What it means
Modern lease accounting rules require most leases to be shown on the balance sheet as a right-of-use asset and a matching lease liability. To calculate that liability, the company must discount the future lease payments at a rate.
If the lessor's implicit rate is not readily available, which is common, the company uses its incremental borrowing rate instead. The word incremental signals that it is the cost of borrowing extra money for this specific purpose, not the company's average cost of debt.
A lease secured on a delivery van for three years should be priced as a three-year secured loan, which will cost less than an unsecured ten-year facility. Finance teams build the rate from observable inputs.
They start with a reference rate for the right currency and term, add the company's own credit spread (the extra margin lenders charge for its level of risk), and then adjust for security, because a loan backed by the asset is cheaper. Quotes from banks are a useful cross-check.
The rate has a direct effect on the numbers. A higher rate shrinks the present value of the payments, so the liability and the asset come out lower, while a lower rate does the opposite.
Auditors therefore look closely at the method and the evidence behind it. Because every lease differs in term, currency and security, a company often keeps a table of rates by lease length and currency rather than one single figure.
Some private companies reporting under US accounting rules may elect a risk-free rate instead, and that choice should be applied consistently to a whole class of leases.
In practice
Real-world examples
Example 1
A retail chain signs a ten-year lease on a new store. The treasury team gets indicative quotes for ten-year secured borrowing in the local currency and adds the chain's credit spread, giving a rate it uses to value the store lease liability.
Example 2
A logistics company leases 40 trucks for five years. Its finance manager picks a rate based on five-year secured truck financing rather than the company's long-term bond yield, because the lease term and the security match the truck loan.
Example 3
A start-up with no borrowing history leases office space for three years. Its accountant asks two banks what they would charge for a loan of that length, adjusts the answers for the start-up's higher risk, and records the result in the lease file for the auditors.
Think of it
Imagine you want to buy a car on finance, but the dealership hides the interest rate and only quotes you a monthly payment. To figure out the true cost, you would call your bank to ask what rate they would charge you for a personal car loan of the exact same amount and term. That bank quote is your incremental borrowing rate.
Formula
Calculation
Lease liability = Sum of lease payments / (1 + incremental borrowing rate) raised to the power of the year of each payment
For level annual payments made at the end of each year, the sum can be written as: Lease liability = Payment x [1 - (1 + r)^-n] / r
A company leases equipment for 5 years at $20,000 per year, paid at each year end, and its incremental borrowing rate is 6%. The discount factor is [1 - (1.06)^-5] / 0.06 = (1 - 0.747258) / 0.06 = 4.21236. The lease liability is 20,000 x 4.21236 = about $84,247. If the rate were 8%, the factor would be 3.99271 and the liability about $79,854, a difference of roughly $4,393 caused by the rate alone.Case study
Seen in the real world
Brightwater Foods is an illustrative, fictional packaging company that signed a seven-year lease for a $1,000,000 production line. Its first draft used the company's average borrowing cost of 9%, taken from an old unsecured overdraft.
The auditors challenged this, because the lease was secured on the machine and ran for seven years, whereas the overdraft was short-term and unsecured. The finance director collected two bank quotes for seven-year equipment finance and settled on 6.5%.
The lower rate raised the lease liability noticeably, and the fictional company had to disclose a higher level of debt-like obligations to its lender. The illustrative lesson is that the rate must match the lease, and that agreeing it early avoids a painful restatement later.
Watch out
Common mistakes
- Using the company's overall average cost of debt for every lease, when the rate should reflect the specific term, currency and security of each lease.
- Choosing the lowest rate available because it makes the liability look different, instead of one that is supported by evidence such as bank quotes.
- Ignoring the rate after day one, when changes to the lease, such as an extension or modification, can require the liability to be remeasured with a new rate.
Questions
People also ask
Is the incremental borrowing rate the same as the interest rate on a bank loan?
Not exactly, because it is a hypothetical rate for a secured loan of a similar term and purpose, built from market data and the company's credit profile.
When is the incremental borrowing rate used instead of the rate implicit in the lease?
It is used when the implicit rate cannot be readily determined, which is common because lessees rarely know the lessor's residual value assumptions.
Does a higher incremental borrowing rate increase or reduce the lease liability?
It reduces it, because future payments are discounted more heavily and so are worth less today.