Before we hop to it, let’s do a brief overview of the history of two of the most important changes to lease accounting principles in the past few decades, seeing as the definition of the incremental borrowing rate is contingent upon the stated definitions of a lease and its term.
The new lease accounting standards 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.
Because of this change, 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 Incremental Borrowing Rate is, and how exactly companies use it.
What is an IBR 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”.
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 IBR in Leases?
To calculate a lease’s liability, ASC 842 states that lessees should 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 it 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 it cannot determine the implicit rate, the challenge instead shifts to determining what rate should be used as the IBR.
Why is IBR Important?
The incremental borrowing rate is important because once it is clear that a contract includes a lease, the lease liability and ROU assets have to be recorded, and a rate needs to be determined in order to discount committed future lease payments. Since the rate implicit in the lease is so often not available, IBR is used.
How Do You Calculate Incremental Borrowing Rate?
There are about six factors to consider before calculating the incremental borrowing rate. These are:
- Lessee-Specific Credit Risk
Since an IBR 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.
- 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 IBR 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.
- 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 IBRs 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.
- 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 10 years left in its contract.
- 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 are much different than those in developed countries.
- 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 company, the less likely they are to default on a loan, which means less risk in the deal overall.
When it comes to determining the IBR 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, AKA 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.
In The End, It’s All Relative.
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.