Last Updated on February 9, 2023 by Morgan Beard
After adopting new lease accounting standards like ASC 842 and IFRS 16, many lease accountants were presented with a new acronym: IBR.
IBR is the incremental borrowing rate. It’s one of the most common terms in lease accounting today. It’s also one of the most misunderstood. To state it as simply as possible: the incremental borrowing rate is the interest rate a lessee would have to pay to borrow funds to finance an asset similar to a lease’s right-of-use (ROU) asset—over a similar term and in a similar economic climate.
As you can see, the IBR is a complex topic because there’s room for subjective interpretation. An analysis of market data is required to justify a part of the formula. Sometimes, this data is not easily found or doesn’t exist.
Calculating the IBR properly also requires in-depth knowledge of your company’s financial picture. Since you’re trying to equate the discount rate paid on the ROU asset to a conventional loan’s interest rate, you need to be confident in your other lease calculations — including any initial direct costs incurred by you, the lessee, as well as any lease incentives received and any lease payments made by the lessor.
Here is the ultimate guide to the incremental borrowing rate to help you understand the ins and outs of this important calculation.
IBR and New Lease Accounting Standards
Concepts like IBR and the ROU asset have become prominent because they are in the new lease accounting standards, ASC 842 and IFRS 16. To understand IBR and the ROU asset, it helps to take a look at why the new standards were adopted.
For years, the Financial Accounting Standards Board (FASB) in the United States and the International Accounting Standards Board (IASB) aimed to update and unify global lease accounting standards. Starting in 2006, FASB and IASB got to work on updating and replacing the old lease accounting standards: ASC 840 in the US and IAS 17 internationally.
The project was finally completed in 2016 with the release of the Accounting Standards Codification 842 and International Financial Reporting Standards 16 standards. Since then, private and public companies have been on varying timeframes to comply.
One of the main objectives is to improve lease reporting transparency. Companies must now capitalize operating leases and include them on the balance sheet as assets and liabilities. Under the previous standards, operating leases were accounted for off the balance sheet. Instead, they were disclosed in a table of future operating lease obligations in the footnotes of financial statements.
FASB and IASB believed analysts, investors, and other users of financial statements would get a better perspective of a company’s lease obligations with operating leases capitalized uniformly. As most users of financial statements figure lease assets and obligations when adjusting financial ratios and other measures, presenting the leases on the balance sheet with other assets and liabilities seemed reasonable.
Today, global lease accounting is now mostly unified. There was a lot of discussion and different ideas considered right up until the release of the new standards. While some differences exist between ASC 842 and IFRS 16, operating leases now appear on the company balance sheet under both new rules. And in both cases, the determination of the incremental borrowing rate is the same.
About the Implicit Rate and the IBR
Under ASC 842 and IFRS 16, a lessee calculates the present value (PV) of the estimated lease payments using the implicit interest rate in the lease—if it’s known to the lessee.
The implicit interest rate on a lease is the interest rate the lessor charges the lessee. It’s called an implicit rate because it’s not explicitly stated in the lease agreement. Instead, the interest rate is implied by the value of the item being leased, compared to the total amount the lessee will pay during the lease term.
This simple two-step formula will allow you to calculate the implicit rate:
The total amount paid/amount borrowed = x
x-1 x 100 = implicit interest rate
Here’s a simple example to clarify the implicit rate. Imagine you borrow $500 from a friend and agree to pay back $550. As an interest rate was not explicitly stated, you can use the formula above to arrive at a 10% implicit interest rate.
Of course, that’s an easy example. As $50 is 10% of $500, you probably didn’t need the formula and could calculate the implied interest in your head. But when the concept is applied to a lease, the picture becomes less clear.
Calculating the implicit rate in a lease requires factoring in other variables such as payment period, fair value, payment amount, the lessor’s investment tax credit, and the deferred lessor initial recognition costs (if applicable). As the latter two items may only be known to the lessor, the lessee may not be able to calculate a lease’s implicit rate correctly.
And that’s where the IBR comes in.
Under the new standards, PV is calculated using the implicit rate in the lease, if known, or the incremental borrowing rate. Since a lessee is often unable to arrive at the implicit rate, the IBR becomes an essential calculation.
Why Is IBR Important?
The incremental borrowing rate is important because it accurately reflects lease obligations on financial statements. As both ASC 842 and IFRS 16 require both operating leases and finance leases (formerly known as capital leases) to be recognized on the balance sheet, the IBR helps determine a company’s financial health.
Therefore, the IBR should be determined in such a manner that is accurate and reflects real-world data. A company’s IBR can generally be seen as a benchmark of its creditworthiness based on two components:
- The risk-free rate, which is determined by the current rate on Treasury bills (T-bills)
- The company’s credit rating
The current risk-free rate for various term lengths can be found on the Treasury Department’s website.
To accurately consider a company’s credit rating, debt structure and capital come into play. These factors become even more critical when dealing with real estate and other high-value leases.
A smaller company or a startup may pose more of a credit risk and thus pay a higher IBR on real estate leases than a larger or more established company.
How Incremental Borrowing Rate Is Determined
So you know that the IBR is the interest rate the lessee would incur under a conventional loan with terms similar to the lease. But just like a lease’s implicit rate, there isn’t a simple formula to determine IBR.
To correctly determine the IBR, all of the following information should be taken into account:
- The lessee’s specific credit risk
- The amount of lease payments
- The amount borrowed
- The currency borrowed
- The underlying asset or assets
- The economic environment and foreign currency considerations
Lessees who operate in multiple jurisdictions will need to consider the economic environments in all their locations and determine their influence on IBR.
Determining an appropriate IBR impacts the present value of the lease, along with several financial ratios. Choosing a higher discount rate will reduce liabilities, affecting ratios and measurements based on liabilities.
For example, lower lease liabilities increase earnings before interest, but taxes will be higher because depreciation is lower. But EBITDA (earnings before interest, tax, depreciation, and amortization) wouldn’t be changed since both interest and depreciation are excluded from EBITDA calculations.
Since the factors determining IBR can vary from lease to lease, a lessee could have incremental borrowing rates specific to each lease. However, the lessee can take a portfolio approach and utilize a single IBR.
ASC 842 Survival Kit
Download the resources your need to kickstart your ASC 842 compliance journey.
IBR and the Portfolio Approach
Using the portfolio approach and determining a single discount rate is allowed under the new standards if the company expects that the results would not be materially different from calculating an IBR for every lease.
The portfolio approach is particularly helpful when a lessee operates in multiple jurisdictions, but funds leases centrally. In some jurisdictions, a lessee may not have borrowing ability and thus can’t determine a local IBR. In these cases, some currency equivalence analytics should be applied.
The lessee will first have to determine the rate at which it could borrow in the currency for which the lease originated. Often, a lease contract is denominated in a currency different from the lessee’s parent company’s functional currency.
The Challenges in Determining IBR
In determining the IBR, you may experience several challenges.
Look at how ASC 842 defines the incremental borrowing rate:
“The rate of interest that a lessee would have to pay to borrow on a collateralized basis over a similar term is an amount equal to the lease payments in a similar economic environment.”
Pay attention to the terms used: collateralized basis; similar term; lease payments; and similar economic environment. Right away, you can imagine differentiating between “uncollateralized” and “collateralized” can be tricky. Determining a rate that reflects a similar lease term and lease payments is open to interpretation. And “economic factors” sounds somewhat vague.
Although you can analyze rates for loans funded near a lease commencement date, your company may not have taken out any loans in that timeframe. You can ask lenders about borrowing rates, but there’s no guarantee you’ll get useful information.
On top of that, most companies borrow uncollateralized, making their finance teams unfamiliar with the ins and outs of collateralized loans.
Here are a few tips for overcoming the challenges in determining IBR.
Determining Credit Risk
Determining credit risk is a subjective process. You can start with your company’s credit rating, but other factors should be considered. Economic conditions, financial ratios like EBITDA, and repayment history should also be considered. As financial ratios heavily influence credit ratings, you will need to consider the state of your company’s books at the time of lease commencement.
If your company took out a loan near the lease commencement date, that loan’s rate could be used as a starting point. Adjustments should then be made to get the rate more in line with current conditions and terms available to your company.
Adjusting Rate for Collateral
When making a rate adjustment for collateral, remember that borrowing on a collateralized basis results in a lower rate than borrowing on an uncollateralized basis. How much lower is dependent on what form of collateral is being used.
A good starting point is to assume that the asset being leased is the collateral. If another form of collateral is used, consider its liquidity. The more liquid the collateral, the lower the rate will be.
Term and Payments Considerations
The term of the lease and the structure of payments also influence the rate. With a longer term, rates are generally higher. If more payments are made upfront, the risk and the rate are also lower.
Private Companies and the IBR
Generally, it can be more difficult for a private company to determine IBR than for a public company. Acknowledging this, ASC 842 allows private companies to utilize the risk-free rate.
This is a choice that private companies can make per lease. The risk-free rate may be more attractive for larger leases such as real estate. They can then opt for the risk-free rate on other leases of lower value.
ASC 842 requires private companies to disclose the asset classes to which the risk-free rate is applied.
IBR Best Practices
Undoubtedly, the incremental borrowing rate has proven to be a difficult change for lease accountants and finance teams. The companies handling it well follow some best practices, though.
Coming up with a reasonable base rate is a great starting point. Your first step should be to consider whether a rate from a recent loan can be used as a point of comparison. If this is of limited value to your company, look at all your company-specific factors like EBITDA and your current assets and liabilities.
From there, make adjustments based on lease-specific factors like lease term and collateral. Considering all the information in this guide will get you to a good estimate you can then work with.
The new lease accounting standards have made a case for comprehensive lease management systems. Software that is designed around the intricacies and nuances of modern lease accounting saves your team a lot of time and ensures compliance. If you haven’t looked into the options available in lease management software today, now is a great time to get started.
Occupier Is the Right Choice for Lease Accounting
At private and public companies, determining the IBR is just one of the challenges in modern lease accounting. A comprehensive lease management solution is a life-saver for businesses that want to spend less time doing the legwork and devote more time to making data-driven decisions. That’s where Occupier can help. We leverage a modern and innovative tech stack for your commercial real estate and lease management needs.
Whether it’s lease accounting, lease administration, or transaction management, our end-to-end solutions integrate with your ERP system to close the books every month, ensuring you are compliant with ASC 842 in the process. Occupier’s solutions will free your stakeholders to make better portfolio decisions for your business.
To see how Occupier can help your business take control of your real estate portfolio to help you comply with the new guidance and unlock opportunities within your business’s lease lifecycle, get in touch today or request a demo.
Schedule a Demo
See how the world’s fastest-growing commercial tenants use Occupier to power efficient tenant lease management workflows.