What is the effective interest-rate method to amortize leases?

A technique for calculating and amortizing the cost of a financial instrument by allocating the interest revenue or expense at a constant periodic rate over its life is the effective interest-rate method.  The effective interest rate (EIR) is the rate that provides a level yield on a financial instrument to its maturity date or next market-based repricing date equal to the rate that exactly discounts the cash flows to its carrying amount, from its initial recognition to its maturity.

Under US GAAP, the effective interest rate is computed on the basis of the contractual cash flows over the contractual term.  Under IFRS, the effective interest rate is computed on the basis of the estimated cash flows that are expected to be received over the expected life by considering the contractual terms (e.g., prepayment, call and similar options), excluding expected credit losses.  While under US GAAP origination fees, direct origination costs, premiums and discounts typically are amortized over the contractual term, under IFRS they are deferred and amortized as part of the calculation of the effective interest rate over the expected life of the asset.

Upon recognition of finance leases, lessors record the difference between the gross investment and the net investment as unearned interest income to be recognized as revenue and amortized over the lease term using the EIR method.  Also, lessees depreciate leased assets in a manner consistent with the lessee’s normal depreciation policy for similar depreciable assets and allocate the MPLs between the repayment of the lease obligation and interest expense using the effective interest method to produce a constant periodic rate of interest.