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These are both from the BPP study kit:
First scenario
On 1 October 20X3, Fresco Co acquired an item of plant under a five-year lease agreement. The lease required an immediate deposit of $2 million with five payments of $6 million paid annually in arrears commencing on 30 September 20X4. The present value of the future lease payments was $22,746,000. The agreement had an implicit finance cost of 10% per annum.Second scenario
On 1 January 20X6 Platinum Co entered into a lease agreement. The initial lease liability was $360,200 and a deposit of $120,000 was payable on 1 January 20X6 with three further instalments of $100,000 payable on 31 December 20X6, 31 December 20X7 and 31 December 20X8. The rate of interest implicit in the lease is 12%.Now in the first scenario the book doesn’t take the $2 million deposit into consideration at all and calculates interest on the PV of $22,746,000.
In the second scenario however it first deducts the $120,000 deposit from the PV of $360,000 and then applies interest.
I don’t get it. Both scenarios seem identical to me. Is it because in the second scenario it says the “initial” lease liability (so you have to deduct the deposit), whereas in the first it says the “PV of future lease payments” so the deposit has already been deducted?
Hi.
Please keep in mind that interest is always accrued on an amount that is ‘payable in the future’. How can you charge interest on an amount that will be paid immediately or is already paid?
Initial deposits, whether included in the initial lease liability or otherwise, cannot accrue interest. Therefore they must not be used for calculating interest.
Secondly, an alternate way of identifying which amounts to charge interest on can be identified using present values. Although there is no need to calculate PVs (they will be given in exam), you can still make your own calculation to confirm the proportion of liability that will accrue interest.
In the first example, PVs are calculated for the five annual instalments of $6m only whereas in second example, the amount of $360,200 includes the initial deposit (it is obvious as the total of three annual instalments of $100,000 will be below $360,200 even before discounting).
Therefore in first example, you don’t need to worry about initial deposit amount. In second example, however, you will need to deduct initial deposit to charge interest.I hope that this answers your query.
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