Accounting for Leases

Topic 1: Accounting for Leases- lessees

Introduction
The accounting and reporting of leases is the main topic of this module. It gives the student an
overview of the topic, walks them through the official text, helps them grasp the requirements
through examples, and highlights important decisions that must be made while accounting for
leases. Additionally, the session contains questions intended to assess the learner's understanding
of the criteria and to enhance their capacity to account for lessee leases.

Learning Outcome:
 Comprehend and Identify a Lease
 Use the finance lease model or general recognition model to account for
leases by a lessee.
 Account for leases by a lessee using the operating lease model or recognition
exemption to account for leases by a lessee.

Learning Objectives:
 To specify a lease using the most recent lease standard
 To understand the lessee's optional application of an operating lease.
 To identify a finance lease's right of use asset.
 To comprehend how an asset with a right of use is measured.
 To identify a finance lease's lease liability.
 To comprehend how a finance lease's lease liability is measured.

Presentation of Topic:

Lease Defined
“A contract is, or contains, a lease if the contract conveys the right to control the use
of an identified asset for a period of time in exchange for consideration.” (PFRS
16.9)

“A contract needs to express the authority to manage the use of a specified asset."

Lessee: the organization that receives payment in exchange for the temporary usage of an
underlying asset.

Lessor is a company that grants permission to use an underlying asset for a specified
amount of time in return for payment.

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Right to Control
An entity has the right to control the use of an identified asset if it has both of the following
throughout the period of use:
1. the right to obtain substantially all of the economic benefits from use of the identified
asset; and
2. the right to direct the use of the identified asset.

Zeus Vernon B Millan

Identified asset
• An asset can be identified by being explicitly stated in the contract or by being
implicitly specified at the time the asset is made available for use by the customer.
• A portion of an asset can be identified if it is physically distinct.
Substantive substitution rights
A customer does not have the right to use an identified asset if the supplier has the
substantive right to substitute the asset throughout the period of use.
• A supplier’s right to substitute an asset is substantive if both of the following
conditions exist:
1. the supplier has the practical ability to substitute alternative assets throughout the
period of use; and
2. the supplier would benefit economically from the exercise of its right to substitute
the asset.

Right to obtain economic benefits from use

A customer controls the use of an identified asset if it has the right to obtain substantially all the
economic benefits from the asset throughout the period of use.
Economic benefits include potential inflows from the asset’s output; which can be
obtained directly or indirectly from using, holding or sub-leasing the asset.

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Right to direct the use

The customer has the right to direct how and for what purpose the asset is used throughout the
period of use if:
1. the customer has the right to direct how and for what purpose the asset is used
throughout the period of use; or
2. the asset’s use is predetermined and the supplier is precluded from changing that
predetermined use.

22.2 Recognition of Lease

GENERAL RECOGNITION (Finance Lease Model)

Lessee recognizes both:
1. Lease liability; and
2. Right-of-use asset

All leases shall be accounted for by the lessee as finance lease under the new standards

RECOGNITION EXEMPTION (Operating Lease Model)

(for ‘short-term” and ‘low value’ leases)

Lessee recognizes lease payments as expense over the lease term using straight line basis, or
another more appropriate basis.

Short term Lease

A lease that at the commencement date, has a lease term of 12 months or less. A lease that
contains a purchase option is not a short term lease.

The election for short term leases is made based on the class of underlying asset to which
the right of use relates.

Low valued asset

The assessment of value is based on the value of the asset when it is new, regardless of the
age of the asset being leased.
Low value is a matter of professional judgment.

22.3 Initial Measurement of use of asset

The right-of-use asset is initially measured at cost. The cost comprises the following:

a. The amount of the initial measurement of the lease liability.

b. Any lease payments made at or before the commencement date, less any lease incentives
received;
c. Any initial direct cost incurred by the lessee and
d. The present value of any decommissioning and restoration costs for which the entity has
incurred an obligation unless those costs are incurred to produce inventories
(PFRS16.24)

22.4 Subsequent Measurement of use of Asset

The right-of-use of an asset is subsequently measured similar to a purchased asset.

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Accordingly, the asset is subsequently measured under the cost model, except when:

• it relates to a class of PPE that is measured under the revaluation model , in which case ,
the asset may be measured under the revaluation model.

• it meets the definition of an investment property and the entity uses the fair value model,
in which case, the asset is measured under the fair value model.

Cost Model
Under the cost model, the right –of-use asset is measured at cost:
a. less any accumulated depreciation and any accumulated impairment losses; and
b. adjusted for any remeasurement of the lease liability.

22.5 Presentation of right of use asset

It is presented as separate line item in the statement of financial position.

22.6 Depreciation
The lessee depreciates the underlying asset over its useful life if:
a. The contract provides for the transfer of ownership to the lessee by the end of the lease
term;
b. There is a reasonable certainty that the lessee will exercise a purchase option.

In any other case the lessee depreciates the underlying asset over the shorter of the asset’s
useful life and the lease term. Depreciation starts from the commencement date of the lease.

22.7 Initial Measurement of Lease Liability

The lease liability is initially measured at the PV of the lease payments that are not yet paid
as at the commencement date.

Discount rate
Discount rate is the interest rate implicit in the lease; if not determinable, then the lessee’s
incremental borrowing rate.

Interest rate implicit is the rate that causes the PV of lease payments equal to the
unguaranteed residual value to equal the fair value of the underlying asset and initial direct
costs of the lessor.

Incremental borrowing rate is the interest rate the lessee would have to pay to borrow funds
to obtain a similar asset, similar term and similar security.

22.8 Components of Lease Payments

a. Fixed payments. Payments made by the lessee to the lessor for the right to use an
underlying asset during the lease term.
b. Variable Payments. Payments made by the lessee to the lessor for the right to use an
underlying asset during the lease term that vary because of changes in facts or
circumstances after the commencement date other than passage of time.
c. Amounts expected to be payable by the lessee under the residual value guarantees;
Residual value guarantee is the guarantee made to the lessor by unrelated party to the
lessor that the value of the underlying asset at the end of the lease term would be at least
a specific amount.
d. The exercise price of a purchase option if the lessee is reasonably certain to exercise
that option; and
e. Termination penalties if the lease term reflects the exercise of termination option

22.9 Subsequent measurement of lease liability

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The lease liability is subsequently measured similar to an amortized cost financial liability
(but re measured to reflect any reassessments or lease modifications). Accordingly:

• Interest on the lease liability is computed using the effective interest method and
recognized in profit or loss, unless it forms part of the carrying amount of another asset.
Interest each period reflects a constant periodic rate of interest on the remaining balance of
the lease liability
• Lease payments are apportioned between the interest and a reduction to the lease liability.

22.10 Disclosures-Lessee
A lessee shall disclose the following for the reporting period:
1. Depreciation charge for right of use assets by class of underlying asset.
2. Interest Expense on lease liability
3. The expense relating to short term leases excluding the expense relating to leases with a term of
one month or less.
4. The expense relating to low value leases excluding expense relating to low value leases with
term of one month or less
5. The expense relating to variable lease payments included in the measurement of lease liability
6. Income from subleasing right of use asset’
7. Total cash outflow for leases
8. Addition to right of use assets
9. The carrying amount of right of use assets at the end o' the reporting period by class Of
underlying asset
10. Short term leases or low value leases accounted for operating lease

Additional disclosures

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A lessee shall disclose additional qualitative and quantitative information leasing activities
necessary help users of financial statements to assess the effect of leases on financial position,
financial performance and cash flows.

1. The nature of the lessee's leasing activities

2. Future cash outflows to which the lessee is potentially exposed that are not reflected in the
measurement of lease liability.

a. Variable lease payments

b. Extension option 2nd termination option

c. Residual value guarantee

d. Leases not yet commenced to which the lessee i' com mitted

3- Restrictions or covenants imposed

Illustration: General Recognition (Finance Lease)

On January 1, 201x1, Entity A enters into a 3-year lease of equipment for an annual rent of P100,
000 payable at the end of each year. The equipment has a remaining life of 10 years. The
interest rate implicit in the lease is 10%, while the lessee’s incremental borrowing rate is 12%.
Entity A uses the straight –line method of depreciation.

 Initial measurement of lease liability and right-of-use-asset

Fixed Payments 100,000

Multiply by: PV of an Ordinary Annuity of P1 @ 10%, n=3) 2.48685
Present Value of lease payments 248,685

Journal entry @ commencement date

Jan.1,20x Right-of-use asset 248,685

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Lease Liability 248,685

 Subsequent measurement –lease liability

The lease liability is subsequently measured at amortized cost

Amortization Table

Date Payments Interest Amortization Present value

1/1/x1 248,685
12/31/x1 100,000 24,869 75,131 173,554
12/31/x2 100,000 17,355 82,645 90,909
12/31/x3 100,000 9,091 90,909 0

 Subsequent measurement-Right-of-use asset

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Annual Depreciation = Cost /lease term(shorter)

248,685/3= 82,895

The entries on December 31,20x1 are as follows:

Dec. 31,20x1 Interest Expense 24,869

Lease Liability 75,131
Cash 100,000
To record the lease payment and to
recognize interest expense
Dec. 31,20x1 Depreciation Expense 82,895
Right-of-use asset 82,895
To record depreciation expense

The entries in 20x2 and 20x3 continue in the same pattern.

 Presentation

Right of use asset 248,685

Right of use asset (82,895)
Carrying Amount 1 5 5 ,79 0

The lease liability of 82,645 will be presented as current and 90,909 as noncurrent

Illustration : Recognition exemption-asset of low value

On January 1,20x1 , Entity A enters into a 3-year lease of a group of office furniture with
similar nature, Entity A assesses that the lease is a lease of an underlying asset of low value
and elects to apply the recognition exemptions of PFRS 16. The annual lease payments
payable at the end of each year are as follows

20x1 P 8,000 The annual expense is computed as follows:

20x2 12,000 30,000/3= 10,000
20x3 14,000

Note: the lessor granted Entity X six months of the lease as rent free

Jan 1,20x1 No entry

Dec. 31, 20x1 Rent expense(Lease Expense) 10,000
Cash 4,000
Rent Payable
6,000
Dec. 31,20x2 Rent expense(Lease Expense) 10,000
Rent Payable 2,000
Cash
12,000
Dec. 31, 20x3 Rent expense(Lease Expense) 10,000
Rent Payable 4,000
Cash 14,000

Initial direct costs

A lessee capitalizes initial direct costs as follows:

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Lease payments made to lessor at or before commencement date

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Feedback/Assessment

Test your knowledge of the requirements for accounting and properly reporting items of leases
by answering the questions below. Encircle the letter of your choice. Show your computation if
required (5 points each)

1. On December 30, 20x5, Hawaiians Co. leased a new machine from G Corp. The following
data relate to the lease at the inception of the lease:

Lease term 10 years

Annual rental payable at the end of each lease year P100000
Useful life of machine 12 years
Implicit interest rate 10%

The lease has no renewal option, and the possession of the machine reverts to G when the lease
terminates. At the inception of the lease, Hawaiians should record a lease liability of

a. 0 b. 615,000 c. 630,000 d. 676,000

(AICPA)

2. On January 2, Ashley Company entered into a ten-year noncancellable lease requiring year-
end payments of PI00, 000 Ashley's incremental borrowing rate is 12% while the lessors implicit
interest rate, known to Ashley, is 10%. Ownership of the property remains with the lessor at
expiration of the lease. There is no bargain purchase option. The leased property has an
estimated economic life of 12 years.

What amount should Ashley capitalize for this leased property on January 2, 20x6?

a. 1,000,000 b. 614,500 c. 565,000 d. 0

(AICPA)

3. Nel Corp. entered into a nine-year lease on a warehouse on December 31, 20x1. Lease
payments of P52,000, which includes payment for non-lease component of P2,000 (at stand-
alone selling price), are due annually, beginning on December 31, 20x1, and every December 31
thereafter. Nel does not know the interest rate implicit in the lease; Nel’s incremental borrowing
rate is 9%.
What amount should Nel report as lease liability at December 31, 20x1?
(AICPA)

a. 280,000 b. 291,200 c. 450,000 d.468, 000

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4. Robinsons, Inc., leased a machine from Ready Leasing Co. The lease requires 10
annual payments of P10, 000 'beginning immediately. The lease specifies an interest
rate of 12% and a purchase option of PI0,000 at the end of the tenth year, even
though the machines 'estimated value on that date is P20,000.It is reasonably certain
that Robinson will exercise the purchase option. Robinson’s incremental borrowing
rate is 14% .
What amount should Robinson record the right-of-use asset at the beginning of the
lease term?

a. 62,160 b. 64,860 c. 66,500 d. 69,720

(AICPA)

5. On January I, 20x7, Bobson, Inc., leased two automobiles for executive use. The
lease requires Bobson to make five annual payments of P13, 000 beginning January
1, 20x7. At the end of the lease term, Bobson guarantees the residual value of the
automobiles will total P10, 000. The interest rate implicit in the lease is 9%.

Bobson's recorded lease liability on initial recognition is

a. 48,620 b. 44,070 c. 35,620 d. 31,070

(AICPA)

6. On January 1, 20x8, Harry Co. as lessee signed a five-year noncancellable

equipment lease with annual payments of P100,000 beginning December 31, 20x8.
The implicit interest rate is 10%.

How much is the interest expense for the year ended December 31, 20x8?

a. 37,900 b. 27,900 c. 24,200 d. 0

(AICPA)

7. On January 1, 20x7, Blove Co. signed a long-term lease for an office building. The
terms of the lease required Blove to pay P10,000 annually, beginning December 30,
20x7, and continuing each year for 30 years. On January 1, 20x7, the present value of
the lease payments is at the 8% interest rate implicit in the lease.

In Blove’s December 31, 20x 7 balance sheets, the lease liability should be

a. 102,500 b. 111,500. c. 112,500 d. 290,000

(AICPA)

8. On January 1 20x6, Dayo Corp entered into a 10-year lease agreement with
Wired Inc. for industrial equipment. Annual lease payments of P10,000 are payable
at the end of each year.Dayo knows that the lessor expects a 10% return on the
lease .Dayo has a 12% incremental borrowing rate . The equipment is expected to
have an estimated useful life of 10 years. In addition , a third party , unrelated to
Dayo has guaranteed to pay Wired a residual value agreement with of Wired a
residual value of P5,000 at the end of the lease.,

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In Dayo's January 1, 20x6 balance sheet, the principal amount of the lease obligation
was

a. 63,374 b. 61,446 c. 58;112 d. 56,502

(AICPA)

9. On December 30,' 20x8, Raffer Corp. leased equipment. Annual lease payments of
20,000 are due December 31 for 10 years. The equipment’s useful life is 10 years,
and the interest rate implicit in the lease is 10%. The present value of the lease
payments on December 30, 20x8 before the first lease payment is P135, 000. The
first lease payment was made on that date.

What amount should Raffer include in current liabilities for this lease in its
December 31, 20x8, balance sheet?

a. 6,500 b. 8,500 c. 11,500 d. 20,000

(AICPA)

10. On January 2, 20x8, Col Co. signed an eight-year noncancelable lease for a new
machine, requiring P15, 000 annual payments at the beginning of each year. The
Machine has a useful life of 12 years, with no salvage value. Title passes to Col at the
lease expiration date. Col uses straight-line depreciation for all of its plant assets.
Aggregate lease payments have a present value on January 2, 20x8, of P108,000
based on an appropriate rate of interest.

For 20x8, Col should record depreciation (amortization) expense for the leased
machine at

a. 0 b. 9,000 c. 13,500 d.. 15,000

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Topic 2: Accounting for Lease -Lessor

Introduction
This module focuses on the accounting and reporting of lease on
the part of the lessor It introduces the learner to the subject, guides the
learner through the official text, develops the learner’s understanding of
the requirements through the use of examples and indicates significant
judgments that are required in accounting for lease-lessor. Furthermore,
the module includes questions designed to test the learner’s knowledge
of the requirements and to develop thelearner’s ability to account for
operating lease on lessor’s side.

Learning outcome:
 Understand the lease classifications by a lessor
 Know the recognition and accounting of leases on the part of the lessor

Learning objectives:

 To identify the lease classifications by a lessor

 To state the indicators of a finance lease

 To account for a finance lease by a lessor

 To account for an operating lease by a lessor

 To account for a sale and leaseback transaction by a seller-lessee and a

buyer-lessor.

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Presentation of Topic

11.1 Classification of Lease by a Lessor

A lessor classifies each of its leases as either a finance lease or an operating lease;

1. Finance lease (capital lease) is a lease that transfers substantially all the risks and rewards
incidental to ownership of an underlying asset.

2. Operating lease is a lease that does not transfer substantially all the risks and rewards
incidental to ownership of an underlying asset.

• Risks include the possibilities of losses from idle capacity or technological obsolescence and of
variations in return because of changing economic conditions.

• Rewards may be represented by the expectation of profitable operation over the asset's
economic life and of gain from appreciation in value or realization of a residual value.

Whether a lease is a finance lease or an operating lease depends on the substance of the
transaction rather than the form of the contract.

11.2 Indicator of a finance lease

Other Indicators of a finance lease

a. If the lessee can cancel the lease, the lessor’s losses associated with the cancellation are
borne by the lessee.(transfer of risk);
b. Gains or losses from the fluctuation in the fair value of the residual accrue to the
lessee(transfer of risks rewards) and
c. The lessee has the ability to continue the lease for a secondary period at a rent that is
substantially lower than market rent (transfer of reward)
(PFRS 16.64)

11.3 Land and Building Lease.

These are considered separately. Lease payments are allocated based on relative fair value of the
leasehold interests in the land and building elements at the inception date. If cannot be clearly
allocated it means that it is classified as finance lease.

11.4 Accounting for Finance Lease-Lessor.

Lessors recognize assets from a finance lease as receivable measured at an amount equal to the

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net investment in the lease.

Lease payments

Fixed payments, including in-substance fixed payments, less any lease incentives
payable;
 Variable lease payments that depend on an index or a rate, initially measured using the
index or rate as at the commencement date;
 Guaranteed residual value;
 The exercise price of a purchase option if the lessee is reasonably certain to exercise that
option; and
 Payments of penalties for terminating the lease, if the lease term reflects the lessee
exercising an option to terminate the lease.
Discount rate

The discount rate to be used in calculating the present value of the lease payments is the
interest rate implicit in the lease.
 Interest rate implicit in the lease – the rate of interest that causes the present value of (a)
the lease payments and (b) the unguaranteed residual value to equal the sum of (i) the fair
value of the underlying asset and (ii) any initial direct costs of the lessor.

Initial direct costs

 Initial direct costs are capitalized except direct costs incurred by a manufacturer or dealer
lessor under a sales type lease, which are expensed immediately.
 The interest rate implicit in the lease is defined in such a way that the initial direct costs
are included automatically in the net investment in the lease; there is no need to add them
separately.

Classification of finance lease as to the lessor

As to the lessor, finance leases may be classified as either:

a. Direct financing lease, or
b. Sales type lease

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Illustration: DIRECT FINANCING

On January 20x1, XYZ Company leased equipment to STR Inc, with the following details:

Cost of equipment P759, 325

Useful life of equipment 4 years
Lease Term 4 years
Annual rent payable at the end of each year 250,000
Interest implicit rate in the lease 12%
PV of annuity of 1 for 4 years @ 12% 3.0373

1. Initial Measurement
a. Annual rental= Net investment / PV of an annuity of 1

759,325
3.0373 = P250, 000
b. Gross rental or lease receivable (250,000 x 4) P1, 000,000
PV of gross rentals 759,325
Unearned Interest Income P 240,675

Jan 1,20x1 Lease Receivable 1,000,000

Equipment 759,325
Unearned Interest Income 240,675
to recognize gross rentals

Dec. 31,20x1 Cash 250,000

Lease Receivable 250,000
to record annual rental

2. Subsequent Measurement
a. Recognition of Interest Income- amortized the Unearned Interest Income using the
effective interest method.
Date Payment Interest Principal PV
1/1/20x1 759,325
12/31/20x1 250,000 91,119 158,881 600,444
12/31/20x2 250,000 72,053 177,947 422,497
12/31/20x3 250,000 50,700 199,300 223,197
12/31/20x4 250,000 26,803 223,197

12/31/x1 Unearned Interest Income 91,119

Interest Income 91,119

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CASE 1- Direct Financing with Initial Direct cost

Using the data in the above illustration, only that the initial implicit rate is before
initial direct cost and the lessor paid initial direct cost of P33, 150 on January 1,20x1

Cost of equipment P759, 325

Useful life of equipment 4 years
Lease Term 4 years
Annual rent payable at the end of each year 250,000
Interest implicit rate in the lease before initial direct cost 12%
PV of an ordinary annuity of 1 for 4 years @ 12% 3.0373

1. Initial Measurement
a. Net investment = Cost of machinery + Initial Direct cost
P 792,475 = P 759,325 + 33,150
b. Gross rental or lease receivable (250,000 x 4) P1, 000,000
Net Investment 792,475
Unearned Interest Income 207,525
Jan 1,20x1 Equipment(initial direct cost) 33,300
Cash 33,300

Lease Receivable 1,000,000

Equipment 792,475
Unearned Interest Income 207,525
to recognize gross rentals

Dec. 31,20x1 Cash 250,000

Lease Receivable 250,000
to record annual rental

2. Subsequent Measurement
a. Computation of the new implicit rate-trial and error to determine the PV of Gross rentals that
would equate the net investment. Try lower rates than 12% thru interpolation. In this problem it
is 10%. We use lower rate because the unearned interest income decreases.

b. Recognition of Interest Income- amortized the Unearned Interest Income using the effective
interest method using the new implicit rate.

Date Payment Interest Principal PV

1/1/20x1 792,475
12/31/20x1 250,000 79,248 170,752 621,723
12/31/20x2 250,000 62,172 187,828 433,895
12/31/20x3 250,000 43,390 206,610 227,285
12/31/20x4 250,000 22,715 227,285
12/31/x1 Unearned Interest Income 79,248
Interest Income 79,248

c. Presentation in Statement of Financial Position

12/31/20x1 Current Portion Non-current Portion

Lease Receivable 750,000 750,000
Unearned Interest Income -62,172 -66,105
Carrying Amount 687,828 683,895
**Note:
Lease receivable is the total of payments from 12.31/20x2-20x4
Unearned Interest income current- collectible 1 year from balance sheet date
Unearned Interest income noncurrent-collectible after 1 year from balance sheet date

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CASE 2- Direct Financing with residual value

The leased asset reverts back to the lessor at the end of the lease term. It means that there is no
transfer of title or purchase options made so any residual vale still is for the benefit of the lessor.
If there’s no benefit is reverted back to the lessor at the end of the lease term meaning the
residual value is ignored.

Illustration
On January 20x1, XYZ Company leased equipment to STR Inc, with the following details:

Cost of equipment P1, 597,205

Residual value 250,000
Useful life of equipment and lease term 4 years
Interest implicit rate in the lease 10%
PV of an ordinary annuity of 1 for 4 years @ 10% 3.1699
PV of 1 at 10% for 4 periods .6830

1. Initial Measurement
a. Annual rental= Cost of Machinery – PV of 1 of residual value
PV of an ordinary annuity of 1 for 4 years @ 10%

=P 1,597,205 - (250,000*.6830)
3.1699
= 450,000

b. Gross Rentals ( 450,000 x 4) P1,800,000

Residual Value (guaranteed or unguaranteed) 250,000
Gross Investment P2, 050,000
Cost of machinery (1, 597,205)
Unearned Interest Income P 452,795

1/1 20x 1 Lease Receivable 2,050,000

Equipment 1,597,205
Unearned Interest Income 452,795
to record direct finacing lease

12/31/20x1 Cash 450,000

Lease Receivable 450,000
to record annual rental collection

2. Subsequent Measurement
a. To record interest Income- use the effective interest method

Date Payment Interest Principal PV

1/1/20x1 1,597,205
12/31/20x1 450,000 159,721 290,279 1,306,926
12/31/20x2 450,000 130,693 319,307 987,619
12/31/20x3 450,000 98,762 351,238 636,381
12/31/20x4 450,000 63,619 386,381 250,000

12/31/20x1 Unearned Interest Income 159,721

Interest Income 159,721

3. Lease Expiration
a. Equipment 500,000
Lease Receivable 500,000
Note: whether guaranteed or unguaranteed, the entry on the book of the lessor will be the same

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b. when fair market value is lower than residual value- assuming 400,000 FMV

Under guaranteed scenario- lessee will pay for the difference

Cash 100,000
Equipment 400,000
Lease Receivable 500,000

Under unguaranteed scenario- lessor shall recognize loss for the difference

Loss on Finance Lease 100,000

Equipment 400,000
Lease Receivable 500,000

CASE 3 Direct financing with transfer of title

When there is transfer of title to the lessee at the end of the lease term , the residual value is
completely ignored.

Illustration
On January 20x1, XYZ Company leased equipment to STR Inc, with the following details:

Cost of equipment P1, 724,800

Residual value 250,000
Useful life of equipment and lease term 5 years
Interest implicit rate in the lease 8%
PV of annuity due of 1 for 5 years @ 8% 4.312

1. Initial Measurement
a. Annual rental= Cost of machinery
PV of annuity due of 1 for 5 years @ 8%
= 1,724,800
4.312
= 400,000

b. Gross rental (400,000 x5) P2,000,000

Net Investment-Cost of machinery (1,724,800)
Unearned Interest Income 275,200

1/1 20x 1 Lease Receivable 2,000,000

Equipment 1,724,800
Unearned Interest Income 275,200
to record direct financing lease

1/1/20x1 Cash 400,000

Lease Receivable 400,000
to record annual rental collection

2. Subsequent Measurement
To record interest Income- use the effective interest method

12/31/20x1 Unearned Interest Income 105,984

Interest Income 105,984
Note: succeeding years will follow the same pattern

18
 Accounting for Leases

ILLUSTRATION: SALES TYPE LEASE

Considerations

1. Gross Investment- same with direct financing

2. Net Investment-PV of gross rentals + PV of residual value(guaranteed or unguaranteed)
3. Unearned Interest Income- Gross Investment- Net investment
4. Sales- Net investment in the lease (PV of lease payments) or fair value of the asset
whichever is lower.
5. Cost of Goods Sold-Cost of the asset sold- PV of unguaranteed residual value plus initial
direct cost paid by lessor.
6. Gross Profit- Sales- Cost of Goods Sold
7. Initial direct cost-expensed immediately as part of the cost of goods sold.

On January 20x1, XYZ Company (lessor) leased equipment to STR Inc,(lessee) with the
following details:

Annual rental payable at the end of each year 200.000

Useful life of equipment and lease term 5 years
Interest implicit rate in the lease 10%
Cost of equipment 500,000
Implicit interest rate 12%
PV of an annuity of 1 for 5 years @ 12% 3.60

Computation

Gross rentals (200,000 x 5) 1,000,000

PV of Rental (200,000 x 3.60) (720,000)
Unearned Interest Income 280,000

PV of rentals – Sales 720,000

Cost of equipment 500,000
220,000

1/1 20x 1 Lease Receivable 1,000,000

Sales 720,000
Unearned Interest Income 280,000
to record sales

1/1/20x1 Cost of Goods Sold 500,000

Inventory 500,000
to record cost of sales

12/31/20x1 Cash 200,000

Lease Receivable 200,000
to record annual rental collection

12/31/20x1 Unearned Interest Income 86,400

Interest Income 86,400
to record interest income

19
 Accounting for Leases

Case 1 – Sales Type lease with residual value

On January 20x1, XYZ Company (lessor) leased equipment to STR Inc,(lessee) with the
following details:

Annual rental payable at the end of each year 400.000

Useful life of equipment and lease term 5 years
Interest implicit rate in the lease 10%
Cost of equipment 1,000,000
Estimated residual value 100,000
Initial direct cost paid by lessor 50,000
PV of an ordinary annuity of 1 for 5 years @ 10% 3.7908
PV of 1 for 5 periods at 10% 0.6209

At the end of the lease term December 20x5, the equipment will revert back to the lessor.
Perpetual Inventory is used.

Residual Value - Re sidual Value -

Guaranteed Unguarante e d
Gross rentals (400,000x5) 2,000,000 2,000,000
Residual Value 100,000 100,000
Lease Receivable- Gross Investment 2,100,000 2,100,000

PV of Gross rentals ( 400,000 x 3.7908) 1,516,320 1,516,320

PV of residual value (100,000 x .6209) 62,090 62,090
Total Present Value-net investment 1,578,410 1,578,410

Lease Receivable 2,100,000 2,100,000

Total Present Value-net investment - 1,578,410 - 1,578,410
Unearned Interest Income 521,590 521,590

Sales- total present value 1,578,410 1,516,320

Cost of Goods Sold- cost of machinery - 1,000,000 - 937,910
Initial Direct Cost - 50,000
Gross Income 578,410 528,410

Note: Gross investment, total PV of net investment and Unearned Income are the same whether
guaranteed or unguaranteed residual value.
Difference only lies in the computation of Sales and Cost of Goods Sold

Journal entries under guaranteed residual value

1/1/20x1 Lease receivable 2,100,000
Cost of Goods Sold 1,000,000
Sales 1,578,410
Unearned Interest Income 521,590
Inventory 1,000,000

Cost of Goods Sold 50,000

Cash 50,000
The initial direct cost is charged directly to cost of goods sold

Journal entries under unguaranteed residual value

1/1/20x1 Lease receivable 2,100,000
Cost of Goods Sold 937,910
Sales 1,516,320
Unearned Interest Income 521,590
Inventory 1,000,000

Cost of Goods Sold 50,000

Cash 50,000

20
 Accounting for Leases

The difference with the guaranteed residual value is on the Cost of Goods Sold and the Sales
Whether guaranteed or unguaranteed the collection of annual rental and recognition of interest
income will always be the same.

12/31/20x1 Cash 400,000

Lease Receivable 400,000
to record annual rental collection

12/31/20x1 Unearned Interest Income 157,841

Interest Income 157,841
to record interest income

Inventory(Equipment) 100,000
Lease Receivable 100,000
12/31/20x4 to record return of assets to lessor

When the lease expires, the equipment will revert back to the lessor company. The entry on the
books of the lessor will be the same.

When fair market value is lower than residual value –assuming 75,000

Under guaranteed scenario- lessee will pay for the difference

Cash 25,000
Equipment 75,000
Lease Receivable 100,000

Under unguaranteed scenario- lessor shall recognize loss for the difference

Loss on Finance Lease 25,000

Equipment 75,000
Lease Receivable 100,000

CASE 2: SALES TYPE LEASE with Purchase Option

On January 20x1, XYZ Company (lessor) leased equipment to STR Inc, (lessee) with the
following details:

Annual rental payable at the end of each year 250.000

Useful life of equipment 5 years
Lease term 4 years
Cost of equipment 500,000
Estimated purchase option 100,000
Initial direct cost paid by lessor 50,000
Implicit interest rate 8%
PV of an ordinary annuity of 1 for 4 periods @ 8% 3.312
PV of 1 for 4 periods at 8% 0.735

It is reasonably certain that the lessee will exercise purchase option at the end of the lease term
on December 31, 2025

Journal Entry on January 1,20x1

21
 Accounting for Leases

1/1/20x1 Lease receivable 1,100,000

Cost of Goods Sold 550,000
Sales 901,500
Unearned Interest Income 198,500
Inventory 500,000
Cash 50,000
see supporting computation below
Gross rentals (250,000x4) 1,000,000
Purchase Option 100,000
Lease Receivable- Gross Investment 1,100,000

PV of Gross rentals ( 250,000 x 3.312) 828,000

PV of purchase option (100,000 x .735) 73,500
Total Present Value-net investment 901,500

Lease Receivable 1,100,000

Total Present Value-net investment - 901,500
Unearned Interest Income 198,500

Sales- total present value 901,500

Cost of Goods Sold - 550,000
Gross Income 351,500

Cost of equipment 500,000

Initial direct cost 50,000
Cost of Goods Sold 550,000

At the end of year 20x1, the entry would be:

12/31/20x1 Cash 250,000
Lease Receivable 250,000
to record annual rental collection

12/31/20x1 Unearned Interest Income 72,120

Interest Income 72,120
to record interest income
The entries for the succeeding period will follow the same pattern

Exercise of purchase option

When time comes that the balance of lease receivable equal to the purchase option and the
unearned income has a zero balance, The purchase option exercised by the lessee on December
31,20x4

Journal Entry
Cash 100,000
Lease receivable 100,000

Non exercise of Purchase Option

The lessee did not exercise purchase option and the fair value of the asset is 50,000

Journal Entry
Inventory 25,000
Loss on finance lease 25,000
Lease Receivable 50,000

Actual Sale of Underlying Asset

22
 Accounting for Leases

When the lessor actually sells the asset it has been leasing under finance lease, the difference
between the sales price and the carrying amount of the lease receivable is recognized as profit
or loss.

The carrying amount of lease receivable is equal to the balance of lease receivable minus the
balance of the unearned interest income

Disclosures

A lessor shall disclose the following amounts for the reporting period

1. For finance lease

a. Selling profit or loss

b. Finance income on the net investment in the lease

c. Income relating to variable lease payment not included in the measurement or the net
investment in the lease

2. For operating lease, lease income, separately disclosing income relating to variable lease
payments that do not depend on an index or rate

Additional disclosures

A lessor shall disclose additional qualitative and quantitative" information about leasing
activities necessary to effect of leases on financial position, financial position and cash flows.

This additional information includes, but is not limited information that helps users of financial
statement to assess:
1. The nature of the lessor's leasing activities

2. How the lessor manages the risk associated with any rights it retains in the underlying
asset,

In particular, a lessor shall disclose its risk management strategy for the rights it retains in
underlying asset including any means by which the lessor reduces the risk

23
 Accounting for Leases

11.5 Accounting for Operating Lease-Lessor. The lessor recognizes the lease payments as rent
income on a straight line basis over the lease term, unless another systematic basis is more
representative of the time pattern of user’s benefit.

Initial Direct Cost- The lessor capitalizes the initial direct cost to the carrying amount of the
underlying asset and recognizes those costs as expense over the lease term on the same basis as
the lease income.

Depreciation- The leased asset remains the asset of the lessor. Therefore, the lessor continues to
depreciate.

Lease Bonus- is an amount, in addition to periodic rentals, paid by a lessee to the lessor in order
to induce granting of leasehold rights to the lessee. The lessor accounts for the lease bonus as
unearned rent to be amortized to rent income over the lease term.

Security Deposits- A lessor recognizes a security deposit as payable , measured as an amortized

cost financial liability.

Illustration

1. On January 1, 2020, Favor Company purchased machinery for P3, 000,000 cash for the
purpose of leasing it. The machine is expected to have a 10-year life and no residual value.

Machinery P 3,000,000
Cash P3, 000,000

2. On April 2020, Favor Company leased the machine another entity for 3 years at a monthly
rental of P45, 000 payable at the beginning of every month.

Cash P 450,000
Rent income P 450,000

3. On April 1, 2020, Favor Company received a security deposit of P600, 000 to be refunded
upon the lease expiration.

Cash P 600,000
Liability for rent deposit P 600, 000

4. In addition to the rental, Favor Company received from the lessee a lease of P 120,000 on
January 1, 2020.

Cash P 120, 000

Unearned rent income P 120,000

5. On April 1, 2020, Favor Company paid initial direct cost of P300, 000.Such costs are
directly attributable to negotiating and arranging the operating lease.

24
 Accounting for Leases

Deferred initial direct cost P 300,000

Cash P300, 000

6. During the year, Favor Company paid repair and maintenance of P 20, 000.

Repair and maintenance P 20,000

Cash P 20,000

7. The lease bonus is amortized over 3 years, or P40, 000 annually.

Unearned Rent Income P 30,000

Rent income (40,000 x 9/12) P30, 000

8. The machinery is depreciated over 10 years or P300,000 annually.

Depreciation P 300, 000

Accumulated depreciation P 300,000

9. The initial direct cost is recognized as expense over the lease term.

Amortization of initial direct cost P75, 000

Deferred Initial direct cost P75, 000
(300,000 3 x 9/12)

The balance of the deferred initial direct cost shall be presented as an addition to the carrying
amount.

Unequal rental payments

IFÄ 16 paragraph 81 provides that lease payments under an operating lease shall be recognized
as income on a straight line or another systematic basis.

Illustration:

On January 1,20x1, Entity A enters into a 3-year operating lease of equipment. The annual lease
payments payable at the end of each year are as follows

20x1 P 8,000 The annual income is computed as

20x2 12,000 30,000/3= 10,000
20x3 14,000

Note: Entity A granted the lessee six months of the lease as rent free

Jan 1,20x1 No entry

December 31,20x1 Cash 4,000
Rent Receivable 6,000
Rent Income 10,000
December 31,20x2 Cash 12,000
Rent Income 10,000
Rent Receivable 2,000
December 31,20x3 Cash 14,000
Rent Income 10,000
Rent Receivable 4,000

25
 Accounting for Leases

11.6 Sale and Leaseback

A sale and leaseback transaction occurs when a party sells an asset to another party and
immediately leases it back from the buyer. The seller becomes the lessee and the buyer becomes
the lessor. It may occur when the seller-lessee is experiencing financing problem or there is a tax
advantage of such arrangement.

To account for a sale and leaseback transaction, both the seller/lessee and the buyer/lessor
determine whether the transfer qualifies a sale based on the requirements for satisfying a
performance obligation in PFRS 15.

Transfer of asset is a Sale

PFRRS 15 or IFRS 16, paragraph 100 provides that the transfer qualifies as a sale if:
a. The seller lessee shall:
i. measure the right-of-use asset arising from the leaseback at the proportion
of the previous carrying amount of the asset that relates to the right of use
retained by the seller- lessee; and
ii. recognize only the amount of any gain or loss that relates to the rights
transferred to the buyer-lessor.
b. The buyer-lessor shall account for the purchase of the asset applying applicable
standards (e.g., PAS 16 if the asset is an item of PPE ) and for the lease applying
the lessor accounting under PFRS 16.

Adjustments
If (a) the sale price is not equal to the fair value of the asset, or if (b) the lease
payments are not at market rates, the following adjustments shall be made to measure
the sale proceeds at fair value:

a. any below-market terms shall be accounted for as a prepayment of lease payments

and
b. any above-market terms shall be accounted for as additional financing provided by
the buyer-lessor to the seller-lessee.
The adjustment is measured based on the more readily determinable of:
a. difference between the fair value of the consideration for the sale and the fair
value of the asset; and
b. difference between the present value of the contractual payments for the lease and
the present value of payments for the lease at the market rates.

Illustration: Sale Price at fair value

On January 1, 20x1 an entity sold equipment with remaining life of 10 years and
immediately leased it back for 4 years at the prevailing market rental.

Sale price at fair value 3,000,000

Carrying amount of an equipment 2,250,000
Annual rental payable at the end of each year 400,000
Implicit interest rate 10%
Present value of an ordinary annuity of 1 at 10% for 4 periods 3. 170

Measurement of Liability
The seller-lessee shall account for the leaseback as finance lease. The lease liability is
measured at the present value of lease payments

Present Value of Rentals (400,000 x 3.170) P 1,268,000

Amortization Table

26
 Accounting for Leases

Date Payment Interest Principal PV

1/1/20x1 1,268,000
12/31/20X1 400,000 126,800 273,200 994,800
12/31/20X2 400,000 99,480 300,520 694,280
12/31/20X3 400,000 69,428 330,572 363,708
12/31/20X4 400,000 36,292 363,708

Measurement of right of use of Asset

Cost of right of use of asset= PV of Lease Liability x CA of the asset

Fair Value
= 1,268,000/3,000,000 x 2,250,000
=P 951,000

Gain or Loss to be Recognize

Right retained by seller-lessee is not recognized

Right transferred by buyer-lessor is recognized

Sale Price at fair value 3,000,000

Carrying amount of the asset -2,250,000
Total Gain 750,000

Fair Value 3,000,000

Right retained by seller-lessee equal to lease liability -1,268,000
Right Transferred to buyer-lessor 1,732,000

Gain to be recognized (1,732,000/6,000,000 x 750,000) 433,000

Gain not recognized 317,000
Total Gain 750,000

Journal entries

Books of Seller-Lessee Books of Buyer-Lessor

The finance lease will be applied in accounting the transaction The operating lease will be applied in accounting the transaction

Jan 1.20x1 Cash 3,000,000 Equipment 3,000,000

Right of use of asset 951,000 Cash 3,000,000
Equipment 2,250,000 to record purchase of underlying asset
Lease liability 1,268,000
Gain on right transferred 433,000
to record sale and leaseback

December 31,20x1 Interest Expense 126,800 Cash 400,000

Lease Liability 273,200 Rent Income 400,000
Cash 400,000 to record annual rental
to record annual rental

Depreciation expense(1902,000/4 years) 237,750 Depreciation expense(3,000,000/10years) 300,000

Accumulated Depreciation 237,750 Accumulated Depreciation 300,000
to record depreciation to record depreciation

The buyer lessor account as operating lease because the lease term is only 40% of its
useful life and the present value of the lease is less than 90% of the fair value of the

27
 Accounting for Leases

asset

Illustration: Sale Price above Fair Value

On January 1, 20x1 an entity sold a building with remaining life of 20 years and
immediately leased it back for 5 years at the prevailing market rental.

Sale price 10,000,000

Fair value 9,000,000
Carrying amount of an equipment 5,400,000
Annual rental payable at the end of each year 750,000
Implicit interest rate 12%
Present value of an ordinary annuity of 1 at 12% for 5 periods 3. 60

Lease liability (750,000 x 3.60) = P 2,700,000

Sale Price 10,000,000

Fair value -9,000,000
Excess sales price over fair value 1,000,000

Present value of lease liability 2,700,000

Additional financing equal to excess sale price -1,000,000

Present value of lease related to rentals 1,700,000

Carrying amount of the asset 5,400,000

Fair value 9,000,000

Cost of right use of asset

(1700,000/9,000,000 x5,400,000 1,020,000

Fair value 9,000,000

Carrying amount 5,400,000
Adjusted total gain 3,600,000

Fair value of buiding 9,000,000

Right retained by seller-lessee except excess sales price -1,700,000

Right transferred to buyer-lessee 7,300,000

Gain to be recognized (7,300,000/9,000,000 x 3,600,000) 2,920,000

Gain not recognized( 1,700,000/9,000,000 x 3,600,000) 680,000
Adjusted total gain 3,600,000

Journal Entries

28
 Accounting for Leases

Books of Seller-Lessee Books of Buyer-Lessor

The finance lease will be applied in accounting the transaction The operating lease will be applied in accounting the transaction

Jan 1.20x1 Cash 10,000,000 Building 9,000,000

Right of use of asset 1,020,000 Financial asset 1,000,000
Buiding 5,400,000 Cash 10,000,000
Lease liability 2,700,000 to record purchase of building
Gain on right transferred 2,920,000
to record sale and leaseback

December 31,20x1 Interest Expense 324,000

Lease Liability 426,000 Cash 472,222
Cash 750,000 Rent Income 472,222
to record annual rental to record annual rental related to lease

Cash 277,778
Financial Asset 157,778
Interest Income 120,000
to record annual rental related to financing

Depreciation expense(2,040,000/5 years) 408,000 Depreciation expense(9,000,000/20years) 450,000

Accumulated Depreciation 408,000 Accumulated Depreciation 450,000
to record depreciation to record depreciation

Allocation of Annual rental

Present Value Fraction Allocation

Rental Income 1,700,000 1700/2700 472,222
Financial Asset 1,000,000 1000/2700 277,778
2,700,000 750,000

Amortization related to financial asset

Date Payment Interest Principal Present Value
1/1/20x1 1,000,000
12/31/20x1 277,778 120,000 157,778 842,222
12/31/20x2 277,778 101,067 176,711 665,511
12/31/20x3 277,778 79,861 197,917 467,594
12/31/20x4 277,778 56,111 221,667 245,927
12/31/20x5 277,778 29,511 245,927 0

Illustration: Sale price below fair value

On January 1, 20x1 an entity sold an equipment with remaining life of 8 years and
immediately leased it back for 5 years

Sale price 2,500,000

Fair value 3,000,000
Carrying amount of an equipment 2,400,000
Annual rental payable at the end of each year 450,000
Implicit interest rate 8%
PV of ordinary annuity of 1 at 8% for 5 periods 3.99

Measurement of Liability

Present value of rentals (450,000 x 3.99) 1,795,500

Amortization table

29
 Accounting for Leases

Date Payment Interest Principal Present Value

1/1/20x1 1,795,500
12/31/20X1 450,000 143,640 306,360 1,489,140
12/31/20X2 450,000 119,131 330,869 1,158,271
12/31/20X3 450,000 92,662 357,338 800,933
12/31/20X4 450,000 64,075 385,925 415,008
12/31/20x5 450,000 34,992 415,008

Measurement of right of use of asset

If the sale price is below fair value, the difference is accounted as prepayment of
rental

Fair value 3,000,000

Sales Price -2,500,000
Excess fair value over sales price 500,000

Present value of rentals(450,000 x3.99) 1,795,500

Excess fair value over sales price 500,000
Total Lease liability 2,295,500

Carrying amount of the asset 2,400,000

Fair value 3,000,000

Cost of right use of asset

(2,295,500/3,000,000 x2,400,000 1,836,400

Fair value 3,000,000

Carrying amount 2,400,000
Total gain 600,000

Fair value of equipment 3,000,000

Right retained by seller-lessee
including excess fair value -2,295,500
Right transferred to buyer-lessee 704,500

Gain to be recognized (704,500/3,000,000 x 600,000) 140,900

Gain not recognized(2,295,500/3,000,000 x 600,000) 459,100
Adjusted total gain 600,000

30
 Accounting for Leases

Books of Seller-Lessee Books of Buyer-Lessor

The finance lease wil be applied in accounting the transaction The operating lease wil be applied in accounting the transaction

Jan 1.20x1 Cash 2,500,000 Equipment 2,500,000

Right of use of asset 1,836,400 Cash 2,500,000
Bui
Equidipnment
g 2,400,000 to record purchase of equipment
Lease liability 1,795,500
Gain on right transferred 140,900
to record sale and leaseback

December 31,20x1 Interest Expense 143,640 Cash 450,000

Lease Liability 306,360 Rent Income 450,000
Cash 450,000 to record annual rental
to record annual rental

Depreciation expense(1,836,400/5 years) 367,280 Depreciation expense(2,500,000/8years) 312,500

Accumulated Depreciation 367,280 Accumulated Depreciation 312,500
to record depreciation to record depreciation
Illustration: Sale Price at Fair Value with a loss

On January 1, 20x1 an entity sold a building with remaining life of 25 years and
immediately leased it back for 3 years

Sale price at fair value 5,000,000

Carrying amount of an equipment 6,000,000
Annual rental payable at the end of each year 250,000
Implicit interest rate 8%
PV of ordinary annuity of 1 at 8% for 3 periods 2.58

Measurement of Lease Liability

Present value of rentals (250,000 x 2.58) 645,000

Amortization table

Date Payment Interest Principal PV

1/1/20x1 645,000
12/31/20x1 250,000 51,600 198,400 446,600
12/31/20x2 250,000 35,728 214,272 232,328
12/31/20x3 250,000 17,672 232,328 -

Measurement of right use of asset

Carrying Amount 6,000,000

Sale Price at fair value 5,000,000

Cost of Right of use Asset

(645,000/5,000,000 x 6,000,000) 774,000

Loss to be recognized

31
 Accounting for Leases

Sale Price 5,000,000

Carrying Amount (6,000,000)
Total Loss (1,000,000)

Fair Value 5,000,000

Right retained by seller equal to lease liability ( 645,000)
Right transferred to buyer-lessor 4,355,000

Loss to be recognized
(4,355,000/5,000,000 x 1,000,000) 871,000
Loss not to be recognized
(645,000/5,000,000 x 1,000,000) 129,000
Total loss 1,000,000
Books of Seller-Lessee Books of Buyer-Lessor

Jan 1.20x1 Cash 5,000,000 Building 5,000,000

Right of use of asset 774,000 Cash 5,000,000
Loss on right transferred 871,000
Equipment
Building 6,000,000 to record purchase of underlying asset
Lease liability 645,000
to record sale and leaseback

December 31,20x1Interest Expense 51,600 Cash 250,000

Lease Liability 198,400 Rent Income 250,000
Cash 250,000 to record annual rental
to record annual rental

Depreciation expense(774,000/3 years) 258,000 Depreciation expense(5,000,000/25years) 200,000

Accumulated Depreciation 258,000 Accumulated Depreciation 200,000
to record depreciation to record depreciation

Transfer of asset is not a sale

If does not satisfy the recognition requirements for the recognition of sale:

a. The seller-lessee shall continue to recognize the transferred asset and shall
recognize a financial liability equal to the transfer proceeds.

Cash xxx
Lease liability xxx
The rental or lease payment is accounted for as part of payment of interest expense
and part payment of lease liability.
The interest is computed based on the implicit interest rate using the effective
interest method.

b. The buyer-lessor shall not recognize the transferred asset but shall recognize a
financial asset equal to the transferred proceeds

Lease Receivable xxx

Cash xxx
The rental or lease payment from the seller- lessee is accounted for as part of
collection of interest income and part collection of lease receivable.

32
 Accounting for Leases

APPLICATION:
I. Computation: Read and understand the problem. Answer what is required.( 5
points each)No solution no point

1. On January 1, 20x1 NUPTIAL OF MARRIAGE Financing Co. leased equipment to

WEDDING, Inc. Information on the lease is shown below.

Cost of equipment P300,000

Useful life of equipment 5 years
Lease term 4 years
Annual rental payable at the end of each year 110,000

Additional information:

The 'annual lease payment includes P9, 049 pertaining to non-lease component. This
amount reflects the stand alone selling price of the service. Direct costs incurred by
NUPTIAL in negotiating the lease amounted to P20, 000. The implicit interest rate
after adjustment for the foregoing items is 10%.

Requirements: Compute for the following:

a. Gross investment in the lease on January 1, 20x1

b. Net investment in the lease on January 1,20x1
c. Unearned interest income on January 1,20x1
d. Prepare the amortization table

Feedback

Use the following information for the next five questions:

On January 1, 20x1, IMBROGLIO Co. leased equipment to COMPLICATION, Inc. Information
on the lease is shown below:

Cost of equipment ₱ 1,200,000

Useful life of equipment 5 years
Lease term 4 years
Annual rent payable at the start of each year 400,000
Interest rate implicit in the lease 10%

Initial direct costs amounted to ₱80,000. The lease qualifies for sales type lease accounting.

1. How much is the gross investment in the lease on January 1, 20x1?

a. 2,000,000 b. 1,600,000 d. 1,200,000 d. 1,800,000

2. How much is the net investment in the lease on January 1, 20x1?

a. 1,200,000 b. 1,280,000 c. 1,394,740 d. 1,474,741

3. How much is the total interest income (finance income) to be recognized by IMBROGLIO
over the lease term?

33
 Accounting for Leases

a. 205,260 b. 235,260 c. 125,259 d. 525,259

4. How much is the gross profit from the sale?

a. 114,740 b. 194,740 c. 125,259 d. 45,259

5. How much is the net profit from the sale?

a. 125,259 b. 45,259 c. 194,740 d. 114,740

Use the following information for the next three questions:

On January 1, 20x1, YATAGHAN Financing Co. leased equipment to LONG KNIFE, Inc.
Information on the lease is shown below:

Cost of equipment ₱ 1,322,588

Useful life of equipment 5 years
Lease term 4 years
Annual rent payable at the end of each year 400,000
Interest rate implicit in the lease 10%
Residual value 80,000

The equipment will revert back to YATAGHAN at the end of the lease term. The lease is
classified as direct financing lease.

6. Assuming the residual value is guaranteed, how much is the gross investment in the lease on
January 1, 20x1?
a. 1,600,000 b. 1,680,000 c. 1,520,000 d. 2,080,000

7. Assuming the residual value is unguaranteed, how much is the net investment in the lease?
a. 1,322,588 b. 1,267,948 c. 1,213,308 d. 1,345,981

8. How much is the total interest income to be recognized by YATAGHAN over the lease term
if the residual value is unguaranteed and guaranteed, respectively?
Unguaranteed Guaranteed
a. 357,412 341,270
b. 341,270 357,412
c. 341,753 341,985
d. 357,412 357,412

9. Wall Co. leased office premises to Fox, Inc. for a five-year term beginning January 2, 20x9.
Under the terms of the operating lease, rent for the first year is ₱8,000 and rent for years 2
through 5 is ₱12,500 per annum. However, as an inducement to enter the lease, Wall granted
Fox the first six months of the lease rent-free. In its December 31, 20x9, income statement,
what amount should Wall report as rental income?
a. 12,000 b. 11,600 c. 10,800 d. 8,000

10. As an inducement to enter a lease, Arts, Inc., a lessor, grants Hompson Corp., a lessee, nine
months of free rent under a five-year operating lease. The lease is effective on July 1, 20x5,
and provides for monthly rental of ₱1,000 to begin April 1, 20x6. In Art's income statement
for the year ended June 30, 20x6, rent income should be reported as
a. 10,200 b. 9,000 c. 3,000 d. 2,550

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 Accounting for Leases

Summary

 A lessor classifies a lease as either a finance lease or an operating lease. A

finance lease transfers substantially all the risks rewards incidental to
ownership of an underlying asset; an operating lease does not.

 Indicators of a finance lease: (1) Transfer of ownership; (2)Bargain purchase

option 'BPO'; (3) Major part of useful life '75%'; (4) PV of LP is substantially
all of fair value '90%'; (5) Specialized in nature.

 Finance lease: Initial accounting: Lessor derecognizes leased asset (and hence,
discontinues depreciating it) and recognizes net investment in the lease.
Subsequent accounting: net investment in the lease is subsequently measured
at amortized cost.

 Net investment = PV of lease payments + PV of Unguaranteed residual value

 Lease payments consist of: (a) Fixed payments (less lease incentives
receivable); (b) Variable payments based on index/rate; (c) Guaranteed
residual value; (d) Purchase option, if reasonably certain; (e) Termination
penalties and Payments in optional extension periods, if reasonably certain.

 Initial direct costs are included automatically in the net investment; no need to
add them separately.

 A manufacturer or dealer lessor recognizes profit from a sales type lease at the
commencement date, in addition to interest income over the lease term. Direct
costs are expensed outright.

 A lessor accounts for both guaranteed and unguaranteed residual value. PV of

residual value is added to sales while PV of unguaranteed residual value is
deducted from cost of sales. profit is the same whether residual value is
guaranteed or not.

 Operating lease: Lessor recognizes lease payments as lease income over the
lease term using the straight line basis, another more appropriate basis. Lessor

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 Accounting for Leases

continues to depreciate the leased asset.

 Sale and lease back: Both seller-lessee and buyer-lessor determines whether
the transaction qualifies as a sale under PFRS 15. If transaction is a sale;
seller-lessee measures use asset as the proportion of the asset's carrying
amount relates to the rights retained; recognizes gain or loss on the portion that
relates to the rights transferred; buyer-lessor accounts for the asset purchased
using applicable Standard and lease using PFRS 16.

 Disclosure: lessors – finance leases [IAS 17.47]

reconciliation between gross investment in the lease and the present value of
minimum lease payments; gross investment and present value of minimum
lease payments receivable for:
the next year years 2 through 5 combined beyond five years unearned
finance income unguaranteed residual values accumulated allowance for
uncollectible lease payments receivable contingent rent recognised in income
general description of significant leasing arrangements

 Disclosure: lessors – operating leases [IAS 17.56]

amounts of minimum lease payments at balance sheet date under

noncancellable operating leases in the aggregate and for:
the next year years 2 through 5 combined beyond five years contingent
rent recognised as in income general description of significant leasing
arrangements

References:

Intermediate Accounting 2020, Conrado Valix

Intermediate Accounting 2019, Zeus Vernon Millan

https://www.iasplus.com/en/standards/ias/ias17

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