Absolute incremental borrowing rate: Meaning, Criticisms & Real-World Uses

What Is Absolute Incremental Borrowing Rate?

The Absolute Incremental Borrowing Rate refers to the rate of interest a lessee would have to pay to borrow funds necessary to obtain an asset of similar value to the right-of-use asset in a lease accounting arrangement. This rate is determined considering a similar term, comparable security, and the prevailing economic environment. It is a fundamental concept within financial accounting, specifically under International Financial Reporting Standard 16 (IFRS 16), and is crucial for measuring the lease liability when the interest rate implicit in the lease cannot be readily determined. The Absolute Incremental Borrowing Rate essentially represents the hypothetical cost a lessee would incur if they were to borrow the funds to purchase the asset outright instead of leasing it.

History and Origin

The concept of the incremental borrowing rate, and by extension, the Absolute Incremental Borrowing Rate, gained significant prominence with the issuance of IFRS 16, 'Leases', by the International Accounting Standards Board (IASB) in January 2016.⁷ This new standard became effective for annual reporting periods beginning on or after January 1, 2019, replacing the previous standard, IAS 17.⁶

Prior to IFRS 16, many leases were classified as "operating leases" and remained off the balance sheet, masking a company's true debt financing obligations.⁵ The IASB's motivation was to bring transparency to these substantial lease obligations, ensuring that nearly all leases are recognized on the balance sheet, thus providing a more faithful representation of a company's financial position. To achieve this, IFRS 16 introduced a single lessee accounting model, requiring lessees to recognize a right-of-use asset and a corresponding lease liability for most leases.⁴ The Absolute Incremental Borrowing Rate became a critical component in the measurement of this lease liability, particularly when the implicit rate in the lease agreement is not easily ascertainable.

Key Takeaways

The Absolute Incremental Borrowing Rate is the hypothetical interest rate a lessee would pay to borrow funds to acquire an asset similar to the one being leased.
It is primarily used in lease accounting under International Financial Reporting Standard 16 (IFRS 16) to measure the lease liability.
This rate is applied when the interest rate implicit in the lease, which is typically preferred, cannot be readily determined by the lessee.
Determining the Absolute Incremental Borrowing Rate requires careful judgment, considering factors like the lease term, type of asset, and the lessee's creditworthiness.
Its application impacts a company's financial statements by affecting the recorded lease liability, right-of-use asset, and subsequent depreciation and interest expenses.

Formula and Calculation

The Absolute Incremental Borrowing Rate itself is not calculated via a fixed formula but rather determined based on market conditions and the specific circumstances of the lessee. However, it is used in the calculation of the lease liability.

Under IFRS 16, the lease liability is initially measured at the present value of the lease payments that are not paid at the commencement date. These lease payments are discounted using the interest rate implicit in the lease. If that rate cannot be readily determined, the lessee must use its Absolute Incremental Borrowing Rate as the discount rate.³

The formula for the lease liability ((LL)) using the Absolute Incremental Borrowing Rate ((IBR)) is:

LL = \sum_{t=1}^{n} \frac{P_t}{(1 + IBR)^t}

Where:

(LL) = Lease Liability
(P_t) = Lease payment in period (t)
(IBR) = Absolute Incremental Borrowing Rate (or the lessee's incremental borrowing rate)
(t) = Period number
(n) = Total number of periods (lease term)

The determination of the IBR involves considering various factors, including:

The term of the lease.
The nature and quality of the collateral (the underlying asset).
The lessee's credit standing and historical borrowing rates for similar financing.
The economic environment at the lease commencement date.

Interpreting the Absolute Incremental Borrowing Rate

The Absolute Incremental Borrowing Rate serves as a proxy for the hypothetical borrowing cost associated with acquiring the leased asset. A higher Absolute Incremental Borrowing Rate implies a higher perceived risk for the lessee or higher general market interest rates. When applied to calculate the lease liability, a higher rate results in a lower initial present value of the lease payments, and consequently, a lower recorded lease liability and right-of-use asset. Conversely, a lower rate will lead to a higher initial lease liability and right-of-use asset.

This rate directly influences the values presented on a company's balance sheet and the subsequent interest expense and depreciation charges recognized in the income statement over the lease term. Entities must exercise significant judgment and gather robust evidence to determine a defensible Absolute Incremental Borrowing Rate, as it has a direct impact on key financial metrics.

Hypothetical Example

Consider "Tech Innovations Inc." (TII), which leases specialized manufacturing equipment for a non-cancellable period of five years. The annual lease payments are $100,000, payable at the end of each year. The interest rate implicit in the lease cannot be readily determined by TII.

To determine the initial lease liability, TII needs to establish its Absolute Incremental Borrowing Rate. After consulting with its bank and considering current market rates for similar collateralized five-year loans, TII determines its Absolute Incremental Borrowing Rate to be 5% per annum.

Using this rate, the present value of the lease payments is calculated as follows:

Year 1: $100,000 / (1 + 0.05)^1 = $95,238.10
Year 2: $100,000 / (1 + 0.05)^2 = $90,702.95
Year 3: $100,000 / (1 + 0.05)^3 = $86,383.76
Year 4: $100,000 / (1 + 0.05)^4 = $82,270.25
Year 5: $100,000 / (1 + 0.05)^5 = $78,352.62

The total initial lease liability (and corresponding right-of-use asset) recognized by TII on its balance sheet would be the sum of these present values: $95,238.10 + $90,702.95 + $86,383.76 + $82,270.25 + $78,352.62 = $432,947.68. This example demonstrates how the Absolute Incremental Borrowing Rate directly translates future lease obligations into a quantifiable balance sheet entry.

Practical Applications

The Absolute Incremental Borrowing Rate is a cornerstone of lease accounting under International Financial Reporting Standards (IFRS), particularly since the adoption of IFRS 16. Its primary application is in situations where the interest rate implicit in a lease agreement cannot be readily determined by the lessee. This often occurs because the lessee lacks sufficient information regarding the fair value of the leased asset or the lessor's initial direct costs.

Companies utilize the Absolute Incremental Borrowing Rate to:

Calculate Lease Liabilities: It is the required discount rate for determining the present value of future lease payments, which forms the basis for recognizing the lease liability and corresponding right-of-use asset on the balance sheet.
Impact Financial Ratios: By influencing the size of lease liabilities, the Absolute Incremental Borrowing Rate indirectly affects key financial ratios, such as debt-to-equity and leverage ratios, which are critical for assessing a company's credit rating and overall financial health.
Ensure Comparability: While challenging to determine, the consistent application of a properly derived Absolute Incremental Borrowing Rate aims to improve the comparability of financial statements among companies that extensively use leases, particularly compared to those that choose to purchase assets outright. The IASB's aim with IFRS 16 was to enhance transparency regarding companies' lease assets and liabilities, thereby improving comparability.,²
Inform Management Decisions: Although primarily an accounting measure, the underlying analysis required to determine this rate can provide management with insights into their effective cost of capital for obtaining asset use rights.
Regulatory Compliance: Publicly traded companies adhering to IFRS must demonstrate robust methodologies for determining their Absolute Incremental Borrowing Rate to comply with regulatory requirements, such as those overseen by bodies like the Securities and Exchange Commission (SEC). An EY publication highlights the complexities and considerations in determining this rate under IFRS 16.¹

Limitations and Criticisms

While the Absolute Incremental Borrowing Rate plays a vital role under IFRS 16, its determination presents several limitations and has drawn criticism.

One primary challenge lies in the subjectivity and judgment required to determine the rate. Unlike a readily available market rate for a specific bond, a lessee's hypothetical borrowing rate for an asset of similar value, term, and security is often not directly observable. Factors such as the lessee's internal credit rating, the specific nature of the right-of-use asset, and the economic environment must be carefully considered and estimated. This can lead to variability in the rate applied by different entities or even within the same entity for different leases, potentially affecting comparability.

Another criticism stems from the data availability. Smaller entities or those with less frequent external borrowing may struggle to identify an appropriate comparable borrowing rate, lacking the necessary market data or internal benchmarks. This can lead to increased costs for obtaining expert valuations or financial advice to arrive at a defensible rate.

Furthermore, the need to regularly reassess and update the Absolute Incremental Borrowing Rate for lease modifications or remeasurements adds complexity and administrative burden. Changes in a company's creditworthiness or general market conditions could necessitate adjustments, requiring ongoing vigilance in lease accounting practices. These complexities can lead to significant changes in a company's reported balance sheet and income statement figures.

Absolute Incremental Borrowing Rate vs. Interest Rate Implicit in the Lease

The Absolute Incremental Borrowing Rate and the Interest Rate Implicit in the Lease are both discount rates used in lease accounting under IFRS 16 to calculate the present value of lease payments. However, their nature and application differ significantly.

Feature	Absolute Incremental Borrowing Rate	Interest Rate Implicit in the Lease
Definition	The rate of interest a lessee would have to pay to borrow funds necessary to obtain an asset of similar value to the right-of-use asset in a similar economic environment, with similar terms and security. It's the lessee's hypothetical borrowing cost.	The discount rate that, at the commencement date, causes the present value of the lease payments and the unguaranteed residual value to equal the sum of the fair value of the underlying asset and any initial direct costs of the lessor.
Primary User/Perspective	Lessee's perspective. It reflects the lessee's credit risk and borrowing power.	Lessor's perspective. It equates the lessor's investment in the lease to the return generated.
Application Order	Used as a fallback. Applied only if the Interest Rate Implicit in the Lease cannot be readily determined.	Preferred rate. Used as the primary discount rate when it can be readily determined by the lessee.
Determinability	Often requires significant judgment and estimation, as it is a hypothetical rate not always directly observable. Lessees may need to reference their own borrowing history or external market data.	Can be challenging for lessees to determine, as it requires knowledge of the lessor's specific inputs (fair value of asset, unguaranteed residual value, initial direct costs), which may not be transparently provided.
Impact on Financials	Directly impacts the initial measurement of the lease liability and subsequent interest expense and depreciation if the implicit rate is unknown.	Directly impacts the initial measurement of the lease liability and subsequent interest and depreciation expenses if it is readily determinable and used.

The core confusion arises because both rates serve the same mathematical function in the present value calculation. However, the Interest Rate Implicit in the Lease is specific to the lease transaction itself, encompassing the lessor's overall return, while the Absolute Incremental Borrowing Rate is external to the lease terms and specific to the lessee's own financing capabilities. IFRS 16 mandates a specific hierarchy, prioritizing the implicit rate when available, and reverting to the Absolute Incremental Borrowing Rate as a necessary alternative.

FAQs

What is the main purpose of the Absolute Incremental Borrowing Rate under IFRS 16?

The main purpose of the Absolute Incremental Borrowing Rate under IFRS 16 is to serve as the discount rate for calculating the initial lease liability when the interest rate implicit in the lease cannot be easily determined by the lessee. This ensures that a lease liability and a corresponding right-of-use asset are recognized on the balance sheet, improving financial transparency.

How does a company determine its Absolute Incremental Borrowing Rate?

Determining the Absolute Incremental Borrowing Rate requires judgment and considering various factors. A company typically looks at rates it would have to pay for new borrowing with a similar term, similar collateral, and in the same economic environment as the lease. This might involve looking at recent loans, current market interest rates for comparable debt, or seeking professional valuation.

Does the Absolute Incremental Borrowing Rate apply to all leases?

No, the Absolute Incremental Borrowing Rate is specifically applied when the interest rate implicit in the lease, which is the preferred discount rate under IFRS 16, cannot be readily determined by the lessee. Additionally, short-term leases (12 months or less) and leases of low-value assets are exempt from these on-balance sheet recognition requirements.