Help on leases (Interest Expense)

CFA Level I FRA
#1

Hi, so I am getting a few questions wrong regarding interest expense for a given year. I think I know why, however, I’d really appreciate it if someone more knowledgeable could confirm my understanding.

On page 533-535 in the Fin Reporting CFA book, the question asks what the interest expense is for 2010. If you don’t feel like opening the book I will try to summarize the question for you:

You have a finance lease starting January 1st 2010 (fair value=PV of lease payments at 10% discount rate= 100,000). The lease term is 4 years, and you will pay 28,679 in lease payments each year. What is the interest expense in 2010?

Now from my understanding, lease payments are always made at the beginning of the year, therefore interest will be accrued over the year (Y) then paid on Jan 1st of the next year (y+1). But for this question, no time as passed in year 1 to when the first lease payment is due so the interest is 0 but the accued interest at the end of year 1 is 7132. When the CFA asks what an interest expense for a given year is for a lease, am I to assume that they want the Accrued Interest?

Am I right to think of it has a Debit to Interest expense in Y1 of 7132 even though it was only accrued? and a Credit to Accounts Payable? Is this always the case for leases that interest expense Y is the interest paid in Y+1? Will CFA ever try to throw me off and ask what the interest paid for Y1 would be in a similar question and the answer would be 0? Would this method be the same for account of a bond with annuity due payments (payments at beginning of year?

Thanks for any help.

#2

Yes, they are looking for the accrued interest here = (100,000 - 28,679) * 0.1 = 7,132. The interest clock started running as of January 1. You would debit interest expense, but credit Bond Interest Payable.

Lease payments don’t necessarily have to occur at the beginning of the year: it depends on the lease contract terms. If payments were to occur at the end of the year, the payment would be $31,547/year and the first year interest expense would be $10,000.

#3

I wrote a series of articles on leases that may be of some help here; they start here: http://financialexamhelp123.com/leases-general/

#4

Great! Thank you. And thanks for the heads up on lease payments not always being at the beginning in the year. Is it more common for the contract to state lease payments at beginning of the year?

#5

Very helpful. Thank you.

#6

Definitely more common for lease payments to be in advance than in arrears.