Introduction to Incremental Borrowing Rates: Understanding the Commercial Impacts
With IFRS 16 now in place for almost three years, businesses are beginning to understand the broader commercial impacts of the standard beyond compliance. As many leases have moved to company balance sheets, the impacts on a company’s fundamentals can’t be overlooked. If your company’s incremental borrowing rate (IBR) isn’t accurate, you increase the risk of significantly higher asset liability and interest costs on credit and debt facilities. Despite these risks, the IBR continues to be a largely misunderstood and ambiguous component of lease accounting. This article provides an introduction to IBRs and the commercial impacts across organisations.
What is the IBR, and how is it calculated?
The IBR is the interest rate a lessee would need to pay if they borrowed the funds to buy an asset of similar value to the right-of-use asset in a similar economic environment. As a rate that companies calculate based on internal and external data points, companies need to consider several factors to accurately calculate their IBR. Many organisations get support from their accountants and advisors to calculate their IBRs accurately. With an independent and external party to analyse the data points that must be included, organisations gain peace of mind that their IBRs and calculation methodology is commercially sound.
According to Deloitte’s A Guide to the incremental borrowing rate: Assessing the impact of IFRS 16 “Leases”, there are three key areas that companies should assess to accurately calculate their IBRs:
- Lease specific adjustment: asset type (including security)
- Financing spread adjustment: lease term, level of indebtedness, lessee entity (including credit risk), the business’s financial performance, and business sector’s current economic environment.
- Reference rate: interest rate yield curves, currency, economic environment, and the lease term.
Why is the IBR important in lease accounting?
The IBR is the most important variable in IFRS 16. It’s involved in the calculation of the balance sheet and profit and loss components of lease accounting, including the lease liability, right-of-use asset, and the resulting interest and depreciation. These components are calculated based on the present value calculation of lease payments.
Whether an organisation is small, medium or large, inaccurately calculating the IBR can have devastating effects on a company’s financial stability. For larger companies especially, the IFRS 16 transition approach and IBR calculation methodology is critical. This is because the higher the value of leases a company has on its balance sheet, the higher the risk of an IBR adjustment having material impacts on the company’s accounts.
Tesco’s financial statements, following the implementation of IFRS 16, highlight the significant financial impacts of the new lease accounting standards and IBRs. For example, in 2018/19, Tesco’s group operating profit increased by GBP401 million due to rent moving to the company’s balance sheet. Further, its lease liability was GBP10.6 billion. This movement would have impacted investor’s perspectives, the company’s share price, banking and credit covenants, and ongoing financial stability. While not every company will have experienced these levels of balance sheet growth as a result of IFRS 16, it’s an important demonstration of how the standards and IBR impacts all areas of a company.
What are the commercial impacts of a company’s IBR?
With the IBR having far-reaching commercial impacts on an organisation, it’s critical for companies to get this number right as a growing balance sheet can make an organisation look over-leveraged. As a result, investors, banks and credit agencies can become cautious about investing in the company or extending further finance. This is an ongoing risk that must be managed under the new lease accounting standards, and there are steps companies can take to ensure their IBR is accurate while deleveraging their balance sheets where necessary.
There are three key areas a business should look at to manage the commercial risks of IFRS 16 and IBRs:
- Compliance: Establish strong systems and processes for IFRS 16 compliance, ideally using software that automates IFRS 16 calculations and reporting. For example, LOIS, Quadrent’s IFRS 16 compliance software, provides organisations with all the tools needed to extract, validate and report on all lease data.
- Leasing: Whether the lease is “on balance sheet” or an Asset-as-a-Service arrangement, having the right support to ensure your leases are structured to provide the best strategic, financial and operational outcomes is critical. Leasing solutions that provide innovative finance solutions can help companies cost-effectively finance their assets.
- IBR benchmarking: Given sharing a company’s IBR is voluntary, it’s difficult for companies to compare rates to their competitors. A benchmarking tool can help organisations proactively manage their IBR and address concerns that investors, banks and credit agencies may raise.
Optimise your balance sheet with Quadrent
When managed proactively with strong systems and processes in place, a company can effectively mitigate the financial risks associated with calculating its IBR as part of its broader leasing strategy. More than a reporting exercise, proactively managing compliance, entering innovative leasing arrangements, and IBR benchmarking can strengthen a company’s performance.
If you’re looking for guidance on managing your IBR, the structure of your leases and whether your lease accounting systems are delivering the strongest commercial results possible for your organisation, click here to learn more about Quadrent’s lease analytics and IBR benchmarking portal.
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