Defining long funding leases: the three tests: the lease payments test: minimum lease payments, present value
The present value of the minimum lease payments is calculated by using the interest rate implicit in the lease, which is the interest rate that would apply in accordance with normal commercial criteria, including GAAP. Exceptionally, where the interest rate cannot be determined (as may happen in the case of some operating leases) the interest rate implicit in the lease is the temporal discount rate given by FA05/S70. (CAA01/S70O (4)).
Where the cost and the implied residual value of the asset are known the interest rate implicit in the lease is merely a matter of calculation. For example, if an asset cost £1000 and the implied residual value is nil, the interest rate implicit in the lease is the rate which, when applied to the lease rentals, gives a present value of £1000.
The same principle can be applied to operating leases as long as the cost and implied residual value are known. Using the example in BLM00065 if the rental payments are known it is a relatively simple matter to calculate the interest rate needed to ‘repay’ £30m of the £50m ‘loan’ over the term of the lease. The final £20m is, of course, not repaid by the lessee but met by the lessor from the value of the leased asset.
In some cases it may not be possible to establish the cost and implied residual value of the leased asset, perhaps because the rental is set by reference to current market rates. This is unlikely to happen in the case of a lease that might be a funding lease. But if it does, then in these circumstances it will be necessary to assume an interest rate in order to calculate the present value of the minimum lease payments. The statutorily prescribed rate is the temporal discount rate given by FA05/S70. This is a relatively low rate, which gives the rentals a relatively high present value.