Incremental borrowing rate

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Incremental borrowing rate is the rate of interest the lessee would have to pay on a similar lease or, if that is not determinable, the rate that, at the inception of the lease, the lessee would incur to borrow over a similar term, and with a similar security, the funds necessary to purchase the asset [1].

The Standard uses the term "incremental borrowing rate of interest" because the average rate of interest on amounts borrowed by the enterprise does not represent the current market situation or the present credit rating of the enterprise. Moreover, the nature of security and the term of loan have significant influence on the interest rate. Therefore, the Standard stipulates that, in the absence of information about the interest rate implicit in the lease, the lessee should consider the incremental borrowing rate of interest as the interest rate at which the lessee has borrowed funds from the lessor in the form of finance lease [2].

Incremental borrowing rate in Lease Classification

Minimum lease payments are the payments that the lessee is obligated to make or can be required to make in connection with the leased property. For purposes of computing the present value of rental and other minimum lease payments, a lessee should use its incremental borrowing rate, unless two conditions apply[3]:

  1. It is practicable for the lessee to learn the implicit rate computed by the lessor.
  2. The implicit rate computed by the lessor is lower than the lessee's incremental borrowing rate.

If the lessee has knowledge about the implicit rate computed by the lessor and lessor's rate is lower than the lessee's incremental borrowing rate, the lessor's implicit borrowing rate is used. Using the lower implicit rate of the lessor rather than the lessee's incremental borrowing rate results in a higher amount of present value of minimum lease payments; it increases the likelihood that the 90% of fair value test leads to capital lease classification[4].

Example of using incremental borrowing rate

For lessees, lease payments are discounted using the interest rate implicit in the lease if that rate can be readily determined. If that rate cannot be readily determined, the lessee uses the incremental borrowing rate. The interest rate implicit in the lease is not necessarily the rate stated in the contract and reflects, among other things, the lessor's initial direct costs and estimates of residual value. Therefore, lessees may find it difficult to determine the interest rate implicit in the lease, in which case they will need to determine the incremental borrowing rate[5].

Advantages of Incremental borrowing rate

Incremental borrowing rate is a beneficial tool for both the lessee and the lender as it allows for the accurate calculation of the cost of a lease. The advantages of using incremental borrowing rate include:

  • It provides a more accurate measure of the cost of leasing since it takes into account the rate of interest that the lessee would have to pay on a similar lease.
  • It helps the lessee to compare different leases to determine which one is the best option for their business.
  • It can help the lessee to make more informed decisions since they can compare the cost of the lease to the cost of borrowing funds to purchase the asset.
  • It can also help the lender to determine the appropriate rate of interest to charge on the lease.
  • Lastly, it helps to ensure that the lease is fair to both parties, as the rate of interest charged is based on the rate that the lessee would incur to borrow the funds necessary to purchase the asset.

Limitations of Incremental borrowing rate

The incremental borrowing rate is not without its limitations. These include:

  • Lack of uniformity: Different countries have different policies regarding the calculation of incremental borrowing rates. This means that the rate may vary from region to region.
  • Difficulty in determining the benchmark rate: It can be difficult to determine the benchmark rate that would be used to calculate the incremental borrowing rate, as there are many factors that need to be taken into account such as the type of loan, the amount borrowed, and the term of the loan.
  • Subjectivity: The rate of interest is typically determined based on the subjective judgement of the lender, which can lead to inconsistencies or inequitable outcomes.
  • Inflation: The rate of interest is not adjusted for inflation, which means that the rate may not remain constant over time.
  • Risk: The rate does not take into account the level of risk associated with the loan, such as the creditworthiness of the borrower or the asset being leased.

Other approaches related to Incremental borrowing rate

One approach to determining the Incremental borrowing rate is to look at other related approaches. These include:

  • The Internal Rate of Return (IRR) - This is the rate of return that an investment must achieve in order to be considered worthwhile. It is calculated by taking into account the present value of all cash flows that the investment will generate over its lifetime.
  • The Yield to Maturity (YTM) - This is the rate of return that a bond must achieve in order to be considered worthwhile. It is calculated by taking into account the present value of all cash flows that the bond will generate over its lifetime.
  • The Discounted Cash Flow (DCF) - This is a method of valuing an investment by taking into account the present value of all cash flows it will generate over its lifetime.
  • The Weighted Average Cost of Capital (WACC) - This is a measure of a company’s cost of capital, which takes into account the company’s cost of debt and cost of equity.

In conclusion, Incremental borrowing rate is an important measure of the cost of borrowing money and other related approaches can be used to determine the rate. These include Internal Rate of Return, Yield to Maturity, Discounted Cash Flow, and Weighted Average Cost of Capital.


Incremental borrowing rate — recommended articles
Implicit interest rate — Accrual rate — Swap Ratio — Adjusted present value — Effective rent — Running yield — Asset-swap spread — Real rate of return — Borrowing Base

References

Footnotes

  1. ↑ Khan M. Y., (2004)
  2. ↑ Bhattacharyya A. K., (2017)
  3. ↑ Davis M. K., (2011)
  4. ↑ Davis M. K., (2011)
  5. ↑ Ernst & Young LLP, (2018)

Author: Piotr Tarsa

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