Incremental borrowing rate

Incremental borrowing rate
See also


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].

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