A Brand-New Method of Quantifying Lease Incremental Borrowing Rate under IFRS 16 and Topic 842

One of the most contentious issues of lessee’s accounting under IFRS 16 and FASB ASC Topic 842 has been how to compute a lessee’s incremental borrowing rate (hereafter, IBR). A proper quantification of IBR is important because it affects the amount of a lessee’s right-of-use asset and lease liability recognized at lease commencement in the statement of financial position, as well as depreciation and interest expenses ongoing. Such a determination poses theoretical and practical difficulties to companies. This article develops a brand-new method that follows a conceptual approach that converge accounting and finance theory, to strike a balance between rigorous theory and practical application for companies. The proposed approach starts with a lessee’s actual average borrowing rate and compares it with its theoretical average borrowing rate based on synthetic rating. It then flexes the average rate along the interest term curve and derives the monthly rates applicable to each monthly cash flow. It adjusts the rates based on each specific lease features as defined in the standards, periodically updates the specific lease interest rate curves, and computes a lease IBR as the internal rate of return of the cash flows discounted at the monthly specific rates applicable to that specific lease. It finally compares with benchmarks. The proposed model is innovative because it is framed within, and consistent with, the definition of incremental borrowing rate in those accounting pronouncements, uses three starting references cross-checking each other, includes both an internal perspective of a company’s actual interest rates and an external market perspective, and is relatively easy to model in a partially automated spreadsheet application.