The incremental borrowing rate or IBR can be defined as the interest payment that a lessee has to make when to borrow to finance the capital asset purchase.
When a company is looking to borrow an asset, it will need to borrow money to finance the purchase. This is where the increment borrowing rate comes in, the implicit borrowing rate allows a company to adjust the interest rate at which it borrowed and adjust it for security, and also, if required, for the foreign currency adjustment. Sometimes, the company may borrow in foreign currency, which requires some adjustments to be made when converting the foreign currency into local currency.
Consider a company ABC, plans to lease capital equipment for its construction business. It has agreed on the lessee term with the leaser. But, now it needs to borrow money to pay for the lease. But, it does not have any collateral to put to borrow money from the bank.
But, there is another way it could work. Company ABC can use its lease agreement with the leaser and put it up as collateral. This, of course, would only happen if the lender, the bank, agrees with the terms, and allows the company ABC to use its lease agreement to be used as collateral.
When such a situation arises, the company ABC has to make some complex changes in its balance sheet to note down the transaction. According to the law, the company ABC must discount its future cash flows to adjust for the incremental borrowing rate.
How to calculate incremental borrowing rate?
Multiple assumptions are to be made when calculating the incremental borrowing rate. Such as the foreign exchange rate, economic condition, bank borrowing rate, index borrowing rate, and industrial borrowing rate. All of these rates and market conditions have to be adjusted for future expectation. It means that all of these assumptions are made by keeping in mind how all of these metrics can look in the future.
This can prove to be a very daunting task, and any small mistake can result in huge losses for the company.
What is implicit interest rate?
The implicit interest rate, as the name suggests is implicit. It can be defined as the rate which a company uses for its internal calculations by taking into account the intangible value of that particular asset plus any initial costs associated with the lesser. The implicit interest rate is different from the interest rate being written in the lease agreement. The implicit rate, basically, tells about all the hidden costs associated with borrowing a capital asset.
Consider again the Company ABC, now as it has borrowed the capital asset, it wants to for internal reasons carry out a calculation of what is the real implicit interest rate it will have to pay. The Company ABC tries to put an intangible value in monetary terms for the capital asset.
The construction equipment does not have any installation or any other such cost associated with it. There is a risk of damage to the equipment. These are some of the metrics which the company ABC analyzes and puts to it an internal implicit interest rate on it.
Consider a man, who borrows about one thousand dollars. He is expected to pay ninety dollars per month for the whole next year for him to pay off one thousand dollars.
Now, here the implicit interest rate is not stated. But, there is a way to find the interest rate from the values given. As the interest rate is not clearly stated, thus the interest rate is not explicated but implicit in its nature.
Now, that man would pay 1080 Dollars over the course of the year. This means that the implicit interest rate he would be charged is 8 percent, annualized.
Difference between IRB and IIR
The main differences between the Incremental borrowing rate and implicit borrowing rate are as follows:
i) The incremental borrowing rate shows the face value of the interest payment, whereas the implicit interest rate shows the implicit value and the true payments which the company has to make.
ii) The incremental borrowing rate is always below the market value, at about ninety percent, whereas the implicit interest rate occurs at the market value. Basically, the implicit interest rate adjusts the value of the payments that have to be made.
iii) The Implicit interest rate is the better measurement of what a company would pay realistically when compared to the incremental borrowing rate.
Which is the better predictor of payment
The implicit interest rate is a better predictor of the payments which a company can expect to make because it takes into account any intangible value of the asset, plus any associated cost with the lease written in the agreement versus the interest rate charged by the lender for the lease.
Both have their advantages and disadvantages, and their specific uses, and where they should be used. For example, the incremental borrowing rate is helpful at the start when preparing for the lease agreement, and the implicit interest rate is useful when the company is trying to calculate the true value of the cost associated with the lease agreement.
Frequently asked questions
What does the ROU asset stand for?
ROU stands for the right of use. The internal revenue service code ASC 842 lease accounting standard, which states the regulations around the use of the leased asset by the leaser. It basically states that the asset listed in the lease agreement is transferred to the leaser until the end of the lease. After the end of the lease, the asset is transferred back to the original owner.
During the lease agreement, the right of use allows the leaser to use the asset as the leaser likes, it depends entirely on the leaser whether even if he/ she uses the asset or not.
What discount rate should be used to evaluate a lease?
The implicit interest rate should be used to evaluate a lease. The real cost of a lease is better estimated if the company uses an implicit interest rate, it is because the implicit interest rate takes into account both tangible and intangible factors under the account, such as the unused value of the asset or the cost of installing the capital equipment.
The incremental borrowing rate does not take into account these factors which makes it less accurate in determining whether the lease is sustainable or not.
What is the lease discount rate?
The lease discount rate is mainly an accounting term. It is used to note down the discounted cash flows from the future cash flow operations. The lease discount rate is very important in accounting terms because it helps in determining the lease liabilities which would occur during the transition of the lease or the liabilities which would occur during the operation of the asset stated in the lease agreement.
By taking into account, the lease discount rate, it can be estimated with high accuracy how and by how much the company’s cash flows would be affected as a result of liabilities associated with the lease agreement.
Why do we have IFRS 16?
IFRS is a single accounting model which is used by companies worldwide involved in the leasing business. It introduces a single lease agreement standard to be used around the world. Basically, it has one point and that is everyone involved in the leasing agreement negotiates in good faith.
The IFRS 16 allows any two parties from any part of the world to enter a leasing agreement. This reduces the administrative costs associated with the lease agreements. It also allows for the lease agreements to be signed quickly by a great reduction in complexity due to the use of a single standard.