Financial reporting standards expert Steve Collings works through an example of a finance lease and how the interest is recognised under FRS 102 using the effective interest method.
Under FRS 102 The Financial Reporting Standard applicable in the UK and Republic of Ireland, leasing transactions are dealt with in Section 20 Leases. Section 20 is broadly similar to the provisions in SSAP 21 Accounting for leases and hire purchase contracts and the FRSSE in many cases, however, there are some notable differences between FRS 102 and outgoing UK GAAP, for example:
- there is no 90% ‘bright line test’ in FRS 102 that indicates a lease is a finance lease; instead there are eight indicators that a lease is a finance lease in paragraphs 20.5 and 20.6 (in practice this is not expected to have a material difference on transition where the fair value of the leased asset was considered to be a sufficiently close approximation to the present value of the minimum lease payments);
- the minimum lease payments in a finance lease are split into the capital and interest elements, and paragraph 20.11 requires the use of the effective interest method to apportion those payments (the worked example in this article shows how this can be done efficiently using Excel); and
- the disclosure requirements in respect of operating lease commitments are different under FRS 102 than in outgoing GAAP (this is considered towards the end of the article).
This article will not consider the detailed intricacies of Section 20 in FRS 102 as these should be fairly-well understood by practitioners at this stage. Where there are still elements of confusion, accountants can download a free copy of Staff Education Note 06: Leases which may help in understanding some of the technical concepts of Section 20.
Initial recognition of a finance lease for a lessee
Paragraph 20.9 of FRS 102 requires a lessee to recognise a finance lease in the balance sheet at an amount equivalent to the fair value of the leased asset or, if lower, the present value of the minimum lease payments determined at the start of the lease. Directly attributable costs (such as legal fees) associated with arranging the lease are also included in the cost of the capitalised asset.
Effective interest method
Where the calculation of the interest expense in a finance lease is concerned, many practitioners have previously used either the level spread method of interest recognition or the sum-of-the-digits method and concerns have been raised as to how the effective interest method works under FRS 102 because for many this is a new method.
The effective interest method uses an effective interest rate. The effective interest rate exactly discounts the estimated future cash payments (for a lessee) or future cash receipts (for a lessor) over the life of the lease. To do this in practice, it is advisable to use the ‘Goal Seek’ function within Excel and this can be illustrated using a simple example as follows:
Example – Dealing with a finance lease for a lessee
A company enters into a finance lease for a machine that has a fair value of £35,000 which is also equivalent to the present value of the minimum lease payments. The lease term is five years and this is also the major part of the economic life of the asset, hence classification as a finance lease per paragraph 20.5(c) is appropriate in these circumstances. The machine is not expected to have any residual value at the end of this five-year useful economic life. The monthly payments, comprising capital and interest, are £685 per month and there is an option to purchase fee payable at the end of the lease term of £150 which is included in the final payment. Arrangement fees have been ignored for the purposes of this example and cash flows have been calculated on an annual basis.
In years 1 to 4, the company will pay £8,220 (£685 x 12) to the lessor and in year 5 it will pay £8,370 (£685 x 12 + £150). The lease provisions can be profiled in an Excel spreadsheet as shown below:
The formulas used in the above spreadsheet are shown below:
The Goal Seek function in Excel can be used to work out an effective interest rate in cell C1 that will then be applied to cells D4 to D8 resulting in cell E8 becoming zero.
To use the Goal Seek function in Excel to work out the effective interest select ‘Data’ and ‘What-if Analysis’ as shown below:
The aim is to get cell E8 to show a value of £nil by changing cell C1 (i.e. to work out the interest over the life of the lease that will be recognised in profit or loss). Once we select the Goal Seek function we enter the following information:
Once we click OK, Excel will calculate the effective interest rate in cell C1 and the interest expense in cells D4 to D8 automatically as follows:
The effective interest rate is charged at 5.72% and in accordance with paragraph 20.11 of FRS 102 is allocated to each period during the term of the lease in order to produce a constant periodic rate of interest on the remaining balance of the liability. In addition, the interest charges are higher in the earlier years of the lease and lower in the later years. In contrast, the level spread method would have simply charged an amount of £1,250 per annum over the life of the lease (£41,250 less £35,000/5). The effective interest rate method, whilst inherently more complex than the level spread method, produces a more realistic interest expense in the profit and loss account as it is based on the remaining balance of the liability.
The depreciation charges on this machine are over the life of the lease at an amount of £7,000 as there is no residual value expected at the end of this five-year period (five years is also the expected useful economic life of the machine) hence the entries in year 1 are as follows:
£ | |
Dr Plant and equipment additions | 35,000 |
Cr Finance lease obligation | (35,000) |
Being new equipment obtained on a finance lease | |
Dr Depreciation charges (profit and loss) | 7,000 |
Cr Accumulated depreciation (balance sheet) | (7,000) |
Being depreciation charge on new equipment | |
Dr Finance lease obligation | 8,220 |
Cr Cash at bank | (8,220) |
Being payment to lessor in year 1 | |
Dr Interest expense (profit and loss) | 2,004 |
Cr Finance lease obligation | (2,004) |
Being interest charge at EIR |
£ | |
Dr Finance lease obligation | 8,220 |
Cr Cash at bank | (8,220) |
Being payment to lessor in year 2 | |
Dr Interest expense (profit and loss) | 1,648 |
Cr Finance lease obligation | (1,648) |
Being interest charge at EIR |
Operating leases
Under SSAP 21, a lessee that had entered into an operating lease would disclose the payments that the entity is committed to make in the relevant time bands according to when the lease commitment expires.
Example – Disclosure under previous UK GAAP
A company enters into a five-year operating lease for some computer equipment on 1 January 2014 and is preparing its financial statements to 31 December 2015. Annual payments in respect of this operating lease are £10,000, therefore this is the amount that will be paid to the lessor in the year to 31 December 2016.
SSAP 21 requires disclosure of annual commitments analysed between those that expire:
- within one year;
- within two to five years; and
- over five years from the balance sheet date.
Therefore, the company would show £10,000 in the two to five years’ time band.
Under FRS 102, the lessee discloses the total future minimum lease payments due within each of the required periods rather than the annual amount due to expire in the relevant year.
Example – Disclosure under FRS 102
Using the example above, the total of future minimum lease payments under non-cancellable operating leases as at 31 December 2015 would be disclosed as follows:
- Not later than one year: £10,000
- Later than one year and not later than five years: £20,000
Conclusion
This article has considered a simple worked example concerning a finance lease and how the interest is recognised under FRS 102 using the effective interest method. The Goal Seek function in Excel is the most efficient means to calculate the interest as this will also result in the creditor falling due within and after more than one year also being calculated.
In addition, the operating lease disclosure has also seen a change from that which was required under previous UK GAAP, so remember to time-apportion the total liability in the operating lease for disclosure purposes rather than disclosing the payments due to be made in the next 12 months.
*13 March: This article has been revised after an issue was flagged with the timings of payments*
Replies
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Hi Steve. Is it right that no interest is charged in year 5 in your finance lease example?
@cwoodthorpe Thanks for pointing this out. Steve has now sent over a revised version.
All the best,
Tom
Thanks Tom. The original workings were based on payments in advance, which was not the case in the example above as the client is paying monthly. The wrong spreadsheet was embedded into the article!
Well spotted, though ;-)
I had a lengthy discussion about this with the institute's helpline who also advised using exactly this approach for our clients that have HP and finance leases. The problem is for me that you end up in exactly the same place you would have ended up if you used the straight line method of interest allocation. I can see the logic but I don't agree that we should have to go to these extremes for our clients who are only small at the end of the day. Hopefully they'll bring back FRSSE once we are out of the EU!
Under FRS 102, can the level spread method of allocating the interest be adopted for small value finance leases based on materiality?
Is the author prepared to comment on the accounting treatment required under FRS 102 for the transitional accounting adjustments where the level spread method of allocating interest has previously been adopted.
I have always used Rule of 78, which is as good an approximation as any tapered cash flow of such a lease. From the perspective of small and micro clients any difference can only be immaterial.
OTT, as are the continual changes in these rules.
Other than the more substantial businesses, (and I am not sure many of those are bothered either), no one cares!
Agree, I will continue with SODS method, any differences for my clients will be so immaterial that the cost/benefit of the b*llocks, with no offence to Steve intended, described above is none - one wonders if these people can't find a useful job instead of changing the goalposts every few years - If one didn't know better one would think they did it just to keep themselves in a job!
Thanks for a very helpful article.
It would be useful to see the changes for FRS102 in respect of Lessors (if there are any)
Thanks for this Steve.
To clarify a couple of points:
1. The straight-line basis is presumably now verboten?
2. The operating lease disclosure example - why £20k for the "later than one year and not later than five years"? Rather than £40k i.e. 4 years @ £10k pa (in addition to the < one year disclosure)?
Thanks in advance
I think the disclosure should be £10k within one year, leaving £30k in later than one year and not later than five years. The loan starts 1 Jan 2014, remember, so one year's liability has been satisfied in the current financial year, leaving 4 yrs outstanding at the year end, not 5 as you surmised.
Cheers Wolfie.
On reflection, years 1 & 2 have already been paid (2014 & 2015), leaving £30k left as payable overall - 10K within 12 months & £20k between 2 & 5 years. i.e. As Steve has in the original article!
Note to self: must read question fully before answering...
Ha! I stand corrected. As my old FT lecturer used to say before exam time - "RTFQ"!!
Hmmm. I have tried to replicate your EIR example but I think you are missing formulas in your Interest column which link these cells to your C1 EIR target cell. Can you advise?
I think it's c1 x B4 then c1 x b5 etc. I redid it and it comes back to the example. I'm using these spreadsheets for our clients and they seem to be a lot easier than discounting these [email protected] things.
Yes for the goal seek to work the interest calculation formulas will need to rely on cell C1
I printed the original article and it had the formulas in that's how I got it To work - the updated article doesn't though.
Thanks everyone for your comments. For some reason when we updated the article the formulas were wiped. An amended (amended) version has now been put up to replace it.
All the best,
Tom
All of this is absurd for "small time" accountants and their clients.
We adopt the "KISS" method
This is the first time I have read an FRS102 article and smiled at the end - this is the way we have always worked out interest on loans, and always described it as Effective Interest Rate to clients who used to quote APR at me, but I never knew about the Goal Seek function and I used to work it out on trial and error to get the same result!
The justification in the extra work was always to allow clients to make sure they were claiming the lions share of interest in the early years which, of course, reflects the reality of the position. After all our job is to help them save tax!
Thanks Steve!
Dear Steve, thank you so much for this as we've been struggling to understand what the effective rate actually means!
I have a question over the initial values in the Balance Sheet. In your example you say that the present value of the minimum lease payments is equal to the fair value of the asset but in the calculation the lease payments are greater than the Finance Liability. Am I missing something on those initial entries?
Hi Steve
Ignore my question, I think I've got majorly confused.
Thanks
Carole
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