Finance Leasing Manual - FLM10.57

Example 2: allocating interest element: Rule of 78

Using the Rule of 78 method for Example 2 (see FLM10.51), the figures are-

Year 1 5/15ths* of £15,000 £5,000
Year 2 4/15ths of £15,000 £4,000
Year 3 3/15ths of £15,000 £3,000
Year 4 2/15ths of £15,000 £2,000
Year 5 1/15th of £15,000 £1,000

* 5 + 4 + 3 + 2 + 1 = 15

These figures call into question whether the Rule of 78 is an appropriate method for allocating borrowing costs between the various years of account in these circumstances (see FLM10.22 onwards). The £1,000 per annum rents paid in years 1,2, and 3 are insufficient to service the loan; so that (looking at this in terms of a loan) the balance outstanding at the end of year 3 is more than at the end of year 2, which in turn is more than at the end of year 1. It would be reasonable in these circumstances to expect more of the finance charge to be allocated to year 3 than to year 2, and more to year 2 than to year 1. The Rule of 78 method fails to do this.

On the other hand the lessee may have other arguments for using the Rule of 78. For example, that it is more straightforward than more precise methods, and more consistent with the facts than other straightforward methods such as the straight line method. Also, that it is too simplistic to look at this as just a loan - one must also have regard to the use of the asset in the business (although, as the asset in this example has a useful life of 20 years, this hardly helps the lessee's argument).