BLM15030 - Lease accounting: finance lease accounting: finance lessees: apportionment of rent and allocation of finance charges

As described at BLM15025

the first step in the accounting process is to apportion rents between

• the amount representing the lessor’s investment (the cost of the underlying asset - for practical purposes this is described as the ‘capital element’ of the rents), and
• the amount representing the lessor’s return on its investment (the lessee’s financing costs, described as the finance charge or ‘interest element’ of the rents).

FRS 102 Section 20.11 says

“A lessee shall apportion minimum lease payments between the finance charge and the reduction of the outstanding liability using the effective interest method. The lessee shall allocate the finance charge to each period during the lease term so as to produce a constant periodic rate of interest on the remaining balance of the liability.”

The effective interest method is a way of allocating the interest expense against the lease liability over the relevant period. The effective interest rate is the rate that exactly discounts the future cash rentals through the term of the lease. The effective interest rate is determined on the basis of the carrying amount of the lease liability at initial recognition.

The effective interest method provides:

(a) the amortised cost of the lease liability is the present value of future cash rentals discounted at the effective interest rate; and

(b) the finance charge in a period equals the carrying amount of the lease liability at the beginning of a period multiplied by the effective interest rate for the period.

Practically this will mean that a higher finance charge will be recognised at the start of the lease because of the higher lease liability. As the lease liability is reduced, and given the constant effective rate of interest, the finance charge will reduce over the term of the lease.