BLM15025 - Lease accounting: finance lease accounting: finance lessees: profit and loss account
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.
This section is applicable听to entities applying FRS 102 pre 2024 amendments or FRS 105.听
See BLM17000听for lessee accounting under the on-balance sheet model under IFRS 16 and FRS 102 (2024 amendments).听
Under the lease the lessee pays rents.鈥� For a 'classic' finance lease the effect of paying rent is that the lessee repays the lessor for 听its听investment in the asset听and听pays interest听for听the finance provided by the lessor.鈥� As with a听loan,听the interest element is written off over the 'loan' period, which will normally correspond to the primary lease period.鈥� In other words, the rents that represent听'interest' are not written off in the same way, nor over the same period of time, as rents that represent听the repayment of the investment.鈥� Thus, to听give effect to the accounting treatment it is necessary to apportion rents听between these two elements.听
The rentals payable by the lessee are split into two elements:听
one is a 'capital' element repaying the 'loan' (reducing the liability in the balance sheet)听
the other is a 鈥榝inance charge鈥� or 'interest' element (which is debited to the lessee's profit and loss account).听
The finance lease will therefore be reflected in the lessee's profit and loss account through a depreciation charge (BLM15010)鈥痑nd a finance charge.听
Note that the depreciation charge is not the same as听the capital element of the rentals on a period-by-period听basis.鈥� However, over the term of the lease the total of the capital elements will in principle be equal to the sum of the depreciation charges as both are based on the cost of the asset at the beginning of the lease.听
In addition,听the lessee shall charge contingent rents (BLM11010) as expenses in the periods in which they are incurred听(FRS 102听(pre 2024 amendments)20.11).听
The first step in the accounting process is to apportion rents between:听
the amount representing听the lessor's investment (the cost of the underlying asset - for practical purposes this is described as the 'capital element' of the rents), and听
the amount representing听the lessor's return on its investment (the lessee's financing costs, described as the finance charge or 'interest element' of the rents).听
FRS 102听(pre 2024 amendments)听Section听20.11 says听
鈥淎 lessee shall apportion minimum听lease payments between the finance charge and the reduction of the outstanding liability using the effective interest method. The lessee shall allocate听the finance charge to each period during the lease term so as to听produce a constant periodic rate of interest on the remaining balance of the liability.鈥�听
The effective interest method is a way of allocating听the interest expense against the lease liability over the relevant period.听 The effective interest rate is the rate that exactly discounts the future cash rentals through the term of the lease.听 The effective interest rate is determined听on the basis of听the carrying amount of the lease liability at initial听recognition.听
The effective interest method provides:听
(a) the amortised cost of the lease liability is the present value of future cash rentals discounted at the effective interest rate; and听
(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.听
Practically this听will mean that a higher finance charge will be recognised at the start of the lease because of the higher lease liability.听 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.听
Checking how a finance lessee鈥檚 finance charges are allocated听between periods of account under GAAP is not likely to be worthwhile, except in the more unusual cases听