When we look at the statement of comprehensive income, the costs associated with the leased asset held under a finance lease will be:
- Finance charges (interest), and
- Depreciation charge
In this article, we look at finance charges and how to calculate them for ACCA F7 Financial Reporting.
Finance charges (interest)
Let’s look at how to calculate the amount of interest and finance charges that will apply.
The total interest charges for a leased asset under a finance lease must be applied in such a way to reflect a constant rate of interest due to the lessor.
What this means is that as the lease liability reduces, the interest payable should also reduce.
IAS 17 allows two methods of calculating the interest applicable to a lease, these are:
- The actuarial method, or
- The sum of digits method
This method uses actuarial or interest tables to calculate the amount of interest chargeable in the period.
The rate will be applied to the opening balance of the lease liability at the start of the accounting period to calculate the finance charge.
Sum of Digits Method
The sum of digits method takes the total interest charge in the lease agreement and distributes it over the life of the agreement in proportion to the balance outstanding.
The result will be an approximation of the actuarial method.
The formula for calculating the sum of digits method is
n(n+1) / 2
n is the number of installments in arrears. If the payments are made in advance, take the number of payments and subtract 1 for n.
An example of this is if 5 annual payments are required under a finance lease.
The sum of digits is calculated as 5(5+1)/2 = 15
We then calculate the total amount of interest payable over the term of the lease agreement and allocate it as follows:
Rental in arrears
If the lease payments are made in arrears, that is at the end of the accounting period, interest will be charged to the amount of the outstanding lease liability, so n is equal to the number of lease payments.
The interest accrual will be paid as part of the repayment made on the last day of the period.
Rental in advance
When the lease payments are made in advance the treatment is slightly different.
By paying in advance, there will be no interest payable in the final period, because the outstanding principal will be paid at the start of the final period, and no interest will accrue during the year.
As a result, there will be no interest charge in the income statement for the final period.
So let’s say a company makes lease payments for five years and pays annually in advance.
For the financial statements in years, one to four there will be an interest charge associated with the finance lease, but none in year 5.
The opening liability for the lease liability is reduced by the rental or lease payment at the beginning of the year and interest accrues on the balance.
Schedule of payments
When you’re working out the lease payments in the exam, a good idea is to create a schedule of payments as follows:
|Period||Opening principal balance||Lease payment||Interest expense||Principal reduction||Closing principal balance|
- L = The annual payment required by the lease agreement
- I = The interest charge for the period
- P = The principal reduction is the lease payment less the interest charge
- C = This is the present value of lease payments minus the amount of the principal reduction. The closing balance for the current period will be the opening balance for the next period. By using a schedule like this before you do any journal entries or go ahead with your question, you’ll see if you’re figures are right if they reduce to nil at the end of the period.