Approaching 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. 

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. However, the FASB recognized that implicit rate information is not always readily available. ASC 842 lets companies use an Incremental Borrowing Rate (IBR) if the lease agreement does not provide rate details.

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.

Automation🤝 Incremental Borrowing Rate

Read now: Automating the IBR for Lease Accounting

Automation🤝 Incremental Borrowing Rate

Defining 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.” 

Why Private Companies go with IBR

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. This is because of the required present value calculations. 

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 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 Net Present Value (NPV) to determine lease liability under ASC 842. Therefore, reducing the impact to the balance sheet and financial statements.

Methods for securing IBR

Many appropriate methods exist for capturing and maintaining the IBR. Some companies have contracted with firms that specialize in valuations. Some work with their bankers regularly to obtain the information. And some work with their internal Treasury department and the list continues. 

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. 

Below is one practical method many companies use:

• Discuss the definition of IBR with your internal Treasury team. Ask for the current rates for each of the buckets you identify.
  • US lease terms of 5, 10, 15, and 20 years are similar for international real estate. Some companies interpret this differently. They often set rates based only on the HQ location because borrowing happens mainly at the HQ.

• 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, 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%.

Now you have a simple mechanism to update the 5-year rate any time lease accounting requires the rate. Going to 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. 

Need more lease accounting?

Check out The Lease Alert Podcast

Need more lease accounting?

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.