementation guide covers where that fits in the wider adoption sequence.
Where the discount rate inputs come from
The rate itself comes from market data, but three of the four conditions in the definition are set by the lease document. The tenor is the lease term including options reasonably certain of exercise. The amount is the payment stream that will be discounted. The currency and jurisdiction come from the lease. Get any of those wrong and a perfectly built rate is applied to the wrong thing.
That is the part lease abstraction handles. Upload the lease and the abstract returns the commencement date, the base term, every renewal and termination option with its notice deadline, the payment schedule and escalation basis, and any purchase option or residual value guarantee, each linked back to the clause it was read from. From there the rate build-up has a defensible tenor and a defensible payment stream behind it, and so does the lease liability calculation that follows, the ASC 842 journal entries after that, and the ASC 842 disclosure requirements at the end, including the weighted average discount rate that has to be disclosed beside the term.
WHAT WE EXTRACT
Every lease term, source-linked
FAQ
Common questions
What is the incremental borrowing rate under ASC 842?
The rate of interest a lessee would have to pay to borrow, on a collateralized basis, over a similar term, an amount equal to the lease payments, in a similar economic environment. It is used to discount lease payments to a lease liability when the rate implicit in the lease is not readily determinable, which is the normal case for real estate.
What discount rate should be used for ASC 842?
The rate implicit in the lease if it is readily determinable, and the incremental borrowing rate if it is not. A lessee that is not a public business entity may elect a risk-free rate instead of the incremental borrowing rate, by class of underlying asset. The rate is set using information available at the commencement date.
How do you calculate the incremental borrowing rate?
Build it up. Start from a risk-free base at the lease tenor, add a credit spread for the lessee at that same tenor, then adjust downward because the lease obligation is secured. A rated company starts from its rating; an unrated company develops a synthetic rating from financial ratios or a peer regression.
What is the difference between the incremental borrowing rate and the implicit rate?
The implicit rate reflects the lessor economics, including the residual value the lessor expects and its deferred initial direct costs. The incremental borrowing rate reflects the lessee cost of secured borrowing. ASC 842 requires the implicit rate when it is readily determinable and the incremental borrowing rate when it is not.
Why is the rate implicit in the lease not readily determinable?
Because two of its four inputs sit only in the lessor records. The lessee can see the payments and sometimes the asset fair value, but not the residual value the lessor expects at the end of the term and not the lessor deferred initial direct costs. Without those, the rate cannot be solved.
Can I use my revolver rate as the incremental borrowing rate?
Not on its own. A revolving facility is short dated and often unsecured, so it fails the similar term condition and usually the collateralized condition. It is a useful data point that helps corroborate a build-up, but a seven year lease discounted at a one year revolver rate will not survive audit.
What is the risk-free rate election under ASC 842?
A policy election available only to lessees that are not public business entities, letting them discount at a risk-free rate, usually a US Treasury yield for a period comparable to the lease term, instead of building an incremental borrowing rate. Since ASU 2021-09 it is made by class of underlying asset and must be disclosed.
Does the risk-free rate election override the implicit rate?
No. ASU 2021-09 made this explicit. If the rate implicit in the lease is readily determinable for an individual lease, a nonpublic lessee must use that rate regardless of whether it has made the risk-free election. The election substitutes for the incremental borrowing rate only.
Does a lower discount rate increase or decrease the lease liability?
A lower rate increases it. The liability is the present value of the remaining payments, so discounting less aggressively leaves a larger present value. On a seven year lease at $200,000 a year, moving from 6.55% to 4.20% raises the initial liability from $1,094,976 to $1,191,589.
Does the discount rate change lease expense?
For an operating lease, no. Single lease cost is total lease payments spread straight line over the term, which is the same at any rate. The rate changes the balance sheet and the split between interest and amortization. For a finance lease the rate does change expense, because interest and amortization are presented separately.
Do I need a different incremental borrowing rate for every lease?
In principle yes, because tenor and amount differ by lease, unless a portfolio approach is elected. In practice companies build a rate curve by tenor and read each lease off it at its commencement date, which satisfies the term matching requirement without a separate valuation exercise per lease.
When does the ASC 842 discount rate get reassessed?
Only on a remeasurement event, not because market rates moved. Reassessment is triggered by a modification not accounted for as a separate contract, a change in the lease term or in the assessment of a purchase option, and for finance leases certain changes in residual value guarantee amounts.
What discount rate do private companies use for ASC 842?
Whichever of the three the hierarchy points to. Many private companies elect the risk-free rate for high volume, low dollar classes such as equipment and vehicles, and build an incremental borrowing rate for real estate, where the balance sheet effect is large enough to justify the work.
Is the weighted average discount rate the same as the incremental borrowing rate?
No. The incremental borrowing rate applies to one lease. The weighted average discount rate is a disclosure that combines the rates across the portfolio, weighted by the remaining lease payments, and is reported separately for operating and finance leases beside the weighted average remaining lease term.
Incremental borrowing rate for leases: how to determine the ASC 842 discount rate
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