Incremental borrowing rate: Meaning, Criticisms & Real-World Uses

What Is Incremental Borrowing Rate?

The Incremental Borrowing Rate (IBR) is the interest rate 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.⁶⁹, ⁷⁰, ⁷¹ This concept is central to financial reporting and accounting standards, particularly under the modern lease accounting frameworks of ASC 842 (U.S. Generally Accepted Accounting Principles or US GAAP) and IFRS 16 (International Financial Reporting Standards or IFRS). When a company leases an asset, such as a building or equipment, and the rate implicit in the lease cannot be readily determined, the lessee must use the incremental borrowing rate to calculate the present value of its lease payments.⁶⁴, ⁶⁵, ⁶⁶, ⁶⁷, ⁶⁸ This calculated present value determines the initial measurement of the lease liability and the corresponding right-of-use asset recognized on the balance sheet.⁶¹, ⁶², ⁶³

History and Origin

The significance of the Incremental Borrowing Rate surged with the introduction of new lease accounting standards, notably ASC 842 in the United States and IFRS 16 internationally. Before these standards, many operating lease obligations were not reported on companies' balance sheets, leading to a lack of transparency regarding a significant portion of their financial commitments.⁵⁸, ⁵⁹, ⁶⁰ Regulators and financial stakeholders identified this "off-balance sheet financing" as a major deficiency.⁵⁷

To address this, the Financial Accounting Standards Board (FASB) and the International Accounting Standards Board (IASB) initiated efforts to converge their standards and bring nearly all leases onto the balance sheet.⁵⁵, ⁵⁶ This global shift aimed to provide investors and other users of financial statements with a more comprehensive and accurate view of a company's financial position and obligations. The new standards require companies to recognize a right-of-use (ROU) asset and a corresponding lease liability for most leases with terms longer than 12 months.⁵², ⁵³, ⁵⁴ The CFA Institute highlighted how these changes, effective typically from January 1, 2019, made previously "invisible leverage" from leasing activities visible, necessitating a deeper understanding of underlying assumptions like the discount rate selected.⁴⁹, ⁵⁰, ⁵¹ The Incremental Borrowing Rate became the default discount rate when the rate implicit in the lease, which is often difficult to ascertain, could not be readily determined.⁴⁶, ⁴⁷, ⁴⁸

Key Takeaways

The Incremental Borrowing Rate (IBR) is the discount rate used by lessees to value lease liabilities when the rate implicit in the lease is not readily determinable.
It represents the hypothetical interest rate a company would incur to borrow funds for an asset similar in value to the right-of-use asset, over a similar term, and with similar collateral.
IBR became crucial with the adoption of new lease accounting standards (ASC 842 and IFRS 16) that require most leases to be recognized on the balance sheet.
Factors influencing IBR include the lessee's credit risk, the lease term, the nature of the underlying asset, and the economic environment.
A higher IBR generally results in a lower recognized lease liability, impacting a company's financial metrics.

Formula and Calculation

While there isn't a single universal formula for the Incremental Borrowing Rate, its determination involves estimating the rate a lessee would face for a hypothetical secured loan. This often begins with observable market rates and then making adjustments based on specific lease and borrower characteristics.

The IBR should consider several factors:

The creditworthiness of the lessee.⁴³, ⁴⁴, ⁴⁵
The term of the lease (maturity).³⁹, ⁴⁰, ⁴¹, ⁴²
The nature and quality of the underlying asset serving as collateral.³⁷, ³⁸
The amount of the hypothetical borrowing, which is equal to the lease payments.³³, ³⁴, ³⁵, ³⁶
The economic environment (e.g., country, currency, date of the lease).²⁹, ³⁰, ³¹, ³²

A common approach to estimating the IBR involves taking a risk-free rate appropriate for the lease term and adding a credit spread that reflects the lessee's credit risk and collateralization. For example, a company might start with a relevant yield curve for government bonds and then add an adjustment for its own specific credit risk profile.²⁸

Interpreting the Incremental Borrowing Rate

The Incremental Borrowing Rate serves as a crucial input for valuing lease obligations on a company's balance sheet under modern accounting standards. Its interpretation directly impacts the reported lease liability and right-of-use asset. A higher Incremental Borrowing Rate results in a lower present value of future lease payments, thereby leading to a lower lease liability recognized. Conversely, a lower IBR yields a higher lease liability.²⁷ This sensitivity means that the determination of the Incremental Borrowing Rate is a significant judgment call for management and can materially affect a company's reported financial position.²⁶

The chosen IBR should reflect a rate that a hypothetical lender would charge for a fully collateralized loan of a similar amount and term. This ensures that the financial statements accurately represent the economic substance of the lease arrangement, reflecting the cost of obtaining the right to use the underlying asset. Analysts reviewing financial statements will scrutinize the Incremental Borrowing Rate assumptions to understand their impact on key financial ratios and to compare companies.

Hypothetical Example

Consider Tech Solutions Inc., a company needing new manufacturing equipment for five years. The total undiscounted lease payments over the five-year term are $1,000,000, payable annually in equal installments of $200,000. The rate implicit in the lease cannot be readily determined by Tech Solutions Inc.

To calculate the lease liability and right-of-use asset under ASC 842, Tech Solutions Inc. must determine its Incremental Borrowing Rate. After assessing its creditworthiness, the current market environment, and the collateral provided by the equipment, Tech Solutions Inc.'s treasury department determines an Incremental Borrowing Rate of 6% for a five-year collateralized loan of a similar value.

Using this 6% Incremental Borrowing Rate, the present value of the $200,000 annual lease payments for five years would be calculated as follows:

PV = \sum_{t=1}^{n} \frac{PMT}{(1 + IBR)^t}

Where:

(PV) = Present Value of Lease Payments (Lease Liability)
(PMT) = Annual Lease Payment ($200,000)
(IBR) = Incremental Borrowing Rate (0.06)
(t) = Year (1 to 5)
(n) = Total Lease Term (5 years)

The present value calculation would yield approximately $842,473. Tech Solutions Inc. would then recognize a lease liability of $842,473 and a corresponding right-of-use asset of $842,473 on its balance sheet. This example illustrates how the Incremental Borrowing Rate directly translates future lease obligations into a quantifiable balance sheet entry.

Practical Applications

The Incremental Borrowing Rate is primarily applied within the realm of financial accounting and financial reporting, particularly under current lease accounting standards.

Lease Liability Valuation: Companies use the IBR to discount future lease payments to their present value, which is then recorded as a lease liability on the balance sheet. This is a mandatory requirement under both US GAAP (ASC 842) and IFRS (IFRS 16) when the implicit rate is not readily available.²⁰, ²¹, ²², ²³, ²⁴, ²⁵
Right-of-Use Asset Recognition: Concurrently with the lease liability, a right-of-use asset is recognized, which is largely based on the initial measurement of the lease liability. The IBR, therefore, directly influences the reported value of this asset.¹⁹
Financial Analysis and Comparability: For investors and analysts, understanding the Incremental Borrowing Rate is crucial for evaluating a company's true leverage and financial health. The adoption of the new lease accounting standards, and thus the use of IBR, has significantly enhanced the comparability of financial statements across companies by bringing previously off-balance sheet obligations onto the balance sheet. This increased transparency helps stakeholders better assess the amount, timing, and uncertainty of cash flows related to leases.¹⁷, ¹⁸
Auditing and Compliance: Companies must meticulously document their determination of the IBR, as it is a key assumption that external auditors will review to ensure compliance with relevant accounting standards. Accounting firms like KPMG offer services to help companies develop robust estimates for Incremental Borrowing Rates, recognizing that market indications for such specific borrowings are often not readily available.¹⁶

Limitations and Criticisms

Despite its crucial role in modern lease accounting, the Incremental Borrowing Rate is not without its limitations and criticisms. One primary challenge lies in its subjective nature and the difficulty in precisely determining the rate.¹³, ¹⁴, ¹⁵

Subjectivity in Estimation: The definition of IBR requires estimating a rate for a "hypothetical" collateralized borrowing in a "similar economic environment." This involves significant judgment, as a readily observable market rate for a loan with the exact same terms, security, and payment profile as a specific lease is rarely available.¹¹, ¹² Companies often start with public corporate bond yields or their existing debt rates and then make adjustments for collateralization, lease term differences, and the specific nature of the underlying asset. The challenge is in quantitatively adjusting these rates to arrive at a precise IBR.¹⁰
Impact on Financial Statements: The discretion involved in determining the IBR can introduce variability in how different companies, or even different leases within the same company, are accounted for. Since the IBR directly influences the lease liability and right-of-use asset, and consequently metrics on the income statement (through depreciation of the ROU asset and interest on the lease liability), an inaccurate or inconsistent rate can affect a company's reported financial performance and position.⁹
Complexity for Non-Experts: Calculating and justifying the Incremental Borrowing Rate can be complex, requiring expertise in corporate finance, credit analysis, and accounting standards. This complexity can be a burden, especially for smaller entities or those with a large volume of diverse leases.

While accounting standards aim for transparency, the inherent estimation required for the Incremental Borrowing Rate means that users of financial statements still need to understand the underlying assumptions and potentially differing methodologies employed by various companies.

Incremental Borrowing Rate vs. Rate Implicit in the Lease

The Incremental Borrowing Rate (IBR) and the rate implicit in the lease are both discount rates used in lease accounting under US GAAP (ASC 842) and IFRS (IFRS 16), but they have distinct definitions and application priorities.

The rate implicit in the lease is the interest rate that, at the commencement of the lease, 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. In essence, it's the actual yield the lessor earns on the lease. This rate is considered the primary discount rate to be used by the lessee if it can be "readily determined."⁵, ⁶, ⁷, ⁸

The Incremental Borrowing Rate, as discussed, is the hypothetical rate a lessee would pay for a secured loan to acquire an asset of similar value over a similar term in a similar economic environment. It is used as a fallback option when the rate implicit in the lease is not readily determinable, which is often the case.¹, ², ³, ⁴ The key difference lies in their source and determinability: the implicit rate is specific to the lease transaction and the lessor's perspective (though used by the lessee), while the IBR is specific to the lessee's borrowing capabilities and the broader market.

FAQs

What is the primary purpose of the Incremental Borrowing Rate?

The primary purpose of the Incremental Borrowing Rate is to serve as the discount rate used by a lessee to calculate the present value of lease payments when the rate implicit in the lease cannot be readily determined. This calculation is essential for recognizing lease liabilities and right-of-use assets on the balance sheet under modern accounting standards.

Does every lease require the use of an Incremental Borrowing Rate?

No. Under both US GAAP (ASC 842) and IFRS (IFRS 16), the rate implicit in the lease is the preferred discount rate. The Incremental Borrowing Rate is only used if the rate implicit in the lease cannot be readily determined by the lessee. In practice, however, the implicit rate is often not readily available, making the Incremental Borrowing Rate frequently used.

How does the Incremental Borrowing Rate impact a company's financial statements?

The Incremental Borrowing Rate directly impacts the initial measurement of the lease liability and the right-of-use asset on a company's balance sheet. A higher IBR results in a lower present value of lease payments and thus a lower lease liability, and vice versa. This also affects the income statement over the lease term through the recognition of interest expense on the lease liability and depreciation of the right-of-use asset.

Can the Incremental Borrowing Rate change over time?

Yes, the Incremental Borrowing Rate can change. It is determined at the commencement date of the lease and reflects the economic environment at that time, as well as the lessee's credit risk. If there are significant changes in market interest rates, the lessee's creditworthiness, or a modification to the lease, the IBR may need to be revised for subsequent accounting adjustments or new leases.

Is the Incremental Borrowing Rate the same as a company's typical borrowing rate?

Not necessarily. While a company's general borrowing rate can be a starting point, the Incremental Borrowing Rate is specifically defined for lease accounting. It requires reflecting a "collateralized basis" and an amount "equal to the lease payments" over a "similar term," potentially requiring adjustments from a company's standard unsecured or general-purpose debt rates to meet the precise definition under accounting standards.