What is the Incremental Borrowing Rate?
The Incremental Borrowing Rate (IBR) is the rate of interest a lessee would have to pay to borrow funds to acquire an asset of similar type, with a similar term and under similar security conditions. In lease accounting, the IBR is the discount rate used to calculate the present value of lease payments when the interest rate implicit in the lease is not readily determinable.
Why is the IBR Important?
IFRS16 and ASC842, the two major leaseaccounting standards, require lessees to recognize lease assets and liabilities on the balance sheet. The discount rate used directly affects the size of the recognized liability and the amount of expense recognized over the lease term. An inaccurate IBR can therefore distort a companys financial ratios, debt covenants, and overall picture of financial health.
When to Use the IBR
The IBR is applied in the following situations:
- When the interest rate implicit in the lease cannot be determined because the lessor does not disclose it.
- When the lessee is required to calculate the present value of lease payments for a new lease.
- When assessing lease modifications that result in a change of the lease term or payment schedule.
Key Elements in Determining the IBR
The rate should reflect the following factors:
| Factor | Explanation |
|---|---|
| Credit Risk | Lessees credit rating or credit spread over a riskfree benchmark. |
| Lease Term | Length of the lease, including renewal options that are reasonably certain to be exercised. |
| Collateral | Security provided for the lease (e.g., lien on the underlying asset). |
| Market Conditions | Current interestrate environment, including base rates such as LIBOR, EURIBOR, or SOFR. |
| Currency | Currency of the lease payments and any related borrowing. |
Steps to Estimate the IBR
- Identify the lessees credit profile. Use credit ratings, internal credit scores, or observable spreads on comparable debt.
- Determine the appropriate base rate. Choose a benchmark (e.g., US Treasury yields, Euribor) that matches the lease currency and term.
- Add a credit spread. The spread compensates for the lessees credit risk and any lack of collateral.
- Adjust for leasespecific features. Factor in the existence of security, optional renewal terms, and payment frequency.
- Validate the rate. Compare the resulting rate with rates on similar term loans or leasing arrangements in the market.
Practical Example
Assume XYZ Corp is entering a fiveyear lease for a piece of equipment. The following information is available:
- Credit rating: BBB (average corporate rating).
- Relevant base rate: 3year US Treasury yield = 2.1%.
- Observed spread for BBB over Treasuries = 1.8%.
- Lease is unsecured.
Estimated IBR = 2.1% (base) + 1.8% (credit spread) = **3.9%**.
If the lease payments total $500,000 per year, the present value of the lease liability would be calculated using a 3.9% discount rate.
Common Pitfalls
- Using the lessees prevailing loan rate. This may ignore differences in security or term length.
- Ignoring renewal options. If renewal is reasonably certain, it must be incorporated into the term.
- Applying a single rate to all leases. Each lease may have distinct characteristics that affect the IBR.
- Failing to update the IBR. Market conditions change; the rate should be reviewed at each reporting date for new leases.
Impact on Financial Statements
The chosen IBR influences:
- Rightofuse asset and lease liability. Higher rates reduce the present value, lowering both assets and liabilities.
- Depreciation and interest expense. A higher IBR results in more interest expense early in the lease and less depreciation overall.
- Key ratios. Debttoequity, EBITDA, and interest coverage can shift noticeably with different discount rates.
Resources for Further Reading
- IFRS16 Leases
- ASC842 Leases (FASB)
- IASB Illustrative Examples Determining the Incremental Borrowing Rate.
- Professional accounting guidance (EY, PwC, KPMG) on lease accounting.
