By LeaseCrunch® on April 28, 2023 at 12:33 PM
Before we define what an incremental borrowing rate (IBR) is, let’s do a brief overview of two of the most important changes to lease accounting principles in the past few decades, since the definition of the incremental borrowing rate is contingent upon the stated definitions of a lease and its term.
The new lease accounting standards (including ASC 842, GASB 87, GASB 96, and IFRS 16) require all leases to be identified under a right-of-use model. Because of this change, any organization that has been granted use of an asset may have to document this asset on a balance sheet. In addition, all leases over 12 months in length have to be documented as assets and liabilities on a company’s balance sheet.
This change in the treatment and definition of a lease is important to review before understanding what the incremental borrowing rate is and how exactly companies use it.
What Is the Incremental Borrowing Rate?
As per the definition stated in ASC 842, one of the new lease accounting standards, the incremental borrowing rate is 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.”
To put it less formally, the incremental borrowing rate is the rate a lessor would have charged a lessee if they had financed the asset in question rather than leasing it.
What Is the Incremental Borrowing Rate in Leases?
To calculate a lease’s liability, ASC 842 states that lessees should first use the rate implicit in a lease to determine the present value of future lease payments.
If a company cannot determine the implicit rate in a lease, then they must use the incremental borrowing rate. Since it is more often the case that the implicit rate is not available, it’s important to know how to calculate the incremental borrowing rate.
From the moment a company realizes they cannot determine the implicit rate, the challenge instead shifts to determining what the incremental borrowing rate should be.
Why Is the Incremental Borrowing Rate Important?
The incremental borrowing rate is important because once it is clear that a contract includes a lease, the lease liability and right-of-use (ROU) assets have to be recorded and a rate needs to be determined to discount committed future lease payments. Since the rate implicit in the lease is so often not available, the incremental borrowing rate is instead used.
How Do You Calculate Incremental Borrowing Rate?
There are six factors to consider before calculating the incremental borrowing rate. These are:
1. Lessee-Specific Credit Risk
Since an incremental borrowing rate is lessee-specific, the ability of a lessee to repay their debts is an important factor in considering the interest rate to which a lessee should be privy.
2. Amount of the Lease Payments
The amount of a lease payment should be considered in relation to the amount of debt the lessee already has. If the lease payments related to the incremental borrowing rate have a significant impact on the capital structure of the lessee, then this should result in a risk adjustment given that the lessee’s debt obligations will have been sizeably altered because of the lease.
3. Collateralized Nature of the Lease
Since the incremental borrowing rate is on a secured basis, the rate should be calculated based on the idea that the lessee can put up assets even if it defaults on its lease payments.
Since incremental borrowing rates are calculated with the belief that the deal is collateralized, this will generally lower the rate of return compared to that of rates on an unsecured basis.
4. Alignment of the Borrowing Term and Lease Term
The length of the duration of the lease is also important to take into consideration. The risk associated with leases depends on the length of time of the lease because of interest rate risk and other factors that affect the yield curve’s structure. For example, a lease with one year left in its contract is going to have a different risk associated with it than a lease that still has ten years left in its contract.
5. Economic Environment of the Lease and Foreign Currency Considerations
The country of origin of the lease should be considered, as the risk profile of leases entered into in developing countries is much different than those in developed countries.
6. Quality of the Lessee's Collateral
A lessee should be evaluated to see if they have enough quality collateral to meet lease payments if a default were to occur.
Creditworthiness also plays a role in this adjustment. The higher the credit of a business entity, the less likely they are to default on a loan, which means less risk in the deal overall.
Incremental Borrowing Rate Calculation Continued
When it comes to determining the incremental borrowing rate for each of your leases, your bank can be a great resource in analyzing these factors. Although banks can recalculate an interest rate every time a company enters into a new lease, usually the incremental borrowing rate is just the bank’s cost of funds and credit spread added together.
The bank’s cost of funds indicates the underlying costs for a bank to craft the loan, also known as the bank’s “break-even” rate. The latter number, or the credit spread, is indicative of the amount a bank charges separate from the cost of its funds to generate the return it needs to insulate itself from the risk it takes in crafting the loan.
What is Incremental Interest?
Incremental interest is the amount of interest that is accrued on a mortgage loan that can be attributed to the incremental rate.
Incremental interest can be confused with the incremental borrowing rate, but they are different. Whereas the incremental borrowing rate is an interest rate designed for a specific lease, incremental interest is a term used when it comes to increasing an initial mortgage interest rate when certain conditions arise.
How to Accurately Implement the IBR Rate
There are many factors to consider when determining the incremental borrowing rate, which means that rarely is there a cookie-cutter approach to determining this aspect of lease contracts. However, making sure you calculate your IBR rate accurately in your balance sheets is crucial to staying compliant with the new lease accounting standards.
The best way to stay compliant is with LeaseCrunch’s automated lease accounting software. With LeaseCrunch, you can simplify the complex, ensure accuracy, reduce risk, and save enormous amounts of time and headaches with accurate and automated calculations of you or your client’s assets according to the new lease accounting standard. To learn more, contact us or schedule a demo to get started using our cloud-based lease accounting solution right away.
Frequently Asked Questions
What Is the Incremental Borrowing Rate?
The incremental borrowing rate (IBR) refers to the interest percentage a lessee would incur if they sought external financing to acquire a comparable asset. Essentially, it serves as a benchmark to determine the present value of lease payments, playing a pivotal role in lease classification and financial reporting.
What Is the Difference Between IBR and WACC?
The incremental borrowing rate (IBR) represents the interest rate that an entity would pay to borrow funds for a specific period, while the weighted average cost of capital (WACC) is the average cost of all the capital sources used by the entity. While IBR is focused on a specific borrowing scenario, WACC takes into account the cost of equity, debt, and other sources of funding for the overall entity.
What Is The IBR Rate IFRS 16?
The IBR (Incremental Borrowing Rate) under IFRS 16 is a distinct financial metric used to calculate the interest rate an entity would incur if they obtained additional debt for a lease arrangement. This represents the estimated borrowing cost for a lease, factoring in the lessee's creditworthiness and the lease's specific terms to ensure accurate accounting and reporting.
How to Calculate Incremental Borrowing Rate?
To calculate the incremental borrowing rate, the equation to remember is adding the bank’s cost of funds and the credit spread. This means calculating the underlying costs for crafting a loan, or the “break-even” rate, and adding it to the amount the bank charges to get the returns it needs to protect itself from risk.