Accurately calculating the incremental borrowing rate formula is crucial for organizations complying with GASB 87 and aligning with the new lease accounting standard. A majority of lease agreements do not have a stated interest rate, and calculating the implicit rate is often not feasible with the information present. When these two facts are true, you must calculate the IBR. This calculation impacts financial statements by helping calculate the lease liability, the present value of future lease payments and receipts, which represent the beginning lease liability and receivable balances.
At DebtBook, we aim to simplify this process with tools that integrate current market conditions. Our updated methodology for calculating the incremental borrowing rate uses real-time yields and spreads from the municipal bond market to ensure precision. This approach incorporates the risk-free rate and reflects modern lease-specific factors, enabling compliance with lease accounting standards. It’s designed to streamline the determination of rates for lessee and lessor leases, as well as subscriptions applicable to GASB 96.
By focusing on practical, repeatable processes and leveraging comprehensive market insights, our approach ensures accurate financial reporting while reducing complexity. Whether managing an entire lease portfolio or calculating rates on an individual basis, our tools prioritize transparency and compliance.
Read on to learn how to calculate an incremental borrowing rate that supports accuracy, compliance, and streamlined lease accounting processes.
Why is Calculating the Incremental Borrowing Rate Important?
Accurate calculation of the incremental borrowing rate is crucial because it impacts the reporting of lease obligations in your financial statements. By considering lease-specific factors, such as the discount rate and the present value of future obligations, organizations can ensure compliance with GASB 87 and GASB 96.
To comply with Governmental Accounting Standards Board (GASB) Statement No. 87, “Leases” (GASB 87), you will likely need to determine the incremental borrowing rate of at least one of your leases. Due to the importance of this calculation, incremental borrowing rates should be determined in a way that is accurate and reflects real-world data.
Calculating the lessee’s incremental borrowing rate is essential to establish the beginning liability and receivable balances enabling proper representation in the balance sheet. This process ultimately supports transparent financial reporting while aligning with the new lease accounting standard.
Calculating the Incremental Borrowing Rate
If you don’t want to go to your banker or financial advisor for a separate interest rate every time you enter into a new lease, we wanted to build a simple yet powerful incremental borrowing rate template to estimate your incremental borrowing rate.
As you read ahead, there are a few things to keep in mind:
- We are not trying to calculate the exact interest rate you would have been charged. The goal of the exercise is to have a reasonable basis for developing an accurate estimate of what your interest rate would have been.
- Instead of assuming each loan would be secured by the underlying asset (which would require you to calculate multiple incremental borrowing rates across multiple asset classes), we assume you would use your lowest interest rate financing vehicle (typically a general obligation or general revenue bond) to purchase the asset. This approach simplifies the process and reduces the information you need to gather. For more details on this assumption, click here.
- We want the framework for calculating your incremental borrowing rate to be simple, practical, and repeatable, as you’ll need to recalculate your incremental borrowing rate periodically moving forward.
With these basic assumptions in mind, DebtBook has created a simple Excel template to calculate your incremental borrowing rate using the basic approach outlined by the formula below:
(Risk-Free Rate of Return) + (Credit Spread) = Incremental Borrowing Rate
To determine both the risk-free rate of return (or market interest rate) and credit spread components of that formula, we take a snapshot of multiple, publicly-available data points from across the municipal bond market to generate a consensus view of municipal bond yields and spreads. The risk-free rate of return represents a consensus view of the cost of funds for a AAA-rated municipal bond issuer, while the credit spread represents a similar consensus view of the additional risk premium investors or lenders would demand to make a similar loan to entities across the rating spectrum.
Here’s an example. If your AA-rated municipality entered into a lease commencing on August 1, 2021 for a term of 36 months, we would use a consensus view of the municipal market rate for a AAA-rated 3-year obligation as of August 1, 2021 to approximate the risk-free rate of return. We would then look at the average credit spread charged to other AA-rated municipalities around that time for other 3-year obligations.
So, if the risk-free municipal market rate on August 1, 2021 for a three year obligation was 0.14% and the average credit spread AA-rated municipal borrowers for a three year obligation was 0.50%, your estimated incremental borrowing rate for that obligation would be 0.64%, as shown below:
(Risk-Free Rate of Return) + (Credit Spread) = Incremental Borrowing Rate
0.14% + 0.50% = 0.64%
Note the calculation above assumes a tax-exempt financing. In our template, you can make simple adjustments to account for a higher taxable rate, if appropriate for your circumstances.
Note we update our IBR template quarterly, which will allow your team to generate an incremental borrowing rate for your lease obligations using actual market data that are never more than 90 days old.
Again, our approach isn’t designed to give you the precise rate your lender may have charged you for a particular obligation. Lenders and investors use different indices (or a combination of indices) and other factors to calculate their own subjective cost of capital and required risk premium, but we believe this approach provides a reasonable and objective proxy, as it encompasses a wide variety of data points across the entire municipal market.
Determining Separate Incremental Borrowing Rates
Consider the following factors when calculating separate incremental borrowing rates.
Credit Risk
Credit risk heavily influences the incremental borrowing rate and affects how an organization's credit rating is evaluated. Entities with a stronger credit profile often secure better rates for secured borrowing, which may reduce the discount rate used in their present value calculations. An incremental borrowing rate is entity-specific. Therefore, the ability to repay debts is a critical factor in considering interest rates.
Lease Payments
Analyzing remaining lease payments or receipts is crucial for managing the lease liability and receivable on the balance sheet while complying with GASB 87 software requirements.
Your Guide to Incremental Borrowing Rates
To help calculate incremental borrowing rates, we recommend using DebtBook’s free template. Although this approach has been vetted with internal accountants and external accounting consultants, we advise consulting with your own advisors and accountants when calculating your incremental borrowing rate (or rates) per GASB standards.
For more in-depth information on improving your lease accounting processes, browse DebtBook’s government accounting software and solutions.
Disclaimer: DebtBook does not provide professional services or advice. DebtBook has prepared these materials for general informational and educational purposes, which means we have not tailored the information to your specific circumstances. Please consult your professional advisors before taking action based on any information in these materials. Any use of this information is solely at your own risk.
