Lease accounting is a critical component of a company’s financial reporting obligations. With the new lease accounting standard, ASC 842, companies are required to recognize most leases on their balance sheets. Companies must report lease liabilities and right-of-use assets for leases that meet certain criteria. One of the key elements of this process is the determination of the lease liability, which is based on the present value of lease payments.
To calculate the present value, companies must use an appropriate discount rate. The incremental borrowing rate (IBR) is practically the discount rate used to determine the present value of lease payments (because the alternative would be to use the lessor’s implicit rate that is almost never known to the lessee in an arm’s length transaction). The IBR is the rate of interest that a lessee would have to pay to borrow funds over a similar term, secured on similar collateral, and with a similar credit rating to the lease. It represents the rate at which a lessee could obtain financing to purchase an asset of similar value to the leased asset.
The IBR is specific to each lessee and is determined at the lease commencement date. It is based on the lessee’s credit worthiness and is influenced by a variety of factors such as the term of the lease, the type of asset being leased, and the economic environment (usually determined by the country the lease is located in). In practice, the IBR can be determined in several ways, such as by looking at the lessee’s incremental borrowing rate for a similar term loan, the rate on a bond with a similar term, or by using a benchmark rate plus a risk premium.
The IBR determines the amount of the lease liability to be recognized on the balance sheet. The IBR is also used to determine the right-of-use asset, which represents the lessee’s right to use the underlying asset over the lease term.
A higher IBR will result in a lower present value of lease payments, which will result in a lower lease liability and a lower right-of-use asset. Conversely, a lower IBR will result in a higher present value of lease payments, which will result in a higher lease liability and a higher right-of-use asset.
Companies whose lease liabilities and assets are significant relative to their balance sheet would need to pay closer attention to the determination of their IBR, because it could have a material impact on the valuation of their lease liabilities and assets. In general, a valid convention should be applied in consultation with the company’s auditors and then applied consistently, until circumstances change.
Lease accounting software can also be a helpful tool for companies when it comes to determining the incremental borrowing rate for lease accounting. Software like EZLease can assist with accurately tracking lease data, automating calculations based on IBR convention applied, and producing reports that can aid in better decision-making.