What is Incremental Borrowing Rate And When To Use it in Lease Accounting

November 14, 2022
Alok Suman
Lease Management

Despite an increasing number of organizations having spent years allocating significant amounts of money and resources to adopt the new lease accounting standard ASC 842, many are still struggling with one critical input - the incremental borrowing rate or IBR.

Since IBR is needed to present value to all the leases, many companies are finding it difficult to adopt the new rule mainly because of a lack of knowledge and their software tools not being equipped to take IBR as an input. 

This post aims to explore the concept of incremental borrowing rate in more detail, including what it is, why it is important to calculate IBR, how to calculate IBR, and more.

What is Incremental Borrowing Rate?

Incremental borrowing rate or IBR in ASC 842 is defined as “the rate of interest that a lessee would have to pay to borrow on a collateralized base over a similar term an amount equal to the lease payments in a similar economic environment.”

Put simply, the incremental borrowing rate refers to the interest rate a lessee needs to pay to be able to fund an asset. The asset here should be similar to the lease’s asset in value, over the same lease term, and in a similar economic environment. 

Some of the key attributes that you need to consider in estimating your incremental borrowing rate include the following:

  • Creditworthiness
  • Collateral involved
  • Term of lease
  • Existing economic environment

While calculating the incremental borrowing rate, you need to tell the treasury department the following things to enable them to calculate and provide you with the correct incremental borrowing rate:

  • Lease term

It is important to keep in mind here that the rate for a 5-year lease will be very different from the rate for a 25-year lease.

Therefore, the total term or length of the lease would increase the overall borrowing rate along with an increase in the term as well. This is primarily because the chances of default rise with an increase in the term.

  • The security structure

The IBR is generally determined from a secured interest perspective, meaning that the credit risk associated with the lessee should either be lower than that of an unsecured interest or equal.

The IBR, therefore, must reflect a collateralized borrowing for a principal amount that is similar to the total lease payments.

  • Subsidiary

The incremental borrowing rate you use needs to be the rate for that particular subsidiary. In case it’s an individual subsidiary, then you are required to use the rate for that particular subsidiary.

  • Collateralized rate

Financing under IBR would presumably be secured by the underlying asset which would then decrease the borrowing cost. 

  • Currency

The overall economic environment where the lease agreement is made mandates the lease to be mentioned in the home currency where all the leased assets are used.

This is the reason why the rate for a lease using one country's currency exchange will be different from that of a lease using another country's currency.

When to Use IBR in Lease Accounting?

Accounting standard IFRS 16/AASB 16 mandates all lessees to assess and recognize various assets and liabilities for different lease agreements they are involved in. This excludes low-value and short-term lease agreements.

The lease liability here is typically determined as the present value of future lease payments. The same is discounted using the interest rate implicit in the lease to see if this can be easily determined or not using its incremental borrowing rate.

Put simply, the latest lease accounting standards across the board, including ASC 842, mandates lessees to work in and calculate a reasonable discount rate for determining the Net Present Value (NPV) of their future lease payments.

This allows lessees to use this net present value as the base for determining the different components of lease schedules, including ROU assets and lease liabilities.

However, the problem with this approach is that determining the discount rate is not an easy task in most cases.

In many leases, the rate is not mentioned clearly or the required information needed to determine the discount rate may either be missing or incomplete. 

Therefore, ASC 842 lease standards let lessees leverage the incremental borrowing rate as an alternative approach for calculating the discount rate for establishing NPV.  

When Do You Need to Update Your Incremental Borrowing Rate?

An updated IBR is a must for all leases that came into inception during a specified period. Organizations, therefore, are liable to update their incremental borrowing rate for an existing lease liability as soon as:

  • There is any change in the lease terms (any modifications)
  • In case the lessee is quite certain to use an option to buy the underlying leased asset.

Importance of Incremental Borrowing Rate in Lease Accounting 

The incremental borrowing rate is important to lease accounting due to two main factors. These are discussed below:

  • a) IBR is a critical area of lease accounting where lessees are required to show and exercise professional judgment.

This is primarily because the incremental borrowing rate is often the key area of focus for auditors; therefore, there is a close watch on the IBR rate utilized to determine whether or not it is right or appropriate.

  • b) IBR has a significant impact on the corresponding balances of the right-of-use asset and a lease liability.  

The higher the incremental borrowing rate, the lower the lease liability, and vice-versa. Besides, the calculation of the incremental borrowing rate will also have an impact on the organization's financial statements.

Higher/lower lease liabilities and right-of-use assets will significantly affect overall lending decisions and other areas of the business.

The Process of Determining the Incremental Borrowing Rate 

As per accounting standards, the most preferred incremental borrowing rate calculation is meant to define, explain or clarify the borrowing rate from the lease.

However, this is always not possible for the operating lease because of a lack of control over the asset details (cost and number of users the asset will be leased to over its useful life).

In such a scenario, the best possible approach for your IBR calculation is to leverage your secured borrowing program in that particular location. Here is how it goes:

  • Begin with estimating the creditworthiness of the organization 
  • In the next stage, do thorough research and come up with a balance between secured and unsecured lending
  • Use data to build an unsecured borrowing rate curve from recovery data, and more
  • Work on reducing your unsecured borrowing rate curve 
  • Now, you need to apply any collateral to the market-secured borrowing rate curve. This will help you calculate your incremental borrowing rate.

In short, the incremental borrowing rate calculation should consider the credit rating of the company currently, which should include its debt structure and capital.

This is especially relevant with real estate and other similar high-value lease agreements.

Additionally, calculating the incremental borrowing rate is generally more complex for a private organization as compared to a  public company. 

How IBR Gets Simpler With Lease Accounting Technology

While the calculation of the incremental borrowing rate is challenging in several ways for organizations, what helps is devising a strategic method to determine the same. 

The best way to approach the process is to collaborate with your auditors to make IBR-related decisions so that they can brainstorm and audit your methodology before transitioning to the new accounting standards, and determine whether or not it is appropriate. 

Overall, the IBR is an estimate that impacts an organization’s financial statements and ratios and therefore should be given due consideration. This is where lease accounting technology helps.

As soon as you determine the IBR to be used in the lease calculation, along with other key inputs such as terms and payments, these can be input into a lease software to calculate the lease liability and corresponding right-of-use asset.

Leveraging the right lease accounting technology and software can be significant in making the process smooth and hassle-free for your organization.

There are multiple advantages to be gained from such lease accounting and lease management software for IBR, using no-code platforms like LeasO. It not only makes the calculation easier but also helps you easily track the status and updates regarding all the active leases and their status at your company.

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