An important accounting issue for lessors recording a lease is how much of the overall value should be recorded as gross investment and how much as unearned income. Vital to the calculation of these balances is the lessor’s implicit rate on the lease, as that percentage allows the lessor to divide the value of the lease. The nature of the implicit rate calculation is somewhat complex but is manageable by using a lease interest rate formula and either a computer spreadsheet or a calculator.
Determine Fair Market Value
Determine the fair market value of the underlying rented property. The fair market value is what the leased property would sell for if placed on the open market, and the seller was not under pressure to sell the property to obtain cash.
Determine Payment Terms
Read the lease and determine the minimum lease payment and number of payments that will occur during the lease. The minimum lease payment is the amount the lessee is expected to pay monthly per the terms of the agreement. The lease may explicitly state how many payments the lessee is expected to make, or you may have to figure it out separately. For example, if the lease just says the lessee will rent the property for four years and pay monthly, the total number of payments will be 48.
Calculate the Interest Rate
You can easily calculate the rate implicit in a lease in Excel, a Google Docs Spreadsheet, or Apple iWorks Numbers by using the "RATE" function. To calculate the implicit rate, find the percentage that, when applied to the sum of the minimum lease payments, causes the present value of all the payments to equal the current fair market price of the rental property. On a computer spreadsheet, type =RATE( in a cell. After the parenthesis, record a series of numbers.
For the first set of digits, record the number of payments and then follow that with a comma. Record the value of each rental payment and follow that with a comma. Record the negative value of the fair market price of the rental property and enter a closed parenthesis.
Hit enter and that will give you the implicit rate per payment period. So for example, assume a lease of 1 year, with monthly payment of $1,000, on a rental property of $10,000. The equation for that would be =RATE(12,1000,-10000). The result is a monthly implicit rate of 3%.
Alternate Method of Calculation
If you don't prefer to use a spreadsheet to make calculations, there is another option. While there is no implicit interest rate calculator per se, you can use a financial calculator. Simply divide the amount of total interest you will pay by the value of the lease and then multiply by 100. For example, (1,000/10,000) X 100 = 10%. Be sure to thoroughly understand how to figure the individual components of the formula so you arrive at a correct result.
If you are about to enter into a lease as either a lessor or lessee, consider consulting a licensed attorney in your area to ensure that your rights are protected. Also, considering using a certified public accountant to ensure that the implicit rate is correctly calculated. Information provided is for educational purposes only.
- If you are about to enter into a lease as either a lessor or lessee, consider consulting a licensed attorney in your area to ensure that your rights are protected. Also, considering using a certified public accountant to ensure that the implicit rate is correctly calculated. Information provided is for educational purposes only.
John Cromwell specializes in financial, legal and small business issues. Cromwell holds a bachelor's and master's degree in accounting, as well as a Juris Doctor. He is currently a co-founder of two businesses.