How to approach IFRS 16 IBR: The Hypothetical Ownership Principle explained

In the current financial reporting standard, the Incremental Borrowing Rate (IBR) is often the most scrutinised component of a lease liability valuation. While a basic search for IBR methodology typically yields a straightforward ‘build-up’ formula: adding a credit spread to a market base rate, then adjusting further with a collateral discount, this surface-level approach often fails to satisfy the technical requirements of a rigorous audit review.

To move beyond the baseline heuristic and into auditable certainty, valuation professionals and auditors must address the core of the IFRS 16 requirement: The Hypothetical Ownership Principle.

The core philosophy: buying vs leasing

IFRS 16 defines the IBR as the rate of interest that a lessee would have to pay to borrow, over a similar term and with similar security, the funds necessary to obtain an asset of a similar value to the Right-of-Use (ROU) asset.

To quantify this, we must imagine a hypothetical scenario: If the lessee were to purchase the property outright instead of leasing it, what would the cost of debt be?

In commercial reality, purchasing a property outright is equivalent to taking out a secured mortgage. Therefore, mortgage-backed lending rates form the most defensible foundation for the IBR. However, a critical ‘collateral gap’ exists because banks rarely provide 100% Loan-to-Value (LTV) financing. A lease, by definition, finances 100% of the asset’s use during the lease term.

The collateral gap in action

Imagine a company is at the commencement date of a new lease for a prime commercial space. If they were to buy the property outright, a bank might offer a mortgage covering 75% of the value (the secured portion) at an interest rate of 5.5% (all figures for illustrative purposes).

But a lease is not a 75% mortgage; it is a 100% funding commitment. To bridge that ‘collateral gap’, the company would effectively need to borrow the remaining 25% on an unsecured basis, carrying the higher risk of the lessee’s general credit profile, say, an unpledged rate of 6.5%.

The correct IBR is neither the secured 5.5% nor the unsecured 6.5%. It is a blended reality. If the funding is a hybrid of two different risk profiles, what is an appropriate single defensible rate?

How do we accurately and consistently calculate this blended rate in a way that satisfies auditing standards? We explore the ‘Practicable-Grade’ framework in Part 2 of this series.