Lease accounting: finance lease accounting: finance lessees: apportionment of rents using Rule of 78
The following is a brief explanation of the Rule of 78.
The number 78 derives from the 12 monthly parts of a one-year period. The sum of those parts (12+11+10+9+8+7+6+5+4+3+2+1) is 78. Thus, for a loan with duration of one year, using this rule the lender expects you to pay 12/78ths of the interest in month one, 11/78ths in month two and so on down to 1/78th in month twelve. Because each repayment instalment is the same size, the part going to pay off the amount borrowed increases over time and the part representing interest decreases.
The SSAP 21 guidance notes for the Rule of 78 method state (paragraph 28)
“The Rule of 78 may normally be regarded as an acceptable approximation to the actuarial method; it works well provided that the lease term is not very long (say, not more than seven years) and interest rates are not very high.”
If these provisos do not apply but this method has nonetheless been used, it would be pertinent to ask why. In addition, where the lease is substantial in relation to the size of the lessee, the difference between the Rule of 78 and the actuarial method may be substantial. If that is the case, and if the difference is material, GAAP may require the actuarial method to be used. On the other hand, where the lease is relatively small compared to the size of the lessee, the finance charges may simply be immaterial and any method would be acceptable under GAAP.
The Rule of 78 is not restricted to monthly payments. For example, where a 5-year lease has rentals payable annually in advance there are 10 parts (4+3+2+1). No ‘interest’ is attributable to the rentals paid on day 1; 40% of the ‘interest’ is attributed to the next rental payment (paid after 1 year); 30% to the next, and so on.
Where a 5-year lease has annual rentals payable in arrears there are 15 parts (5 + 4 + 3 + 2 + 1).