BLM11210 - Lease accounting: lease classification: meaning of 'present value'

This manual is being updated to reflect FRS 102 (2024 amendments). For guidance on the tax treatment of accounts prepared under IFRS 16 or the revised FRS 102, please refer to pages within the BLM50000 chapter.

The ‘present value’ (sometimes referred to as ‘net present value’) is the current value of money due to be received at a later date.  It is most easily explained by an example.

Assume market interest rates are 10% a year payable annually in arrears.  This means a sum of £1000 today will be worth £1,100 in a year's time.  On the other hand, £1000 receivable in a year’s time is worth £909.09 today (£909.09 plus 10% is £1000) and, of course, £1,100 receivable in a year’s time is worth £1000 now.

On the same assumptions, and assuming that interest is compounded, £1,000 in two year’s time will be worth £826.45.  (£826.45 x 110% x 110% = £1,000).

The intervals at which compounding of interest occurs can have a significant effect.  Interest at 10% calculated at monthly rests is worth more than interest at 10% calculated at annual rests.  Interest is earned on interest earlier in the monthly case.

It is relatively simple to calculate the value of a stream of rentals.  On the simple assumptions used here (10% interest annually in arrears), rentals of £1,000 receivable annually for 10 years will have a value of £6,144.57. 

On the same assumptions, had the money receivable annually been £1,627.46 its net present value would have been £10,000.

Had the interest rate been only 6% the net present value of £1,000 receivable annually in arrears for 10 years would have been £7,360.09 and if £1,358.68 was receivable annually in arrears it would have a value of £10,000 today.

Therefore, ignoring the complexities of profits and tax benefits, which, in practice are very important, if the interest rate was 10%, a lessor buying an asset for £10,000 would break even at an annual rental in arrears of £1,627.46.  And if interest rates were 6% a rental of £1,358.68 would allow the lessor to break even.