BLM11210 - Lease accounting: lease classification: meaning of 'present value'
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 to entities applying FRS 102 pre 2024 amendments or FRS 105, and for lessors only under IFRS 16 and FRS 102 (2024 amendments).
See BLM17000 for lessee accounting under the on-balance sheet model under IFRS 16 and FRS 102 (2024 amendments).
FRS 102 (pre and post 2024 amendments) and FRS 105 Glossary defines ‘present value’ as a current estimate of the present discounted value of the future net cash flows in the normal course of business. It is most easily explained by an example. The concept of present value also applies in IFRS 16.
Assume market interest rates are 10% a year payable annually in arrears. This means a sum of £1,000 today will be worth £1,100 in a year’s time. On the other hand, £1,000 receivable in a year’s time is worth £909.09 today (£909.09 plus 10% is £1,000) and, of course, £1,100 receivable in a year’s time is worth £1000 now.
On the same assumptions, and assuming that interest is compounded, £1,000 in two years’ time will be worth £826.45. (£826.45 x 110% x 110% = £1,000).
The intervals at which compounding of interest occurs can have a significant effect. Interest at 10% calculated at monthly intervals is worth more than interest at 10% calculated at annual intervals. Interest is earned on interest earlier in the monthly case.
It is relatively simple to calculate the value of a stream of rentals. On the simple assumptions used here (10% interest annually in arrears), rentals of £1,000 receivable annually for 10 years will have a value of £6,144.57.
On the same assumptions, had the money receivable annually been £1,627.46 its net present value would have been £10,000.
Had the interest rate been only 6% the net present value of £1,000 receivable annually in arrears for 10 years would have been £7,360.09 and if £1,358.68 was receivable annually in arrears it would have a value of £10,000 today.
Therefore, ignoring the complexities of profits and tax benefits, which, in practice are very important, if the interest rate was 10%, a lessor buying an asset for £10,000 would break even at an annual rental in arrears of £1,627.46. If interest rates were 6% a rental of £1,358.68 would allow the lessor to break even.