If your company leases vehicles—whether a single company car or an entire fleet—you've likely encountered one of the trickiest aspects of ASC 842 compliance: determining the Incremental Borrowing Rate (IBR).
The IBR directly impacts your lease liability and right-of-use (ROU) asset calculations, making it a critical number to get right. In this guide, we'll walk through exactly how to determine an appropriate IBR for vehicle leases and address common complications like sales tax, residual value guarantees, and initial direct costs.
What Is the Incremental Borrowing Rate?
The IBR is defined under ASC 842 as:
"The rate of interest that a lessee would have to pay to borrow, on a collateralized basis, over a similar term, an amount equal to the lease payments, in a similar economic environment."
In plain terms, it's the interest rate your company would pay on a secured loan with terms similar to your lease. For a 3-year vehicle lease, think about what rate you'd get on a 3-year auto loan.
The 12-Step Process for Determining Your Vehicle Lease IBR
Check for the Rate Implicit in the Lease
Before calculating your own IBR, check whether the lessor has disclosed the interest rate implicit in the lease. For vehicle leases, this is rarely disclosed.
Consider the Risk-Free Rate Option
Private companies can elect to use a risk-free rate as a practical expedient. However, this typically results in higher lease liabilities.
Recognize Vehicle Lease Characteristics
Vehicle leases are typically short-term (1–5 years) with marketable collateral, which generally supports a lower credit spread.
Gather Internal Borrowing Data
Look at existing auto loans, equipment financing, credit lines secured by similar assets, and recent vehicle purchases financed through banks.
Establish a Risk-Free Base Rate
Use the U.S. Treasury yield curve or SOFR curve. Match the lease term with the equivalent point on the curve.
Perform Credit Risk Assessment
Assess creditworthiness using debt-to-equity ratio, EBITDA coverage, cash flow stability, and industry risk factors.
Estimate Your Credit Spread
Consult with your bank, use loan pricing tools, or reference publicly available data on similarly-rated borrowers.
Calculate the IBR
Combine your components: IBR = Risk-Free Base Rate + Credit Spread. Example: 2.8% + 3.0% = 5.8% IBR
Adjust for Lease-Specific Factors
Consider payment timing, balloon payments, and seasonal variations. Standard vehicle leases typically don't require adjustments.
Document Everything
Maintain records of data sources, assumptions, calculation methodology, and approval process. Update annually.
Apply Consistently
Group leases by asset class, lease term, and commencement period. You don't need a unique IBR for every lease.
Know When IBR Can Change
IBR can only change when lease liability is remeasured due to term changes, payment modifications, or option likelihood changes.
Practical Example: Calculating a Vehicle Lease IBR
Scenario: Company leasing a delivery van for 3 years with monthly payments of $500
| Component | Value | Notes |
|---|---|---|
| Base Rate | 2.8% | 3-year Treasury yield |
| Credit Assessment | Moderate | Good cash flow, reasonable leverage |
| Collateral Factor | Favorable | Vehicles are marketable assets |
| Credit Spread | 2.7% | Reduced slightly for collateral quality |
| Calculated IBR | 5.5% |
This 5.5% rate is then used to discount the lease payments and calculate your initial lease liability and ROU asset.
Handling Sales Tax, Residual Values, and Other Costs
Sales Tax Treatment
How you account for sales tax depends on when the legal obligation arises:
Scenario 1: Lump sum at lease commencement
If your state requires full sales tax payment upfront, record it as a separate liability and initial direct cost—not as part of the lease liability.
Scenario 2: Monthly with each payment
If sales tax is charged monthly, expense it as incurred each month.
Residual Value Guarantees (RVG)
Vehicle leases commonly include residual value guarantees. Here's how to handle them:
- For lease classification: Include the full guaranteed amount
- For measuring the lease liability: Include only amounts probable to be owed
RVG Example
- Contractual RVG: $3,000
- Expected vehicle value at return: $2,800
- Amount included in lease liability: $200
Remember: Reassess this estimate at each reporting period.
Initial Direct Costs (IDC)
ASC 842 significantly narrowed the definition of initial direct costs compared to ASC 840.
✓ Qualifies as IDC
- Commissions paid only after lease execution
- Incremental fees that wouldn't exist without the lease
- Payments to existing tenants to terminate early
✗ Does NOT Qualify as IDC
- Employee salaries (paid regardless of lease)
- Legal and tax advice costs
- General overhead and administrative costs
- Any costs incurred before signing
The impact: IDC is added to the ROU asset, not the lease liability.
Vehicle Lease Component Summary
| Component | Treatment | Affects Liability? | Affects ROU Asset? |
|---|---|---|---|
| Monthly base payment | Lease payment | Yes (PV) | Yes |
| Sales tax (monthly) | Expense as incurred | No | No |
| Sales tax (lump sum) | Separate liability + IDC | No | Yes |
| Residual value guarantee | Probable amount only | Yes | Yes |
| Acquisition fee (incremental) | Initial direct cost | No | Yes |
| First month at signing | Prepaid rent | No | Yes |
| Security deposit | Separate asset | No | No |
| Maintenance included | Non-lease component | No* | No* |
*Unless you elect the practical expedient to combine lease and non-lease components.
Complete Example: Putting It All Together
A comprehensive example showing how all the components come together.
Lease Terms
- 3-year vehicle lease
- Monthly payment: $500
- Sales tax: 6% monthly ($30/month)
- Residual value guarantee: $8,000 (expected FMV: $8,500)
- Acquisition fee: $300 (incremental)
- First month at signing: $500
- IBR: 5.5%
Calculations
- Lease Liability = PV of 35 payments × $500 + $0 residual guarantee
(Probable RVG = $0 since FMV exceeds guarantee) - ROU Asset = Lease Liability + $500 (prepaid) + $300 (IDC)
- Monthly Entry = Record $30 sales tax expense
- Ongoing = Reassess RVG at each reporting period