How to Calculate Incremental Borrowing Rate with ASC 842 Software

As companies navigate lease management, they often need to update their discount rates. This helps them with accounting calculations for new and for existing leased assets that have changed. This can be a time-consuming task for companies that have many leases. But with the best lease accounting software, you can complete the process quickly and efficiently.

When to Use an Incremental Borrowing Rate (IBR)

ASC 842 requires lessees to use the rate in the lease agreement for Net Present Value (NPV) calculations. You need this to set up lease liabilities and Right of Use (ROU) assets for most assets in your lease portfolio. When the rate information is not included in the lease agreement—or the implicit rate can’t be readily determined—ASC 842 allows companies to use an Incremental Borrowing Rate (IBR).

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.”

In simpler terms, the incremental borrowing rate represents the interest rate a company would expect to pay if it borrowed money to purchase a similar asset over a similar timeframe.

To fully calculate the implicit rate in a lease, the lessee has to know about many variables. The lessor typically controls most of these extremely closely. Some even impact negotiations and therefore the lessor is seldom likely to release all lease data. Therefore, lessees most often use the IBR in concert with ASC 842 software to ensure compliance.

IBR vs. the Interest Rate Implicit in the Lease

ASC 842 requires companies to use the interest rate implicit in the lease when it can be readily determined. However, this rate often depends on inputs controlled by the lessor, such as residual value assumptions or internal financing costs.

When these details are unavailable, companies estimate an incremental borrowing rate instead.

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Why Many Companies Choose an Incremental Borrowing Rate

The ASC 842 lease accounting standard 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 because it more closely reflects their true borrowing cost.

Balance sheet feeling wobbly?

How Private Companies Can Account for all ASC 842 Lease Types

Balance sheet feeling wobbly?

The charts below show a stream of 5 annual payments that equal $500,000. Using the Net Present Value (NPV) calculation in Excel with different discount rates shows that a lower discount rate leads to a higher NPV. 

Many companies use the higher Incremental Borrowing Rate (IBR) instead of the risk-free rate. This occurs because companies use the NPV to determine lease liability under ASC 842. Therefore, reducing the impact to the balance sheet and financial statements.

Methods Companies Use to Determine an IBR

Companies use several approaches to determine and maintain their incremental borrowing rate. Some rely on third-party valuation specialists, while others work with their internal treasury teams or banking partners to estimate borrowing costs.

The IBR is an important factor in complex calculations. Therefore, companies should create an IBR policy. Then, they should discuss it with their auditors and clearly implement it throughout the audit trail. 

A Practical Method for Calculating the Incremental Borrowing Rate

Step 1

Step 2

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.

Step 3

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, your company's Treasury department states that the current rate for 5 years is 3.59%. However, Bloomberg reports a rate of 1.59%. The difference between these rates is 2%.

Step 4

Now you have a simple mechanism to update the 5-year rate any time lease accounting requires the rate. Going to the Treasury each time for an update is inefficient. 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.

Simplify ASC 842 Lease Accounting with the Right Tools

This approach provides a practical framework for maintaining incremental borrowing rates over time. While other methods may be appropriate, the key is to document the methodology and review it regularly with auditors.

As your lease portfolio grows, maintaining consistent discount-rate assumptions across new leases, modifications, and remeasurements can quickly become difficult to manage manually, but luckily ASC-842 software can do all the heavy lifting for you.

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