Lease accounting: finance lease accounting: finance lessors: gross earnings under SSAP 21
The finance lessor’s gross earnings (‘interest’) each year are generally found by attributing the total ‘interest’ lessors get over the whole period of the lease to each accounts year proportionately to the capital outstanding in each period. This produces a declining amount of gross earnings (and so net profit) each year where the rentals are structured like a repayment mortgage. This is because the ‘loan’ owed by the lessee at the outset gradually reduces. Hence the high loan figure in the early years allocates proportionately more ‘interest’ earnings to those years and vice versa for the later years.
SSAP 21 expresses this ‘interest’ recognition principle as follows:
“For the purposes of profit recognition the total gross earnings (i.e. the ‘interest’ receivable) “should normally be allocated to accounting periods to give a constant periodic rate return on the lessor’s net cash investment in the lease in each period.”
(Paragraph 39 of SSAP 21 and further explained in paragraph 78 of the Guidance Notes on the Standard.)
Net cash investment is explained at BLM14020.
Translated this simply means that you spread the gross earnings (‘interest’) so that the lessor earns the same percentage rate in each period on the capital he has invested in that period. The result will be different where the ‘interest’ rates are variable but that is only a minor complication of the general principle.
The lessor’s main expense by far is the interest it has to pay on the money used to buy the asset it leases. This interest expense obviously declines as the ‘capital’ is repaid by the lessee. Accountants seek to match the interest payable by the lessor with the ‘interest’ earned on the capital each year.