Incremental Borrowing Rate
The incremental borrowing rate (IBR) is 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, used under ASC 842 to discount lease payments when the rate implicit in the lease cannot be readily determined.
The discount rate used to measure the present value of lease payments has a direct and material impact on the size of the lease liability and right-of-use asset recognized on the balance sheet under ASC 842. ASC 842 requires lessees to use the rate implicit in the lease if that rate can be readily determined, and to use the incremental borrowing rate if it cannot. In practice, the rate implicit in the lease — which requires the lessee to know the lessor's initial direct costs and residual value assumptions — is rarely determinable by lessees, so the IBR is used for the vast majority of leases in practice.
Determining the IBR requires judgment and involves constructing a hypothetical borrowing rate for the lessee that reflects the specific characteristics of the lease. The key inputs are the lessee's credit quality, the collateralized nature of the borrowing (since a lease effectively grants the lessee a collateral interest in the right to use the underlying asset), the currency of the lease payments, the lease term (since borrowing rates vary by duration), and the economic environment at the commencement date.
For large investment-grade corporations with public debt outstanding, estimating the IBR is relatively straightforward because observable market rates exist for collateralized borrowings of similar terms and credit quality. For smaller companies, private companies, or companies with complex capital structures, the IBR estimation process is more involved and may require interpolation from observable rates, credit spread analysis, or assistance from treasury advisors.
The IBR has important consequences for comparability across companies. Two companies with identical lease payment schedules but different IBRs — perhaps because one is investment-grade and the other is sub-investment-grade, or because one adopted ASC 842 in 2019 when interest rates were low and the other commenced a lease in 2023 when rates were higher — will carry materially different lease liability balances. Investors comparing operating lease liabilities across companies should be aware of the IBR assumptions disclosed in the notes to financial statements, which under ASC 842 must include the weighted average discount rate applied to operating and finance leases.
Changes in the IBR over time also affect how newly commenced leases are measured relative to legacy leases on the balance sheet. In a rising interest rate environment, new leases are discounted at higher rates, producing smaller initial lease liabilities for the same payment stream. This can mask the economic growth of a company's lease obligations if investors look only at balance sheet totals without examining the maturity schedules and undiscounted payment commitments.