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Understanding Incremental Borrowing Rate

30 September 2020

Understanding Incremental Borrowing Rate

The lease liability reflects the obligation to make their lease payments, and the right-of-use asset represents the right to use the underlying asset for the lease term. In most of the situations, the new lease accounting guidance requires recognition by a lessee of a right-of-use asset and a lease liability on its balance sheet. The lease liability is measured as the present value of remaining lease payments. In general, each lease will require its own discount rate unless the lessee has elected to apply a portfolio approach. Our analysis will present the requirements for developing the discount rate according to the new lease accounting guidance, with a focus on determining the Incremental Borrowing Rate for lessees.

Initial Measurement of the Lease Liability

At the commencement date, a lessee shall measure the lease liability at the present value of the lease payments that are not paid at that date. The lease payments shall be discounted using the Interest Rate Implicit in the Lease (IRIL), if that rate can be readily determined. If that rate cannot be readily determined, the lessee shall use the lessee’s Incremental Borrowing Rate (IBR).

Interest Rate Implicit in the Lease

 The rate of interest that causes the present value of – (a) the lease payments and (b) the unguaranteed residual value to equal the sum of (i) the fair value of the underlying asset and (ii) any initial direct costs of the lessor.

Lessee’s Incremental Borrowing Rate

The rate of interest that a lessee would have to pay to borrow over a similar term, and with a similar security, the funds necessary to obtain an asset of a similar value to the right-of-use asset in a similar economic environment.

IBR Determination – Key Factors

When determining an IBR specific to a lease, there are some below mentioned key factors to consider in analysis:

1. Lessee-specific Credit Risk:

As the IBR is lessee-specific, the analysis over creditworthiness of the lessee is the base consideration for determining the IBR. If the lessee already has an established credit rating from one of the major credit rating agencies (e.g., Standard & Poor’s or Moody’s), that credit rating will be used to determine the base credit-risk profile of the lessee for IBR analysis. Alternatively, if lessee do not have an established credit rating, the Valuer will need to assign a rating to a firm based upon its liquidity and solvency financial ratios; this rating is called a synthetic rating. A synthetic credit rating can be determined using any of widely used approaches which includes linear regression, an Ordered Logit Model, Damodaran’s Model or Moody’s online credit rating tool. Once the credit rating is available, this rating can be used as the starting point for the credit-risk component of the IBR.

Adjustments to the Rating:

The public company ratings used in this analysis are “issuer ratings,” and therefore correspond to a senior unsecured rating. It needs to adjust the Company’s senior unsecured issuer rating upward by one or two notches in order to arrive at the secured credit rating (one if BBB- or better, two if lower). Refer to “Notching Corporate Instrument Ratings Based on Differences in Security and Priority of Claim,” Moody's Investors Service published on October 26th, 2017.

The next step is to map the concluded secured rating into an appropriate yield curve. The output of this analysis is a yield curve, with varying rates corresponding to different maturities. The computed synthetic credit rating will be translated into an IBR by considering the Corporate Composite Yield Curve which is generally sourced from databases like Bloomberg or S&P Capital IQ. The Corporate Composite Yield Curve reflects the yields-to-maturity prevailing in the public debt market across a spectrum of geographies and maturities. Therefore, the Valuer may need to correct variation in order to get to an accurate IBR. When applying a credit-spread adjustment to the IBR, the Valuer should consider the term structure of the IBR curve and the nature of credit spreads varying by term.

Additionally, the lessee credit risk should be carefully considered for all leases that require an IBR calculation for a company. Specifically, applying the corporate parent’s credit-risk profile to one of its subsidiaries is generally appropriate if the corporate parent assumes a guarantor relationship with the subsidiary. Understanding the guarantor relationship is a critical step in determining the IBR because it affects the scope of work for lessees. Consider, if a corporate parent guarantees the leases for all of its subsidiaries, then only the corporate parent’s creditworthiness needs to be considered in the IBR calculation (not the subsidiaries’ credit risk).

The alternative scenario, where the corporate parent is not the guarantor for its subsidiaries, requires the development of a specific subsidiary’s credit-risk profile in determining the IBR.

2. Amount of the Lease Payments:

Since the discounted outstanding lease payments will be reported on the balance sheet as a liability, they will have an impact on the amount of the lessee’s debt obligations. To the extent that the lease payments have a significant impact on the capital structure of the lessee, one should consider the increased credit-risk profile due to this increase in debt obligations. On the other hand, if the amount of the lease payments is insignificant compared to the lessees existing debt obligations, a risk adjustment to consider this component may be negligible.

3. Collateralized Nature of the IBR:

The IBR is on a collateralized, or secured, basis. Therefore, the rate should reflect the belief that the lessee can pledge its assets in the instance that it defaults on its lease payments. This is unique compared to unsecured debt, which typically has no recourse when the obligor defaults. Therefore, the IBR, on a secured basis, will typically command a lower rate of return compared to its unsecured counterpart. Market rates that reflect the lessee’s credit-risk profile are generally on an unsecured basis. Therefore, an adjustment is needed to convert the market rates to reflect a secured borrowing rate for the lessee.

4. Currency of the Lease

The IBR applicable for each lease should be specific to the currency in which it is denominated. Suppose the Company has both USD and EUR leases, we require two separate yield curves. Accordingly, we first calculate the credit spread applicable to the USD-based yield curve (i.e., the premium over a USD risk-free rate). Next, we apply that credit spread to the EUR risk-free rates to determine the EUR-based curve (note that as of this time period, EUR-based risk-free rates were less than USD rates).

Last, the IBR specific to an individual lease of the Company would be determined based on the remaining term and currency of the lease, where the term is interpolated into the relevant curve to derive an appropriate yield.

5. The Term of the Lease

The term of the lease must also be taken into consideration when determining an appropriate IBR, as risks vary, depending on the length of time due to interest-rate risk and other factors that affect a yield curve’s term structure. The IBR applicable for each lease should be specific to the remaining term of the lease. For example, given a typical upward sloping yield curve, a longer-term lease would have a higher IBR, all else equal.

Depending on the cycle of the economy and the general shape of the interest-rate curve, the discount rate is expected to differ based on the term. The entity should consider this in the determination of the IBR in order to reflect the risk profiles of leases appropriately. In other words, a lease with one year remaining should have a different IBR than a lease with ten years remaining because the risks are different.

6. Reassessment of the Discount Rate

Generally, a reassessment of the discount rate is required if any of the above components have changed since the initial determination of the IBR. It’s important to assess how to determine the IBR on a forward basis when new leases are entered into after the implementation date.

The analysis and evaluation of each of aforementioned key factors requires significant professional judgment and proficiency. One must carefully consider the factors defined and seek assistance from Proxcel’s Valuation Team due to the nuances and differing interpretations. Proxcel is committed to provide reliable deliverables and customized reports for Client’s unique financial reporting needs based on our up-to-date knowledge of accounting and tax compliance issues, regulatory changes and the latest valuation developments.

Please feel free to reach us for any discussion on the topic at contact@proxcel.in

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