Businesses often enter into agreements that involve long-term payments, such as property leases, equipment rentals, office spaces, and vehicles. When accounting for these arrangements, companies may need to determine an appropriate discount rate to calculate the present value of future payments. One important concept used for this purpose is the Incremental Borrowing Rate.

Understanding this rate can help businesses make more accurate accounting calculations, especially when the company does not have an interest rate directly stated in a lease agreement. It is particularly relevant under lease accounting requirements such as Ind AS 116 and IFRS 16.

What Is an Incremental Borrowing Rate?

The Incremental Borrowing Rate is the interest rate that a company would have to pay if it borrowed money over a similar period, with similar security, and under comparable economic conditions.

In simple terms, it answers the question: What interest rate would this business realistically pay if it borrowed an amount similar to the lease liability?

For example, suppose a company enters into a five-year lease for office premises. The lease agreement does not specify an interest rate. The company may then need to estimate the rate it would have paid to borrow a similar amount for five years under similar conditions.

This estimated rate can then be used to discount future lease payments to their present value.

Why Is the Incremental Borrowing Rate Important?

The Incremental Borrowing Rate is important because the discount rate can significantly affect the value of a lease liability and corresponding right-of-use asset.

A higher discount rate generally produces a lower present value of future payments, while a lower rate generally produces a higher present value.

The rate can therefore influence:

• Lease liabilities
• Right-of-use assets
• Finance costs
• Depreciation and amortisation
• Profit and loss reporting
• Financial statement presentation
• Key financial ratios

Because of these effects, businesses should avoid selecting a rate without proper analysis and documentation.

When Is It Used?

The Incremental Borrowing Rate is commonly relevant when the interest rate implicit in a lease cannot be readily determined.

Under lease accounting frameworks, companies generally consider the interest rate implicit in the lease when it can be readily determined. When that information is unavailable, the company's incremental borrowing rate may be used.

This situation is common because lease agreements do not always provide enough information for a company to calculate the implicit rate.

How to Determine the Incremental Borrowing Rate

Determining the Incremental Borrowing Rate requires more than simply checking the company's latest bank loan interest rate. The rate should reflect the specific characteristics of the borrowing being considered.

1. Determine the Lease Term

The company should first identify the relevant lease period. A two-year lease and a ten-year lease may have substantially different borrowing rates.

The expected lease term should consider factors such as:

• Contractual lease period
• Renewal options
• Termination options
• Management's reasonable expectations
• Economic incentives affecting renewal or termination

2. Consider the Currency

The borrowing rate should generally be consistent with the currency of the lease payments.

For example, a lease with payments denominated in Indian rupees should normally be assessed using borrowing information relevant to Indian rupee financing rather than a borrowing rate in another currency.

3. Consider the Company's Credit Risk

A company's creditworthiness is another important factor. A financially strong company may be able to borrow at a lower rate than a business with higher credit risk.

Factors that may be considered include:

• Credit rating
• Existing borrowing costs
• Financial performance
• Debt levels
• Historical repayment record
• Industry conditions

4. Consider the Security of the Borrowing

The rate should also reflect the nature of the security associated with the borrowing.

A secured loan may carry a different interest rate from an unsecured loan. Therefore, businesses should consider whether the hypothetical borrowing would be secured and what type of security would be involved.

5. Consider the Economic Environment

Market conditions can have a significant effect on borrowing rates.

Interest rates, inflation, monetary policy, credit conditions, and market expectations may all influence the rate applicable at the relevant measurement date.

A rate from several years ago may not accurately represent current financing conditions.

Approaches for Estimating the Rate

There is no single method that works for every company. Businesses may use different approaches depending on the availability and quality of information.

Observable Borrowing Rates

A company can begin with rates from its existing borrowing arrangements. However, adjustments may be necessary if the existing loan differs significantly from the lease in terms of maturity, security, currency, or other characteristics.

Reference Market Rates

Businesses may also consider observable market borrowing rates for comparable companies or transactions.

For example, market data for companies with similar credit profiles and borrowing characteristics can provide useful evidence.

Build-Up Approach

Another approach involves starting with a reference rate and making adjustments for factors such as:

• Credit risk
• Lease term
• Country risk
• Currency
• Security
• Market conditions

This approach can be useful when directly comparable borrowing information is unavailable.

Example of an Incremental Borrowing Rate

Consider a company that enters into a five-year property lease. The company will make annual lease payments, but the lease agreement does not provide a readily determinable interest rate.

The company reviews its financing arrangements and finds that it can obtain five-year secured borrowing at 9%. However, the proposed lease has characteristics that differ from its existing loans.

After considering credit risk, security, market conditions, and other relevant factors, management determines that a rate of 9.5% is an appropriate estimate.

The company can use this rate to discount the future lease payments and calculate the initial lease liability.

The example demonstrates why the rate should be based on the characteristics of the specific transaction rather than simply copying an existing loan interest rate.

Common Challenges in Determining the Rate

Businesses often face practical difficulties when estimating the Incremental Borrowing Rate.

One challenge is the lack of directly comparable borrowing data. A company may have loans, but those loans may have different maturities, currencies, security arrangements, or credit characteristics.

Another challenge is determining the appropriate adjustments. Management may need to use professional judgment when market data is limited.

Documentation is also important. A company should be able to explain how the rate was determined and why the selected assumptions are reasonable.

Best Practices for Businesses

Companies can improve the quality and consistency of their calculations by following a structured process.

Maintain Supporting Documentation

Keep records of:

• Borrowing agreements
• Market interest rates
• Credit assessments
• Economic assumptions
• Calculation methodologies
• Management judgments
• Relevant adjustments

Good documentation makes the calculation easier to review and support during an audit.

Use Consistent Methodology

Companies with multiple leases should establish a consistent methodology while still considering the individual characteristics of each lease.

A practical framework can help finance teams avoid unnecessary differences between similar transactions.

Review Rates When Circumstances Change

Borrowing conditions can change over time. Changes in interest rates, creditworthiness, economic conditions, or lease terms may affect the appropriate rate.

Companies should therefore assess whether previously determined rates remain appropriate when required by the applicable accounting framework.

Role of Professional Advice

Calculating the Incremental Borrowing Rate can become complicated when a business has a large lease portfolio or operates across different countries and currencies.

Accounting professionals and valuation specialists can help businesses assess market data, determine appropriate adjustments, document assumptions, and develop a defensible methodology.

Professional review can also help reduce inconsistencies and improve the quality of financial reporting.

Conclusion

The Incremental Borrowing Rate is an important concept for businesses that need to measure lease liabilities when the interest rate implicit in a lease cannot be readily determined. It represents the rate a company would reasonably expect to pay for borrowing under similar terms and circumstances.

Determining the appropriate rate requires consideration of factors such as lease term, currency, credit risk, security, and current market conditions. Businesses should avoid relying on a single interest rate without assessing whether it accurately reflects the specific transaction.

A structured methodology, reliable market information, and clear documentation can make the process more consistent and transparent. By taking a careful approach, companies can improve the accuracy of lease accounting and support reliable financial reporting.