What Is the Incremental Borrowing Rate in Lease Accounting?

The incremental borrowing rate (IBR) is the interest rate a company would pay to borrow the funds necessary to purchase an asset, assuming a loan with a similar repayment term and collateral. This rate estimates the cost of financing the asset if it were bought instead of leased. It is defined as the rate a lessee would incur to borrow on a collateralized basis over a similar term for an amount equal to the lease payments.

The Role of the Incremental Borrowing Rate in Lease Accounting

Under accounting standards ASC 842 and IFRS 16, the incremental borrowing rate is a discount rate used to calculate the present value of future lease payments. This calculation is foundational because it establishes the initial value of the lease liability and the corresponding right-of-use (ROU) asset on a company’s balance sheet. These standards require nearly all leases longer than 12 months to be recognized on the balance sheet, increasing financial transparency.

The primary discount rate is the “rate implicit in the lease,” which is determined by the lessor. This rate equates the present value of lease payments and any residual value to the asset’s fair value. However, information needed to calculate this rate, such as the lessor’s initial costs and the asset’s residual value, is often unknown to the lessee.

When the implicit rate is not readily determinable, accounting rules permit using the IBR as an alternative, making it the default discount rate for most leases. The accuracy of the IBR is important, as a higher rate results in a lower lease liability, while a lower rate leads to a higher liability. This directly impacts a company’s financial statements.

Key Factors for Determination

The Lease Term

The length of the lease is a direct input into the IBR. A longer lease term introduces more risk for a lender, which translates into a higher borrowing rate due to interest rate risk and uncertainty of the borrower’s stability. The term used for this determination should include any renewal or extension options the company is reasonably certain to exercise.

Entity-Specific Credit Risk

A company’s creditworthiness is a primary driver of its borrowing costs. This is reflected in the credit spread, which is the additional interest a lender charges to compensate for default risk. A company with a strong credit history will secure a lower IBR than one with a weaker credit profile. If a company lacks a formal credit rating, one can be estimated based on its size, industry, and key financial metrics.

The Nature of the Leased Asset

The IBR assumes the borrowing is collateralized, with the leased asset serving as security. The quality and liquidity of this collateral affect the rate. An asset that is highly liquid and retains its value well, such as certain equipment or real estate, may lead to a lower IBR because it provides better security. A highly specialized or less marketable asset might result in a higher rate.

Economic Environment

Prevailing market conditions provide the baseline for borrowing rates. The IBR must reflect the economic environment of the transaction, including the country and currency. This is established by starting with a risk-free benchmark rate, such as the yield on a government bond with a term that matches the lease. This base rate captures the macroeconomic factors influencing interest rates.

Total Lease Payments

The total amount of the lease payments represents the sum being financed. This amount is factored into the lender’s overall risk assessment in conjunction with other factors like credit risk and the lease term. The IBR is determined for a borrowing amount equal to these payments.

Methods for Estimating the Rate

There are several methods for estimating the IBR.

• Look at recent, similar financing the company has secured. The interest rate on a secured loan for a comparable amount and term can serve as a strong starting point, with adjustments needed for any differences in collateral or economic conditions.
• Ask banks or other lenders for a quote. A company can request the interest rate for a secured loan that matches the lease term and payment amount, with the leased asset acting as collateral. This provides a current, market-based rate.
• Build a rate from the ground up. This process starts by identifying a risk-free benchmark rate, such as a U.S. Treasury yield, that corresponds to the lease term. To this base rate, the company adds its entity-specific credit spread and an adjustment to reflect the collateral.
• Use a portfolio approach for a large number of similar leases. This involves grouping leases with similar characteristics, such as asset class and term, and developing a single IBR for the entire portfolio to streamline the process.

The Risk-Free Rate Alternative

ASC 842 provides a practical expedient for non-public entities, such as private companies and not-for-profit organizations. These organizations can elect to use a risk-free rate instead of calculating an IBR. This election can be made by class of underlying asset, allowing a company to use the risk-free rate for equipment leases while still calculating an IBR for real estate leases.

The risk-free rate is determined using the yield on a U.S. Treasury security with a term comparable to the lease. While this option reduces complexity, it has a direct financial reporting consequence. The risk-free rate is lower than a company’s IBR, which includes a credit spread, and using it will result in a higher calculated lease liability and right-of-use asset on the balance sheet.