How to Calculate the Incremental Borrowing Rate under ASC 842

by Lucas Russell | 2021-05-12

The incremental borrowing rate is the fall back to the lessee if the rate implicit in the lease is not readily determinable.

Before going any further, we should note why the incremental borrowing rate is needed for compliance with ASC 842. Under the new lease accounting standard, all leases are now recorded on the balance sheet in the form of a lease liability and right of use asset. The lease liability is the present value of future lease payments. To calculate that present value, the lessee needs a discount rate. That discount rate can either be the lease's implicit rate or, if unavailable, the incremental borrowing rate.

So before getting into the incremental borrowing rate, the first step is to try and calculate the rate implicit in the lease. To do that, refer to our article How to Calculate the Discount Rate Implicit in the lease. If you are unable to calculate the rate implicit to the lease, you've come to the right place, as the purpose of this article is to help you determine the incremental borrowing rate of the lease.  So what is the incremental borrowing rate?

Incremental Borrowing Rate Definition

ASC 842 defines the incremental borrowing rate 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.

Change in Definition from ASC 840 - from Unsecured to Secured Collateral

The above definition of the incremental borrowing rate has changed from ASC 840. Previously the incremental borrowing rate was the rate that, at lease inception, a lessee would have incurred to borrow over a similar term the funds necessary to purchase the leased asset.

Under ASC 842 the lessee must use a secured rate. To use an interest rate from unsecured funding may not be considered.

What type of Secured Collateral

The standard does have any guidance on the collateral that could be used for the loan. In PwC’s opinion:

We believe any form of collateral can be used to determine the incremental borrowing rate as long as the lessee has the right to pledge the collateral. For example, assume an entity enters into a lease of a building. We do not believe the lessee may use the building as collateral when determining the incremental borrowing rate because the lessee does not own the building and therefore does not have the right to pledge the building.

This makes sense as if you already had the asset to pledge as collateral, why would the company bother entering into a lease!

It has been suggested that the lessee can use its leasehold interest in the lease if the lender accepts that as collateral. In other words, use the lease as collateral. Of course, the lessee could use any other unrelated assets to fully secure the borrowing. An alternative is an observable interest rate for an existing line of credit.

With the collateral, the assumption is it is a recourse loan as opposed to a non-recourse. This decision will decrease the incremental borrowing rate as it lowers the risk from the lender’s perspective. If the borrowing entity has few assets, the lender will accordingly adjust the interest rate.

Consideration of Lease Options

The hypothetical borrowing amount being calculated needs to resemble that of the lease terms. Otherwise, it’s a pointless exercise. But the next question that arises is what terms within the lease? Does the lessee include renewals, terminations, and purchase options? This answer to this is not stated within ASC 842.

What PwC advises is the following:

We believe a lessee may make an accounting policy election to either include or exclude options that are not reasonably certain of exercise when determining the borrowing term.

Either way is acceptable as long as the decision is applied consistently. PwC’s conclusion stems from the fact that the existence of options to renew or terminate a borrowing arrangement would affect the rate a lender would charge irrespective of whether or not the options are reasonably certain of exercise.

Conclusion

Once the incremental borrowing rate is calculated you now have the discount rate to calculate the lease liability under ASC 842. Some related articles to further help familiarize yourself with ASC 842 are:

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