Discount rate selection for calculating the present value of lease payments: which rate should be used if the rate implicit in the lease cannot be determined?

• A. Incremental borrowing rate
• B. Cost of equity
• C. Market rate for similar leases
• D. Vendor's stated rate

Answer: (A)

When valuing the lease liability, you discount the future lease payments at a rate that reflects the financing cost to the lessee. If the rate implicit in the lease cannot be determined, the appropriate choice is the lessee’s incremental borrowing rate—the rate the entity would incur to borrow over the lease term with similar security. This rate best represents the lessee’s cost of financing the asset and aligns the lease liability with the actual funding it would need.

The other options don’t fit as well. The cost of equity is a return on shareholders’ investment, not a borrowing cost for financing a leased asset. A market rate for similar leases could vary and isn’t the standardized fallback required when the implicit rate isn’t determinable. The vendor’s stated rate is the lessor’s financing rate, not the lessee’s cost of funds, and may not reflect the lessee’s credit risk or term.