Last Updated on January 12, 2023 by Morgan Beard
Accounting for and/or transitioning to the new lease accounting standards, ASC 842 and IFRS 16, has proven to be a painful, complex and time-consuming exercise for virtually every organization. The determination of the incremental borrowing rate (IBR), which is used to derive the lease liability by discounting the present value of the future lease payments, is foundational to ASC 842.
ASC 842 and IFRS 16 state that if the rate implicit in the lease can be readily determined, then lessees should use that rate when calculating the lease liability. If the rate implicit in the lease cannot be determined, lessees shall use the incremental borrowing rate. In practice, the rate implicit in the lease is rarely readily determinable and as a result, the lessee more likely than not will need to use an incremental borrowing rate. The challenge comes in defining exactly what rate should be used. If an incorrect incremental borrowing rate is defined then there could be financial reporting consequences, such as audit findings and/or misstatements. The article below will outline practical challenges that organizations typically face when determining an incremental borrowing rate, and common methods to overcome those challenges.
What is an Incremental Borrowing Rate?
An 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.” In other words, it is the rate of interest that a lessee would pay to a lender if they were to seek out financing to purchase the leased asset outright.
The incremental borrowing rate is pivotal to lease accounting primarily due to two factors:
1) It has a severe impact on the corresponding balances of the right-of-use asset and lease liability.
2) It is one of the few areas in lease accounting where lessees are required to exercise professional judgement.
The higher the incremental borrowing rate, the lower the lease liability will be, and the lower the incremental borrowing rate, the higher the lease liability will be. The determination of the incremental borrowing rate will also have an impact on financial statements. Higher/lower lease liabilities and right-of-use assets will affect lending decisions and other areas of the business.
Lastly, the incremental borrowing rate is one of the few areas where lessees can exercise judgement when accounting for leases. It is often the area of focus for auditors and as a result, scrutiny will be placed on the rate utilized to determine whether or not it is appropriate.
Common challenges when determining an Incremental Borrowing Rate
Now that we have defined what an incremental borrowing rate is and why it is fundamental to lease accounting, the next step is determining it.
When determining an incremental borrowing rate, most organizations start with a base rate that approximates their cost of borrowing at a point in time. Then they adjust that rate to reflect differentiating factors, such as company-specific factors, lease-specific factors and economic conditions.
Determination of a base rate
The typical starting point for a base rate is rates for loans that were granted close to the lease commencement date, with a similar term and payment structure. Although this is an ideal starting point, it is often uncommon for an organization to have a loan granted immediately before or after a lease commencement date. In rare cases, organizations may be able to retrieve their cost of lending from the financial institution that they are lending from. Another consideration is that commercial lending, such as lines of credit, are often uncollateralized-. n incremental borrowing rate should reflect the cost to borrow on a collateralized basis.
When all things are considered it is often most practical to start with your current cost of borrowing, even though it may not line up with the lease commencement date, and then adjust that rate for the differentiating factors outlined below.
Company-specific factors to consider
The primary company-specific factor to consider is the credit rating and how/if it has changed since the granting of the last piece of debt. Oftentimes, lending decisions and credit ratings are based on financial ratios at a point in time, and are therefore subject to change as a company continues to operate.
Sometimes, an organization may be able to source its credit rating from a credit bureau or a lender but oftentimes, this information is unavailable. A practical method for adjusting the base rate for changes in credit is to calculate financial ratios, such as debt to EBITDA or debt to equity at the time of the most recent lending. Then, compare that to the same financial ratios at the lease commencement date. For example, if an organization’s debt to equity ratio was 4 to 1 when they were granted their line of credit but is now 4.2 to 1, it is an indication that their creditworthiness has likely diminished around 5% and can serve as a basis for adjusting the base rate.
Lease-specific factors to consider
The first item to consider when adjusting the base rate for lease-specific factors is the collateralization aspect. As discussed earlier, commercial debt is often uncollateralized. An incremental borrowing rate should reflect what it would cost a company to lend on a collateralized basis. Generally, offering up collateral when lending will reduce your cost of lending,resulting in a lower incremental borrowing rate.
The next thing to consider is the term of the leasing arrangement. The longer the term of a debt arrangement, the lower the interest rate would be.his is due to the diminished risk of default over time and the increase in interest income a lender would receive over a longer term. Keeping in mind that the term of the leasing arrangement and the term of the commercial debt used for the base rate may differ, adjustments to the incremental borrowing rate will likely be needed to reflect the different risk profile of a longer/shorter term.
The final lease-specific adjustment to consider is the payment structure of the leasing arrangement versus that of the base rate. Most leasing arrangements and debt instruments utilize a monthly payment structure. However, sometimes landlords may require prepayment of rent, which would reduce the risk of default and ultimately reduce the incremental borrowing rate. In other instances, rent might be paid quarterly or even annually while the debt instrument may have monthly payments. This too would require adjustments to account for the differing risk portfolios.
Economic factors to consider
Finally, an organization should consider changes in the economic environment when adjusting the base rate to arrive at an estimated IBR. The first economic consideration is changes to the economy from the debt commencement date. A recent example would be the COVID-19 pandemic. Lending rates prior to the pandemic were much different than those post-pandemic. This would require organizations to adjust the base rate to reflect the new economic circumstances.
Another economic consideration is the location of the leased asset. If the location of the leased asset differs from the location of the corporate debt instrument, then an additional adjustment may be needed. For example, if the debt instrument was denominated in the United States of America, but the leased asset is a warehouse in Germany, the incremental borrowing rate should be adjusted to reflect the current economic situation in Germany.
Practical Solutions to Estimate your Incremental Borrowing Rate
Now that we have outlined all of the challenges associated with determining an appropriate incremental borrowing rate and identified when and why you would need to adjust the base rate, let’s discuss some practical solutions that organizations are currently utilizing to estimate an incremental borrowing rate.
Perhaps the easiest method for determining an incremental borrowing rate that can only be used by private companies is the risk-free-rate election. This election allows private companies to utilize the risk-free-rate as the incremental borrowing rate. Although this method saves organizations time and effort, the caveat is that the risk-free-rate is likely much lower than any organization’s internal incremental borrowing rate.his results in much higher balances for both the right-of-use asset and the lease liability. Organizations that want to avoid significant impacts to their financial statements should avoid this election.
Another option used to determine an appropriate incremental borrowing rate is to hire an external valuations specialist, such as an accounting or consulting firm. The valuations specialist will use tools like Bloomberg to determine an organization’s credit rating and arrive at an approximate rate that an institutional lender would charge. The caveat to this common method is that although it saves time, it is the priciest option.
Develop an internal methodology
The final method to be discussed that is commonly utilized by organizations is to develop an internal process for determining an incremental borrowing rate.
The process begins with determining a base rate and then adjusting that rate on a lease-by-lease basis for company-specific factors, lease-specific factors and economic conditions. Although an incremental borrowing rate should be applied on a lease-by-lease basis, organizations often utilize what is called a portfolio approach to blanket the same rate across leased assets of a similar term and type. This is permissible so long as it does not result in material differences. This should be kept in mind as auditors will often ask organizations to substantiate that material differences are not present.
For example, an organization that enters into fifty truck leases all within two months of each other may want to utilize the same incremental borrowing rate for all fifty leases since they all have the same term, payment structure and were entered into at approximately the same point in time.
Although the determination of the incremental borrowing rate has proven to be challenging in many ways for many companies, devising a method to determine it goes a long way. It also helps ease the burden of calculating an incremental borrowing rate every time a new lease is entered or modified.
A common key to success is to involve your auditors in the decision-making process so that they can audit your methodology in advance of transitioning to the new standards, and determine whether or not it is appropriate. This will save organizations from potential audit findings and/or material adjustments down the line.
At the end of the day, the incremental borrowing rate is an estimate that has impacts on an organization’s financial statements and ratios, and therefore should be given appropriate consideration.