Navigate IBR: Portfolio or Lease-Specific Approach?

Portfolio vs. Lease-Specific IBR: When Each Approach Works

The implementation of ASC 842, Leases, fundamentally changed how lessees account for their agreements. A cornerstone of this new accounting framework is the incremental borrowing rate (IBR), which directly influences the measurement of lease liabilities and right-of-use (ROU) assets. Getting portfolio vs. lease-specific IBR: when each approach works right is critical for accurate financial reporting and, frankly, for avoiding audit headaches. The decision between a portfolio and a lease-specific IBR approach really boils down to a company's specific situation, the nature of its leases, and what's practical. While the Financial Accounting Standards Board (FASB) does offer practical expedients, we've seen they need to be applied with a good deal of judgment.

Q: What is the difference between portfolio and lease-specific IBR under ASC 842?

A: The incremental borrowing rate (IBR) is the rate of interest a lessee would pay to borrow, on a collateralized basis, over a similar term, an amount equal to the lease payments in a similar economic environment. A lease-specific IBR is tailored to each individual lease, factoring in its unique terms, duration, and the underlying asset. In contrast, a portfolio IBR applies a single rate, or a limited set of rates, to a group of similar leases, typically grouped by asset class, lease term, or currency. This distinction is absolutely vital for ASC 842 compliance and managing complexity, especially when you're dealing with a large volume of leases.

What Auditors Are Actually Looking For

When we, as auditors, look at IBR determination, we're not just checking numbers; we're evaluating the underlying methodology, the assumptions made, and the internal controls supporting management's chosen IBR. The completeness assertion – ensuring all transactions and accounts that should be recorded have been – is particularly relevant here for both lease identification and IBR application. We'll scrutinize whether the choice between a portfolio or lease-specific approach aligns with the entity's specific facts and circumstances and that the methodology is applied consistently.

⚠️ Risk Alert: We've seen a common audit finding where companies lack adequate supporting documentation for their IBR methodology, often leading to significant adjustments. This can materially impact ROU asset compliance and lease liability accuracy.

Here's what we typically focus on during an audit:

• Methodology Rationale: We expect a clear justification for either a portfolio or lease-specific approach, or a combination, including a robust assessment of qualitative and quantitative factors.
• Data Integrity: The accuracy and completeness of inputs used to calculate the IBRs are paramount. This means checking credit ratings, lease terms, and collateral characteristics.
• Consistency: We need to see consistent application of the chosen methodology across similar leases and reporting periods.
• Expert Reliance: If external experts determined the IBRs, we'll evaluate their competence, objectivity, and the reasonableness of their assumptions, consistent with AICPA standards¹.
• Documentation: Comprehensive documentation supporting all inputs, calculations, and management judgments is non-negotiable. We're looking for a clear audit trail for every IBR used.

As Deloitte highlights, a robust IBR methodology framework is crucial. From our perspective, a "well-defined and consistently applied methodology for determining the IBR is crucial for both accurate financial reporting and ease of audit" ². This framework really needs to articulate the criteria for using a portfolio versus a lease-specific rate.

Q: How do auditors test portfolio vs. lease-specific IBR: when each approach works?

A: Our testing primarily focuses on the chosen methodology, the inputs used, and how the IBRs are applied. This involves reconciling selected leases to the IBR in the lease accounting software, vouching inputs (like credit ratings or benchmark rates) to external evidence, and re-performing calculations for a sample of leases. We'll also review management’s rationale for applying a portfolio or lease-specific strategy to ensure it aligns with ASC 842 principles (FASB ASC 842-20-30-3)³. Our audit procedures will always include lease compliance procedures to confirm the appropriate IBR has been used.

Key Risks and Failure Points

We've seen that missteps in determining the appropriate IBR – whether taking a portfolio or lease-specific approach – can lead to material misstatements, requiring significant re-work and potentially impacting key financial ratios.

• Inappropriate Use of Portfolio Rates: Applying a single portfolio rate to leases with materially different characteristics (e.g., lease term, credit risk, collateral) can result in an IBR that simply doesn't reflect the specific lease's true borrowing cost. This often leads to an under- or overstatement of the lease liability and ROU asset. For example, using an average portfolio rate for a 5-year office equipment lease and a 20-year warehouse lease is generally inappropriate unless there's a very specific, well-documented justification.
• Insufficient Documentation: A lack of robust documentation for the IBR methodology, inputs, and the ultimate rate selection is a significant audit risk. Without clear evidence, we can't verify management's judgments, which often leads to audit adjustments. This directly impacts ROU asset compliance.
• Failure to Update Rates: IBRs are highly sensitive to economic conditions. Failing to reassess or update portfolio rates, particularly during periods of significant interest rate volatility, can lead to inaccurate lease measurements for new or modified leases. This is where most teams get tripped up.
• Inconsistent Application: Applying a lease-specific rate for some leases and a portfolio rate for others without clear, documented criteria creates inconsistencies that we will undoubtedly challenge. This is especially true for entities assessing portfolio vs. lease-specific IBR: when each approach works controls.
• Poor Estimation of the Collateralized Rate: Management often struggles to accurately estimate the equivalent collateralized borrowing rate. Without recent collateralized borrowing history, the uncollateralized rate has to be adjusted, a process prone to error if not appropriately supported by market data or expert judgment.

Calculation Example: Impact of IBR Choice

Scenario: A company has two new leases starting on the same day: Lease A (5-year term, office equipment) and Lease B (10-year term, warehouse). The company's uncollateralized borrowing rate is 6.0%.

Key Takeaway: Using a single, higher portfolio IBR for Lease A understates its liability by $1,368. Conversely, for Lease B, a lower portfolio IBR overstates its liability by $1,752. Across a large lease portfolio, these differences can quickly become material.

Practical Checklist for IBR Determination

This checklist offers a structured approach for controllers and accounting managers to assess their IBR methodology, particularly when considering how to identify embedded leases in contracts and apply the right rates.

✅ Best Practice: We've observed that organizations with strong execution conduct quarterly lease reviews to identify new leases and assess macro-economic changes that may impact IBRs for future leases ⁴. This proactive approach significantly aids lease identification testing.

How Accounting Teams Should Validate Their Approach

Validation is absolutely key to ensuring your chosen IBR approach – whether portfolio or lease-specific – is robust and defensible during an audit. This means internal checks and balances, independent reviews, and proper documentation. For additional validation insights, we've put together a guide on IBR documentation requirements.

Accounting teams should consider these steps:

1. Conduct Internal Spot Checks: Periodically pick a sample of leases and recalculate their IBRs (both lease-specific, if applicable, and portfolio if used) using your documented methodology. Then, compare your results to what's recorded in the lease accounting software.
2. Seek Independent Review: Consider engaging your internal audit function or even an external valuation specialist to independently review your established IBR methodology and a sample of IBR calculations. That outside perspective can often flag potential weaknesses before an external audit does.
3. Review Inputs for Reasonableness: Verify that market data, credit ratings, and other inputs used in your IBR calculations are current and appropriate for your entity’s economic environment. For instance, are the spreads you're using for collateralization still reasonable given current market conditions?
4. Confirm Consistency: Ensure that the criteria for applying a portfolio versus a lease-specific rate are consistently applied across your entire lease portfolio. Any deviations need to be explicitly documented and justified, in line with FASB guidelines. The AICPA Audit Guide also emphasizes the significance of consistency across periods.
5. Maintain a Comprehensive Audit Trail: Every decision point, input, and calculation for IBRs must be meticulously documented. This includes expert reports, internal memos, external market data, and management's rationale for any judgments made. This directly addresses what documentation is required for portfolio vs. lease-specific IBR: when each approach works.

💡 Key Takeaway: An organization’s commitment to implementing rigorous validation steps really signals maturity in its lease accounting compliance processes.

Common Mistakes and How to Avoid Them

The complexities of IBR determination often lead to common pitfalls, particularly concerning portfolio vs. lease-specific IBR: when each approach works controls.

🚨 Critical: Failure to adequately differentiate or properly support the choice between portfolio and lease-specific IBRs is among what are common portfolio vs. lease-specific IBR: when each approach works audit findings, often requiring recalculations and, in severe cases, re-issuance of financial statements. PwC emphasizes that auditors will critically review the basis for applying any practical expedients or portfolio approaches⁵.

What Strong Execution Looks Like in Practice

Organizations that truly excel in IBR determination demonstrate a clear, well-documented, and consistently applied methodology for both portfolio and lease-specific IBRs. This is what leads to efficient audits and reliable financial reporting.

Consider, for example, a manufacturing company with a large vehicle fleet and several corporate office leases. They might establish a portfolio IBR for their vehicle fleet because the terms and asset types are largely similar. However, their significant, long-term manufacturing facility leases, each with unique financing terms and credit profiles, would absolutely warrant lease-specific IBRs. Their finance team maintains robust documentation, which includes a detailed IBR policy, market data from credible sources, and periodic reviews of its credit rating. New leases are automatically routed through a defined IBR determination workflow. Monthly reconciliations confirm the rates in the lease accounting software align with the approved methodology. This proactive approach ensures that when auditors perform lease identification testing and assess the IBRs, the company has immediate access to all supporting evidence, significantly reducing audit time and potential findings. The result? A smooth audit process, clean financial statements, and confidence in its lease accounting compliance.

Next Steps

To further enhance your understanding and ensure robust compliance, we recommend reviewing your organization's current IBR determination process. Consider whether your methodology aligns with current best practices and audit expectations. Prioritize comprehensive documentation for all IBR-related decisions and calculations.

Related Articles

• IBR Documentation Requirements
• How to Calculate Incremental Borrowing Rate
• ASC 842 Audit Findings: What to Expect
• Mastering the IBR Under ASC 842