What is the Incremental Borrowing Rate?
Among the many different calculations used in lease accounting, the incremental borrowing rate may be one of the most misunderstood. Theincremental borrowing rate (IBR)is the interest rate a lessee would have to pay to borrow funds to finance an assetsimilar tothe lease’s ROU asset in value, over a similar term and in a similar economic environment.
And according toFASB ASC 842,lessees are now allowed to use the incremental borrowing rateto determine the discount rate used to measure their leases.
Let’stake a closer look at when and how to use the incremental borrowing rate in lease accounting.
When is the incremental borrowing rate used in lease accounting?
All the latest lease accounting standards, including ASC 842, require lessees to determine a reasonable discount rate for establishing the Net Present Value (NPV) of all their future lease payments. Lessees then use the NPV as the basis for determining the different components of lease schedules, including lease liabilities, ROU assets and amortization.
However, the accounting board also acknowledges the discount rate is not always easy to determine. In many leases, the rate is not clearly spelled out (explicit) or the information that could be used to determine the (implicit) discount rate may be missing or incomplete.
For instance, a lease might not specify an interest rate used to calculate the payments or the residual value at the end of the lease might be subject to change.
Therefore, ASC 842 guidelines allow lessees to use the incremental borrowing rate as an alternative method for determining the discount rate when theydon’thave access to all the information (explicit or implicit) used to determine lease payments.
Why is IBR so important in lease accounting?
The incremental borrowing rate is used to discount future cash flows to reflect the impact of time on the remaining lease obligation.
For instance, on a lease with payments of $1,000 a month for five years, the organization’s lease accounting needs to recognize not only current payments but also what will be paid in the future, using the IBR to reflect the timing of individual cash flows.
Using the IBR as the discount rate has a tremendous impact on an organization’s balance sheet. That is because every piece of data in a lease schedule is generated off the NPV, which is determined by the discount rate — in this case, IBR — and the date and amount of each lease payment.
How is the incremental borrowing rate determined?
An organization’s incremental borrowing rate is generally a reflection of its creditworthiness based on six components:
- Company’s Creditworthiness: The first step is evaluating a company’s credit rating or, if not available, estimate it based on company size, industry, and financial performance. A higher credit risk typically results in a higher IBR.
- Lease Term: The IBR must reflect the specific term of the lease, including any renewal or extension options that the company is reasonably certain to exercise.
- Type of Asset Being Leased: The IBR should be adjusted for the nature of the leased asset, including its risk and market value. A lease for high-value equipment may have a lower IBR compared to a lease for a short-term, low-value asset.
- Market Conditions: The IBR should reflect current market interest rates for borrowing funds with similar terms and conditions. Companies should look at the existing interest rates in the market, adjusted for inflation and economic conditions.
- Collateralization: If the lease involves collateral, the IBR should be lower than it would be for an unsecured borrowing. Companies must assess the security provided by the leased asset itself.
- Available Resources: Financial models, external borrowing rates, and industry benchmarks can help companies estimate a reasonable IBR. Lease accounting software can also simplify the process by providing built-in tools for rate calculations.
In addition, the risk-free rate can have an influence on the IBR.The current risk-free rate for different term lengths can be found in trusted sources such as theTreasury Department websiteor publications such as Bloomberg or the Wall Street Journal.
Ideally, the IBRshould also consideran organization’s current credit rating, including its debt structure and capital. This is especially true with real estate and other high-value leases.
For instance, a small startup company may pose more of a credit risk and therefore pay a higher IBR on real estate leases compared to a larger and more established company.
In addition, determining the incremental borrowing rate is often more difficult for a private organization than for a public company.
How is IBR different for public and private companies?
Public companies typically know what their IBR is, due to the ongoing financial tracking and reporting required from publicly traded companies. By necessity, these organizations usually know their average cost to capital, borrowing interest rates and other factors that affect their credit.
Private companies are less likely to know those factors and may not have up-to-date credit information readily available. Instead, they may have to pick a theoretical IBR based on a wide range of issues such as:
- The interest rate paid the last time they borrowed money
- How much above the risk-free rate they are likely topay
- The type of asset — for example, the interest on financing a vehicle vs. financing a building
- Whether the asset will depreciate or appreciate
- The length of time over which payments will be made
- The organization’s borrowing activity and credit risk
- Market conditions and borrowing costs
Therefore, for simplicity, private companies often opt to use the risk-free rate as their IBR — for example, basing the IBR for a five-year lease on the rate at which five-year T-bills are currently trading.
What is the impact of using the risk-free rate as your IBR?
Looking up the risk-free rate and using it as an organization’s incremental borrowing rate is certainly easy. However, it will inflate the organization’s liabilities.
The risk-free rate is always the lowest borrowing rate, minus the inflation expectation. But when factored over time, the lower the interest rate is, the higher the NPV will be. That means the risk-free rate has a larger impact on the balance sheet.
Therefore, while it is less work to use the risk-free rate, it may not be as advantageous as determining your actual incremental borrowing rate.
When must the incremental borrowing rate be updated?
The good news is ASC 842 says once a lease schedule is established, youdon’tneed to recalculate the discount rate unless you need to remeasure future lease obligations due to changes such as:
- Renewals or options that add time and payments to a lease
- Abatements or other modification of existing leases
For example, if you decide to exercise an option for a new five-year term on an existing lease, you will want to calculate the additional time and payments at a current rate rather than use the rate established at the start of the original lease.
However, it is important to stay up to date on inflation expectations and market rates, as well as the organization’s current credit standing. That way, if and when lease re-measurements are needed, the organization will be prepared to recalculate its IBR.
IBR is simpler with lease accounting technology.
To the extent you can determine the discount rates used to calculate lease payments, you should use those rates in your lease accounting. But when you cannot reasonably determine a discount rate, the incremental borrowing rate is a quick and easy alternative allowed by ASC 842.
Determining the incremental borrowing rate is a complex issue, and there is no simple formula. However, a lease management solution like Visual Lease makes it easy to manage and track borrowing rates.
For instance, the platform’s Borrowing Rate table lets you establish a series of IBRs based on type of asset, organization credit rating, country,currencyand the remaining lease term.
With all the necessary values in one place, you can easily track and modify the data points as needed. In addition, when you create a lease schedule, the Visual Lease platform will automatically select the appropriate rate based on the parameters you set up in the table.
To learn more, contact us at (888) 876-6500 orrequest a demoto see Visual Lease in action.
