How Your Incremental Borrowing Rate Impacts Your Balance Sheet Risk

The introduction of the IFRS 16 lease accounting standards saw $3 trillion worth of assets move to balance sheets amongst listed companies alone. Private companies have also seen their balance sheets grow as a result of the new standards.

While having a sizeable book of assets and liabilities can help companies secure debt and other sources of finance and investment, it’s not necessarily the best way to unlock capital and ensure the financial stability of a company. And with the added complexity of calculating an incremental borrowing rate (IBR) on leased assets, inaccuracies can lead to material changes to a company’s accounts. This article outlines how IBRs impact a company’s balance sheet risk and what companies should do to mitigate their risk.

How does the IBR impact a balance sheet?

As the rate used to determine the interest a company would pay if the asset was capital expenditure instead of a lease over the term, it’s the most important component of lease accounting to get right. Any adjustments in a lease require modification to the corresponding IBR. Therefore, it’s important companies have an IBR calculation methodology that’s not only accurate but easily repeatable. Ideally, a centralised system of storing and updating lease data would be implemented not only to help in calculating the IBR but to ensure compliance with the IFRS 16 lease accounting standards as well.

Two key balance sheet risks have emerged with IFRS 16:

• Companies can look over-leveraged with all their leases now “on balance sheet” resulting in difficulties accessing further finance.
• The IBR, if inaccurate and requiring modification may result in large increases to asset liability and interest costs.

According to Deloitte, for the average mid-cap company, a 1 per cent increase in a company’s IBR can result in a 5 per cent increase in asset-liability and a 39 per cent increase in interest costs.

How do banks and rating agencies view the IBR?

Banks and rating agencies have recently started looking at the lens in which they view a company’s reporting. For example, most financial institutions assess accounts and reporting under a frozen GAAP or floating GAAP model. In order to avoid defaulting on a loan agreement, the company needs to adhere to a range of covenants, many of which were set out when the previous IAS 17 standards were in place. Common covenants include:

 

Companies must now report under the IFRS 16 standards but continue to report to their financiers using frozen or floating GAAP. These differing standards double reporting workflows. Further, any balance sheet movements that have occurred due to IFRS 16 and IBR increases the risk that companies may not be able to access further finance through their traditional channels and may need to deleverage quickly.

 

When will banks and credit agencies align with the IFRS 16 standards?

Banks and credit agencies are now beginning to look at how they can align their assessment frameworks with the IFRS 16 standards, which presents an opportunity to proactively negotiate your current agreements. The process may be a lengthy one, not only due to the complexity of changing frameworks but due to the need for alignment across banks and agencies. In early 2020, for example, rating agency Fitch announced how they would be dealing with lease accounting under their credit metrics, but it differed from Moody’s and Standard & Poor’s approach.

The key difference — while nuanced across operating profit, expense classification, lease liabilities, financial leverage, lease liability, and cash flow — is that Fitch typically defaults to the US GAAP model while Moody’s and Standard & Poors makes adjustments. Given the time it will take to align the approaches of the major credit agencies, it gives businesses the opportunity to provide their input to their finance providers while proactively addressing their balance sheet risk now.

Manage balance sheet risk and strengthen your business with Quadrent

When managed proactively with strong systems and processes, a company can effectively mitigate the financial risks associated with calculating its IBR as part of its broader leasing strategy.

Three key actions companies can take today to reduce their balance sheet risk include:

• Implementing systems to efficiently manage the data inputs and automate reporting under IFRS 16, frozen GAAP and floating GAAP standards.
• Calculate your IBR correctly by implementing a reliable and repeatable calculation and modification methodology.
• Benchmarking your IBR against the market to aid in managing your balance sheet.

 

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.