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What is the Difference Between a Stated Interest Rate, an Implicit Interest Rate, and an Incremental Borrowing Rate?

What is the Difference Between a Stated Interest Rate, an Implicit Interest Rate, and an Incremental Borrowing Rate?


Stated interest rate: A stated interest rate in a lease agreement.

Implicit interest rate: An implicit interest rate uses the fair value of the asset at commencement to determine a rate based on the total payments during the lease. In many agreements, it is very difficult to calculate the fair value of the asset at commencement if it is not explicitly stated in the agreement.

Incremental borrowing rate: An incremental borrowing rate is a rate you would normally be charged by a bank when receiving a loan with terms and an amount similar to your lease. 

Under GASB 87, you should discount future lease payments at the interest rate the lessor charges the lessee. If there is no obvious interest rate, then one must be estimated. 

Learn how to calculate your incremental borrowing rate

Your treasury department should be able to calculate an incremental borrowing rate for your lease. 

The term of the lease.

The term of the lease is its length; the rate on a 5-year lease will vary from a 20-year lease.

The currency of the lease.

Specifically, mention which currency the lease uses. A lease in Canadian dollars or Mexican pesos will have a different rate than a lease in US dollars.

If there is a subsidiary, which one?

If your organization has multiple subsidiaries with separate cash flows, calculate the rate for the specific subsidiary that’s involved in the lease.

Your treasury department may choose to use a centralized treasury rate, especially if a parent entity guarantees the lease.

Again, it will really come down to the cash flow for the lease.

The correct dates for the rate.

GASB states that your organization should apply the guidance retrospectively in situations where it’s considered “practicable to do so.” So use a rate that’s consistent with the date that you apply GASB 87 to your financial statement.

If your entity is in the process of transition, your rate should be selected based on the effective date of the transition to GASB 87.

When entering into a lease after the transition for all standards is completed, the incremental borrowing rate will be the same as the commencement date of the lease (also known as the lease start date.)

Is it a purchase or a lease?

Under GASB 87, the incremental borrowing rate is estimated without taking collateral into consideration. It only represents the rate that you’d pay to borrow funds to lease an asset.

Stated Interest Rate Example:

The lease for a piece of equipment explicitly states within the lease agreement that the interest rate is 5%.

Implicit Interest Rate Example:

When agreeing to either purchase or lease a piece of equipment, you're given the option to pay $20,000 in cash today or to make 24 monthly lease payments of $933 over the next two years. 

While the second option has no stated interest rate, you are able to calculate an implicit interest rate. This is based on the fact that you’ll pay an additional $2,392 in exchange for spreading out the payment over 24 months. This excess amount will be used to calculate the implicit interest rate.

Incremental Borrowing Rate Example:

Your entity is leasing a piece of equipment from a company for $500,000 over five years. There is no stated interest rate in the lease agreement, and it is not practicable to determine the fair market value.

You need to obtain an estimated incremental borrowing rate to record for the lease.

To get this, you would make a request from your treasury department and provide them with the following information that they’ll need to make the calculation:

Term of the lease: 5 years
Date: Assuming you have fully transitioned for all standards, you would include the commencement date of the lease. (State that it is the commencement date of the lease to avoid any confusion.)
Purchase or lease: Leased equipment will be returned to the lessor upon completion.

Your treasury department should be able to provide details of the loan to the bank and receive a rate that they would typically provide on a similar debt. Treasury can then use this to complete their calculations and provide you with an estimated implicit interest rate.

What’s important here?

All lease agreements have an interest rate associated with them. 

If a lease agreement has no stated interest rate, there is still an implicit interest rate.

When no interest rate is stated in the lease agreement, you’ll need to use the implicit interest rate or estimate an incremental borrowing rate.

The incremental borrowing rate under GASB 87 is the rate your entity would be charged by a bank when receiving a loan with similar terms and amount to your lease.

Try DebtBook’s Incremental Borrowing Rate template. 

We’ve created a simple Excel template that you can use to calculate your incremental borrowing rate using the same process that we’ve outlined above. You can find a link to the template in DebtBook’s Guide to the Incremental Borrowing Rate.