What Is an Incremental Borrowing Rate?

The Incremental Borrowing Rate (IBR) is a financial concept used in lease accounting. It represents a hypothetical interest rate a company would pay to borrow funds to purchase an asset similar to one it intends to lease. This rate considers a comparable term, an equivalent level of security, and the current economic environment. Understanding the IBR is important because it directly impacts how lease obligations are recorded on financial statements, providing a transparent view of a company’s financial commitments.

Defining the Incremental Borrowing Rate

The incremental borrowing rate is the interest rate a lessee would pay to borrow funds, over a similar term and with similar security, to obtain an asset of comparable value to the right-of-use asset in a similar economic environment. This rate is hypothetical, meaning it is not necessarily an actual borrowing rate an entity currently has for existing debt. Instead, it reflects a theoretical cost of funds for a specific, collateralized borrowing related to the leased asset.

The IBR is used when the interest rate implicit in a lease agreement cannot be readily determined by the lessee. This implicit rate, often unknown, considers factors like the lessor’s fair value of the asset and its residual value. Since this information is frequently unavailable, the IBR serves as a practical alternative for discounting lease payments.

The IBR is unique to each lessee and specific to the leased asset. It reflects a company’s individual creditworthiness, the specific characteristics of the leased asset, and the prevailing market conditions at lease commencement. For example, a company with a strong credit rating would have a lower IBR than one with a weaker profile. The rate also considers that the borrowing is collateralized by the right-of-use asset, which results in a lower rate than unsecured debt.

Determining the Rate

Estimating the incremental borrowing rate involves professional judgment, as there is no single prescribed method for its calculation. Companies identify a base rate from observable market interest rates for public or liquid corporate debt. This base rate is then adjusted for factors relevant to the lessee and the lease.

One common approach uses existing debt as a reference. A company analyzes interest rates on current loans and adjusts them to reflect the lease’s specific term, the right-of-use asset’s collateral, and the lease’s currency. For example, if a company has a five-year unsecured loan, but the lease is for three years and involves a secured asset, adjustments align the borrowing profile.

Alternatively, entities may use a “build-up” approach. This starts with a risk-free rate, such as the U.S. Treasury yield curve or the Secured Overnight Financing Rate (SOFR), for a term comparable to the lease. A credit spread is added to reflect the lessee’s credit risk, with further adjustment for the collateralized nature of the borrowing. For private companies lacking credit ratings, estimating the credit spread can involve benchmarking against similar borrowers or consulting lenders. The ultimate IBR should reflect what the company would pay for a secured loan for an amount equal to the lease payments over the lease term.

Application in Lease Accounting

The incremental borrowing rate is important in lease accounting under standards like ASC 842 in the United States and IFRS 16 internationally. These standards require lessees to recognize nearly all leases on their balance sheets, shifting from prior “off-balance sheet” treatment. The IBR serves as the discount rate to calculate the present value of future lease payments when the implicit rate cannot be readily determined.

This present value calculation determines both the lease liability and the corresponding right-of-use (ROU) asset on a company’s balance sheet. The lease liability is the present value of remaining lease payments, while the ROU asset reflects the lessee’s right to use the leased asset. A higher IBR results in a lower present value, leading to a smaller lease liability and ROU asset, and vice versa.

The IBR also influences a company’s income statement and cash flow statement. On the income statement, the ROU asset is depreciated or amortized, and interest expense on the lease liability is recognized. On the cash flow statement, lease payments are split between principal repayment (financing activity) and interest expense (operating activity), impacting cash flow classification compared to prior standards where operating lease payments were operating cash outflows.

Factors Influencing the Rate

Several internal and external factors contribute to the determination of an entity’s incremental borrowing rate. The lessee’s creditworthiness is a primary internal factor. A company’s credit rating, financial health, and debt-to-equity ratio directly influence a lender’s perceived risk. Entities with stronger credit profiles and lower default risk qualify for lower borrowing rates and a lower IBR.

The lease term is another factor. Longer lease terms imply higher incremental borrowing rates due to increased interest rate risk and uncertainties over extended periods. For example, a 10-year lease will likely have a higher IBR than a 3-year lease for the same asset and lessee. The leased asset’s characteristics (type, risk, market value, collateral) also adjust the rate.

External economic conditions also influence the IBR. Prevailing market interest rates, such as SOFR, directly impact borrowing costs. When national interest rates rise, the IBR will increase. The lease’s currency and the broader economic environment, including geographic location and country-specific risks, are also considered. The IBR is entity-specific and situation-dependent.