dontknow1987

Just work through the whole life cycle of the lease to understand it. Your firm signs a lease today (January 1, 2006) for a 5 year term with payments due the first of each year for $10,000 a payment. Interest rate is 8%.

You write the check today for $10,000. That's done, book it, forget about it. Now what about the next 4 years? Find the present value of those payments: FV = 0, Int = 8%, PMT = 10,000, N = 4, calculate PV = $33,121.27. That's your lease liability. But we can also see that $40,000 total payments - $33,121.27 PV = $6,878.73 in interest for the whole lease.

January 1, 2007 rolls around. You owe $10,000. Write the check for the full amount, send it out. Part of that was for interest. 8% of $33,121.27 is $2,649.70 (interest expense). The payment to the lease liability is $7,350.30. That reduces the lease liability to $25,770.97. Total interest paid so far is $2,649.70.

January 1, 2008 rolls around. You owe $10,000. Write the check for the full amount, send it out. Part of that was for interest. 8% of $25,770.97 is $2,061.68 (interest expense). The payment to the lease liability is $7,938.32. That reduces the lease liability to $17,832.65. Total interest paid so far is $4,711.38.

January 1, 2009 rolls around. You owe $10,000. Write the check for the full amount, send it out. Part of that was for interest. 8% of $17,832.65 is $1,426.61 (interest expense). The payment to the lease liability is $8,573.39. That reduces the lease liability to $9,259.26. Total interest paid so far is $6,137.99.

January 1, 2010 rolls around. The last payment date. You owe the last $10,000. Write that check for the full amount. Part of it is interest. 8% of $9,259.26 is $740.74 (interest expense). The payment to the lease liability is $9,259.26, which matches our lease liability bringing it to $0. The total interest paid is $6,878.73, which matches what we said way up in the first paragraph.