Incremental leasing cost: Meaning, Criticisms & Real-World Uses

What Is Incremental Leasing Cost?

Incremental leasing cost, also known as the incremental borrowing rate, is a key concept within lease accounting that refers to the interest rate a lessee (the company or individual leasing an asset) would have to pay to borrow funds necessary to purchase the asset over a similar term and with a similar security in a comparable economic environment. This rate is crucial for determining the present value of lease payments and, consequently, the lease liability and right-of-use asset recognized on a company's balance sheet under modern accounting standards like IFRS 16 and ASC 842. When the interest rate implicit in a lease cannot be readily determined, the incremental leasing cost serves as the required discount rate for lease accounting purposes.

History and Origin

The concept of incremental leasing cost gained significant prominence with the overhaul of global lease accounting standards. For decades, many leases, particularly those classified as "operating leases," were not fully recognized on a company's balance sheet, leading to what was often termed "off-balance sheet financing." This practice made it difficult for investors and other stakeholders to fully assess a company's financial leverage and true contractual obligations.

To address this lack of transparency, the International Accounting Standards Board (IASB) and the Financial Accounting Standards Board (FASB) collaborated to develop new standards. The IASB issued IFRS 16, Leases, in January 2016, effective for annual periods beginning on or after January 1, 2019¹¹. Similarly, the FASB issued Accounting Standards Update (ASU) 2016-02, Leases (codified as FASB ASC 842), in 2016, with varying effective dates for public and private companies⁹, ¹⁰. Both standards aimed to bring most leases onto the balance sheet by requiring lessees to recognize a right-of-use asset and a corresponding lease liability⁷, ⁸.

A central challenge in implementing these new standards was determining the appropriate discount rate for lease payments. While the interest rate implicit in the lease is preferred, it is often not readily determinable by the lessee. Therefore, both IFRS 16 and ASC 842 stipulate the use of the lessee's incremental borrowing rate—the incremental leasing cost—as a practical alternative. This requirement cemented the incremental leasing cost as a fundamental input in modern lease accounting, providing a standardized, albeit estimated, approach for valuing lease obligations.

#⁶# Key Takeaways

The incremental leasing cost is the interest rate a lessee would pay to borrow funds to acquire the leased asset.
It is used as the discount rate for lease payments when the implicit interest rate in the lease cannot be easily determined.
This rate is critical for calculating the lease liability and right-of-use asset on the balance sheet under IFRS 16 and ASC 842.
A higher incremental leasing cost results in a lower recognized lease liability and right-of-use asset.
Factors like the lessee's credit risk, lease term, and collateral influence the determination of the incremental leasing cost.

Formula and Calculation

The incremental leasing cost itself is a rate, not a calculated value derived from a specific formula. However, this rate is a crucial input into the formula used to calculate the present value of lease payments, which in turn determines the lease liability. The general formula for the present value of lease payments is:

$\text{Lease Liability} = \sum_{t=1}^{n} \frac{\text{LP}_t}{(1 + r)^t}$

Where:

(\text{LP}_t) = Lease Payment in period (t)
(r) = The discount rate, which is the implicit interest rate in the lease if determinable, or the incremental leasing cost if not.
(n) = Total number of lease payments over the lease term

For example, if a company has lease payments of $1,000 per month for 60 months and determines its incremental leasing cost to be 5% per annum, this rate would be used to discount each monthly payment back to its present value to arrive at the initial lease liability.

Interpreting the Incremental Leasing Cost

Interpreting the incremental leasing cost involves understanding its role as a proxy for the actual cost of financing the leased asset. It reflects the borrowing rate available to the lessee given its specific financial standing, the nature of the collateral (the leased asset itself), and prevailing market interest rates at the commencement of the lease.

A higher incremental leasing cost implies that the company would face higher borrowing expenses for an equivalent asset. This higher rate, when used in the present value calculation, results in a lower initial lease liability and a corresponding lower right-of-use asset. Conversely, a lower incremental leasing cost (due to, for example, a strong credit rating or favorable market conditions) leads to a higher initial lease liability and right-of-use asset.

Companies must exercise judgment in determining this rate, considering their credit rating, recent borrowing activities, and publicly available data for similar transactions involving secured debt. The objective is to arrive at a rate that faithfully represents the economic reality of the specific borrowing scenario for that lessee and asset.

Hypothetical Example

Consider TechSolutions Inc., a company looking to lease new office equipment. The lease agreement specifies monthly payments of $5,000 for a five-year (60-month) term. The interest rate implicit in the lease is not readily available to TechSolutions.

Determine the Incremental Leasing Cost: TechSolutions' finance team assesses its current borrowing environment. It recently secured a loan for similar equipment with a 6% annual interest rate. Factoring in the lease term and the nature of the equipment as collateral, they determine their incremental leasing cost to be 5.5% per annum, or approximately 0.4583% per month (5.5% / 12).
Calculate Present Value of Lease Payments: Using this incremental leasing cost, TechSolutions calculates the present value of the 60 monthly payments of $5,000.
Record on Balance Sheet: The calculated present value, say $260,000, is then recorded as both a lease liability and a corresponding right-of-use asset on TechSolutions' balance sheet. This entry provides transparent insight into the company's financial obligations related to the lease.

Practical Applications

The incremental leasing cost has several practical applications across various aspects of financial reporting and analysis:

Financial Statement Preparation: Under IFRS 16 and ASC 842, companies are required to recognize nearly all leases on their balance sheets. The incremental leasing cost is the primary rate used when the lease's implicit rate is unknown, directly impacting the recorded lease liability and right-of-use asset amounts. Th⁵is ensures a more comprehensive view of a company's assets and obligations.
Financial Analysis: Analysts use the lease liability derived from calculations using the incremental leasing cost to better assess a company's overall debt obligations and leverage ratios. This provides a clearer picture than under older accounting standards, where significant lease commitments could be hidden off-balance sheet.
⁴ Comparability: By standardizing how leases are brought onto the balance sheet, even with the use of the incremental leasing cost, the new accounting rules enhance the comparability of financial statements between companies that lease assets and those that purchase them outright.
³ Credit Decision Making: Lenders and creditors analyze a company's lease liabilities, which are influenced by the incremental leasing cost, to evaluate its ability to meet its financial commitments. A more transparent view of these obligations aids in assessing borrowing capacity and risk. The Financial Accounting Standards Board (FASB) provides extensive guidance on ASC 842 for proper accounting of lease changes, which directly impacts these considerations.

#²# Limitations and Criticisms

While the incremental leasing cost is a necessary component of modern lease accounting, it is not without its limitations and criticisms:

Subjectivity: Determining the precise incremental leasing cost can be subjective. It requires management's judgment to estimate the rate a company would incur for similar collateralized borrowing. This subjectivity can lead to variations in the reported lease liabilities between companies, even if their objective borrowing rates are similar. Companies must maintain robust documentation to support their chosen rate.
Complexity: Calculating and applying the incremental leasing cost adds complexity to the lease accounting process, particularly for companies with numerous leases or those that traditionally relied on off-balance sheet operating leases. The estimation process requires careful consideration of the lessee's credit profile, the lease term, and the nature of the underlying asset. The American Institute of Certified Public Accountants (AICPA) highlights the ongoing challenges private companies face in implementing and maintaining compliance with ASC 842, including proper discount rate determination.
¹ Impact on Financial Ratios: The capitalization of operating leases due to the application of the incremental leasing cost can significantly alter key financial ratios, such as debt-to-equity and return on assets. While this improves transparency, it can initially impact how investors and analysts perceive a company's financial health if they do not adjust their analytical models accordingly.
Lack of Readily Available Information: For private companies or those with less frequent borrowing activities, determining a reliable incremental leasing cost can be challenging, as there may not be easily accessible market data for comparable secured borrowings. In such cases, entities may need to rely on alternatives like the risk-free rate, adjusted for their credit risk, or seek professional valuation assistance.

Incremental Leasing Cost vs. Lease Liability

It is important to distinguish between the incremental leasing cost and lease liability, as they are related but distinct concepts in lease accounting.

The incremental leasing cost is an interest rate—specifically, the rate a lessee would have to pay to borrow funds to purchase the asset it is leasing, considering a similar term and security. It is essentially a hypothetical borrowing rate used as a discount factor.

In contrast, the lease liability is a monetary amount—it represents the present value of the lessee's obligation to make lease payments over the lease term. It is a financial obligation recognized on the balance sheet, similar to a loan.

The confusion often arises because the incremental leasing cost is a crucial input used to calculate the lease liability. If the interest rate implicit in the lease is not known, the incremental leasing cost becomes the primary rate applied to discount future lease payments to arrive at the lease liability. Therefore, while one is a rate and the other is an obligation, the latter's measurement often directly depends on the former.

FAQs

What is the primary purpose of the incremental leasing cost?

The primary purpose of the incremental leasing cost is to provide a discount rate for calculating the present value of lease payments when the interest rate implicit in a lease cannot be readily determined. This allows companies to properly record lease liabilities and right-of-use assets on their balance sheet under new accounting standards.

How does a company determine its incremental leasing cost?

A company determines its incremental leasing cost by considering the interest rate it would pay for a new loan to purchase the same asset, for a similar term, and with similar collateral. This involves assessing its own creditworthiness and current market conditions for similar debt.

What happens if the incremental leasing cost is higher or lower?

A higher incremental leasing cost results in a lower recognized lease liability and right-of-use asset on the balance sheet, as future payments are discounted more heavily. Conversely, a lower incremental leasing cost leads to a higher initial lease liability and asset, reflecting a lower cost of financing.

Is the incremental leasing cost always used in lease accounting?

No, the incremental leasing cost is only used if the interest rate implicit in the lease cannot be readily determined by the lessee. If the implicit rate is known, it is the preferred discount rate for calculating the lease liability.