ASC 842 requires lessees to use the rate implicit in the lease agreement for the Net Present Value (NPV) calculations furthermore required to set up lease liabilities and ROU assets for virtually every lease. However, the FASB recognized that implicit rate information is not always readily available. ASC 842 allows the use of an Incremental Borrowing Rate (IBR) when the rate information is not included in the lease agreement
To fully calculate the implicit rate in a lease, the lessee has to know about many variables. Most of which are typically controlled very closely by the lessor. Some even impact negotiations and therefore the lessor is seldom likely to release all information. Therefore, the IBR is used most often in practice as lessees comply with lease accounting guidelines.
ASC 842 defines the IBR specifically as, “The rate of interest that 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.”
Why private companies go with IBR
ASC 842 also allows private companies to use a risk free rate. However, many private companies are opting to calculate an IBR as opposed to using the risk free rate. This is because of the required present value calculations. The charts below show a stream of 5 annual payments that add up to $500,000. Applying the NPV calculation in Excel using various discount rates proves that the lower the discount rate, the higher the NPV. Because NPV is the basis for the Lease Liability under ASC 842, many companies are correspondingly opting to use the higher IBR vs the risk free rate. Thus reducing the impact to the balance sheet.
Methods for securing IBR
There are many appropriate methods for capturing and maintaining the IBR. Some companies have contracted with firms that specialize in valuations, some work with their bankers on a regular basis to obtain the information, some work with their internal Treasury department, and the list goes on. Because the IBR is a key variable with a major impact on lease accounting calculations, it is important for companies to set an IBR policy and review with auditors. Below is one a practical method many companies use:
Five steps to calculate and maintain the IBR (an example)
- Discuss the definition of IBR with your internal Treasury team. Ask for the current rates for each of the buckets you identify.
- US 5, 10, 15, 20 year leases and similar for international locations, note that some company’s interpretations lead to only setting up rates based on the HQ location, because that is where all borrowing occurs.
- Compare the rates that Treasury identifies with current readily available risk free rates. The example presented in the chart shows the US Treasury Yields from the Bloomberg website.
- Compare the difference in the current risk free rate and your company’s current IBR by bucket. The industry term for the difference is the “spread”. For example, if your company’s Treasury department confirms that the current rate for 5 years is 3.59% and the rate pulled from Bloomberg is 1.59%, the spread is 2%.
- Now you have a simple mechanism to update the 5 year rate any time lease accounting requires the rate. It would be inefficient to go to Treasury each time for an update. However, it is quick and easy to pull the latest risk free rate from Bloomberg. You simply add the pre-established spread and move on. For example, assume one month has gone by and the Bloomberg site says the new risk free rate is 1.75%. Add the 2% spread, and your new IBR is 3.75%.
- This method is reasonable because it captures the macroeconomic factors regarding interest rates (fluctuations in the publicly available risk free rate). It also captures more microeconomic factors (e.g. company credit rating) in the spread. It is important to review the method with your Treasury team and update the spread periodically.
This is one practical method for capturing and maintaining effectively used IBR data. There are, however, others that may be appropriate. The best practice is to identify a reasonable method, document internally, and review with auditors.
There are many details and calculations associated with real estate and equipment leases. A comprehensive lease management software solution designed to efficiently and effectively control that data is essential. Contact CoStar Real Estate Manager today to learn more.