LEASE ACCOUNTING

 Definition of terms:
 Lease – is a contract or part of a contract that conveys the right to use the
underlying asset for a period of time in exchange for consideration.
 Lease term – refers to non-cancellable period for which the lessee has the right to
use the underlying asset.
 Finance lease – is a lease that transfers substantially all the risks and rewards
incidental to ownership of an underlying asset.
 Operating lease – is a lease that does not transfer substantially all the risks and
rewards incidental to ownership of an underlying asset.
 Right of use asset – is an asset that represents the right of a lessee to use an
underlying asset over the lease term in a finance lease.
 Lease incentives – are payments by the lessor to the lessee associated with a lease
or the reimbursement or assumption by the lessor of the costs of the lessee.
 Initial direct costs – are incremental costs of obtaining a lease that would not have
been incurred if the lease had not been obtained.
 Fixed payments – are payments made by the lessee to the lessor
for the right to use an underlying asset during the lease term.
 Variable payments – are payments made by the lessee for the right
to use the underlying asset during the lease term that vary because
of changes in facts or circumstances occurring after the
commencement date other than passage of time.
 Residual value guarantee – is the guarantee made to the lessor by
a party unrelated to the lessor that the value of an underlying asset
at the end of the lease term will be at least a specified amount.
 Unguaranteed residual value – is that portion of the residual value
of the underlying asset, the realization of which by the lessor is not
assured or is guaranteed solely by a party related to the lessor.
 LESSEE  LESSOR
 IFRS 16 provides that at the commencement  IFRS 16 provides that a lessor shall classify
date, a lessee shall recognize a right of use leases as either an operating lease or a
asset and a lease liability. In other words, a finance lease. It further provides among
lessee is required to initially recognize a right others, any of the following situations would
of use asset for the right to use the underlying normally lead to a lease being classified as a
asset over the lease term and a lease liability finance lease by the lessor:
for the obligation to make payments.
 a. The lease transfers ownership of the
 All leases shall be accounted for by the lessee underlying asset to the lessee at the end of
as a finance lease under the new lease the lease term.
standard.
 b. The lessee has an option to purchase the
 The standard provides that the lessee is asset at a price which is expected to be
permitted to make an accounting policy
sufficiently lower than the fair value at the
election to apply the operating lease
date the option becomes exercisable
accounting and not recognize an asset and
lease liability on two optional exemptions:  c. The lease term is for the major part of
the economic life of the underlying asset
 a. if the lease is short-term
even if the title is not transferred.
 b. if the underlying asset is low value  d. The present value of the lease payments
amounts to substantially all of the fair value
 The standard defines short-term of the underlying asset at the inception of the
lease as a lease that has a term of 12 lease.
months or less at the commencement  Under USA GAAP, major part means at least
date of the lease. A lease that contains 75% of the economic life of the asset.
a purchase option is not a short-term  Under US GAAP, substantially all means at
lease. least 90% of the fair value of the leased asset.
 Low value asset is a matter of
 Operating lease – Lessor
professional judgment. A lease of an  IFRS 16 provides that a lessor shall recognize
underlying asset does not qualify as lease payments from operating lease as
income either on a straight line basis or
a low value lease if the nature of the
another systematic basis. Lease payments are
asset is such that the asset is typically recognized as rent income.
not of low value when new.
 Initial measurement of right of use asset
 IFRS 16 provides that the lessee shall measure the right of use asset at cost, at
commencement date. It comprises the following:
 a. The present value of lease payments or the initial measurement of the lease
liability
 b. Lease payments made to lessor at or before commencement date, less any lease
incentives received
 c. Initial direct costs incurred by the lessee
 d. Estimated cost of dismantling, removing and restoring the underlying asset for
which the lessee has a present obligation.
 Subsequent measurement of right of use asset
 IFRS 16 provides that a lessee shall measure the right of use asset applying the cost model.
In other words, the lessee shall measure the right of use asset at cost less accumulated
depreciation and impairment loss. Moreover, the carrying amount of right of use asset is
adjusted for any re-measurement of the lease liability.
 Depreciation of right of use asset
 IFRS 16 provides that the lessee shall depreciate the right of use asset over the
useful life of the underlying asset under the following conditions:
 a. The lease transfers ownership of the underlying asset to the lessee at the end of
the lease term.
 b. The lessee is reasonably certain to exercise a purchase option.
 If there is no transfer of ownership to the lessee or if the purchase option is not
reasonably certain to be exercised, the lessee shall depreciate the right of use asset
over the shorter between the useful life of the asset and the lease term.
 Measurement of lease liability
 IFRS 16 provides that at the commencement date, the lessee shall measure the lease
liability at the present value of lease payments. The lease payment shall be
discounted using the interest rate implicit in the lease. If the implicit interest rate
cannot be readily determined, the incremental borrowing rate of the lease is used.
 Illustration:  Answers:
 At the beginning of the current year, Ashe Company  1.PV of lease payments: 6,145,000
entered into a ten-year non-cancelable lease requiring
year-end payments of P1,000,000. Ashe’s incremental
 (1,000,000 x 6.145)
borrowing rate is 12%,while the lessor’s implicit interest  Initial direct cost: 200,000
rate, known to Ashe is 10%.
 Right of use asset 6,345,000
 On the same date, Ashe Company paid initial direct cost
of P200,000 in negotiating and securing the leasing  2.Right of use asset 6,345,000
arrangement.  Divided by: 10 years
 Ownership of the property remains with the lessor at  Depreciation for current year
expiration of the lease, The lease property has an
634,500
estimated economic life of 12 years.
 Required:
 3.Lease liability 6,145,000
 1. What is the cost of the right of use asset?
 Annual rental 1,000,000
 2. What is the depreciation of the current year?
 Interest(6,145,000 x 10%) 614,500 385,500
 3. What is the lease liability at the end of the current  Lease liability at end of current year
year? 5,579,500
 Illustration – Certain purchase option  Answers:
 Lessee Company leased a machine on January 1, 2020  1. PV of lease payments (1,000,000 x 5.65) 5,650,000
with the following pertinent information:  PV of purchase option (500,000 x 0.322) 161,000
 Fixed rental payment at the end of each year  Right of use asset 5,811,000
1,000,000  2. Lease liability 5,811,000
 Lease term 10 years  Payment - 12/31/20 1,000,000
 Useful life of machine 12 years  Interest for 2020 697,320 302,680
 Incremental borrowing rate 14%  Lease liability-12/31/20 5,508,320
 Implicit interest rate 12%  3. Right of use asset (5,811,000 – 600,000) 5,211,000
 Lessee Company has the option to purchase the  Divided by: 12 years
machine upon the lease expiration on January 1, 2030  Depreciation 434,250
by paying P500,000.
 The lessee is reasonably certain to exercise the
purchase option at the commencement date of the
lease. The estimated residual value of the machine at
the end of the 12-year life is P600,00
 Required:  4. Lease liability 500,000
 Cash 500,000
 1. How much should be the right of use
 5. Right of use asset 5,811,000
asset?
 Accu depreciation (434,250 x 10 years) 4,342,500
 2. What is the balance of the lease liability  Carrying amount – 1/1/30 1,468,500
on December 31, 2020.
 Lease liability – 1/1/30 500,000
 3. How much should be the annual  Loss on finance lease 968,500
depreciation?  6. Accumulated depreciation 4,342,500
 4. What is the journal entry if the purchase  Lease liability 500,000
option is exercised?  Loss on finance lease 968,500
 5. How much should be the loss on finance  Right of use asset 5,811,000
lease if purchase option is not exercised?
 6. What is the journal entry if purchase
option is not exercised?
 Illustration – Residual value guarantee  Answers:
 Easy Company leased an equipment on January 1,
 1. PV of lease payments (1,000,000 x 3.16987) 3,169,870
2020 with the following information:  PV of residual value guarantee (200,000 x .683) 136,600
 Fixed annual payment at the end of each lease  Cost of right of use asset and lease liability 3,306,470
year 1,000,000  2. PV of Lease liability - 1/1/20 3,306,470
 Lease term 4 years  Lease payment 1,000,000
 Useful life of equipment 5 years
 Interest expense (3,306,470 x 10%) 330,647 669,353
 Lease liability – 12/31/20 2,637,117
 Implicit interest rate 10%
 3. Depreciable amount (3,306,470 – 200,000)
 Easy Company guaranteed a P200,000, residual value 3,106,470
on December 31, 2023 to lessor. Compute the  Divided by 4 years
following:
 Annual depreciation 776,618
 a. What is the right of use asset?  Note: The asset is depreciated over the lease term of 4
 b. What is the balance of lease liability on December years because there is neither a transfer of title nor a
31, 2020? reasonable certain purchase option.

 c. What is the annual depreciation

 Illustration – Initial direct cost  Answers:
 On January 1, 2020, Simple Company leased an  a. PV of rentals (1,000,000 x 4.3121) 4,312,100
equipment with the following information:  PV of residual value guarantee
 Annual fixed payment in advance at the  (300,000 x .6806) 204,180
beginning of each lease year 1,000,000.
 Lease liability-1/1/20 4,516,280
 Initial direct cost paid 250,000
 b. Initial direct cost 250,000
 Lease incentive received 150,000
 Lease incentive received (150,000)
 Residual value guarantee 300,000  Cost of right of use asset
 Lease term 5 years 4,616,280
 Useful life of equipment 6 years  c. Depreciable amount of right of use asset
 Implicit interest rate 8%  (4,616,280 – 300,000) 4,316,280
 Required: a. How much is lease liability? b.  Divided by: 5 years
How much is cost of right of use asset? c. how  Annual depreciation
much is depreciation? 863,256
 Table of amortization  Answers:
 Date Payment Interest Principal Present value  1. Right of use asset 4,616,280
 1/1/20 4,516,280  Lease liability 4,516,280
 1/1/20 1,000,000 - 1,000,000 3,516,280  Cash (250,000 – 150,000) 100,000
 1/1/21 1,000,000 281,302 718,698 2,797,582  Lease liability 1,000,000
 1/1/22 1,000,000 223,807 776,193 2,021,389  Cash 1,000,000
 1/1/23 1,000,000 161,711 838,289 1,183,100  Interest expense (3,516,280 x 8%) 281,302
 1/1/24 1,000,000 94,648 905,352 277,748  Accrued interest payable 281,302
 1/1/25 300,000 22,252 277,748 -  2. Accrued interest payable 281,302
 Journal entries:  Lease liability 718, 698
 1.To record the acquisition of equipment and first payment
on January 1, 2020 and interest on December 31, 2020.
 Cash 1,000,000
 2. Journal entries for 2021.
 Interest expense (2,797,582 x 8%) 223,807
 Accrued interest payable 223,807
 Illustration: Unguaranteed residual value  Answers:
 Ezzy Company leased a warehouse on January 1, 2020 with  Lease liability (600,000 x 4.36) 2,616,000
the following information:
 Payment to lessor to obtain a long-term lease 224,000
 Annual rental payable at the end of each year 600,000
 PV of restoration cost (634,920 x 0.63) 400,000
 Unguaranteed residual value 200,000
 Total cost of right of use asset
 Payment to lessor to obtain a long-term lease 224,000
3,240,000
 Cost or restoring the asset as required by contract 634,920
 Journal entries for 2020:
 Annual executory cost paid 50,000
 1. To record the acquisition of the warehouse:
 Lease term 6 years
 Right of use asset 3,240,000
 Useful life of equipment 8 years
 Lease liability 2,616,000
 Implicit interest rate 10%
 Discount rate for the restoration cost 8%
 Cash 224,000
 The lease provides for neither a transfer of title to the
 Estimated liability for restoration (at PV) 400,000
lessee nor a purchase option.  Note: The PV of residual value is not included in the
lease liability because it is not guaranteed. The annual
executory cost is treated as outright expense.
 Required: Compute the total cost of right of use asset  2. To record the payment of executory cost:
and journal entries for 2020.  Executory cost 50,000
 Return of equipment to lessor  Cash 50,000
 On January 1, 2026, the return of the warehouse to the  3. To record the first rental payment on December 31, 2020:
lessor is recorded as:  Interest expense (2,616,000 x 10%) 261,600
 Accumulated depreciation (540,000 x 6) 3,240,000  Lease liability (600,000 – 261,400) 338,400
 Equipment 3,240,000  Cash 600,000
 4. To record the depreciation for 2020:
 Note: The lessee has no financial obligation but to
return the underlying asset to the lessor  Depreciation (3,240,000 / 6) 540,000
 Payment of liability for restoration cost  Accumulated depreciation 540,000
 5. To record the interest on the liability for restoration cost for
 On January 1, 2026, the carrying amount of the
2020:
estimated liability for restoration cost would be
P634,920. after recognizing interest for 6 years.  Interest expense (400,000 x8%) 32,000
 Estimated liability for restoration cost 32,000
 Estimated liability for restoration cost 634,920
 Cash 634,920
 Actual purchase of underlying asset  Answer:
 An entity can actually purchase an equipment
 Equipment 3,700,000
that it has been leasing under a finance lease.  Accumulated depreciation 1,500,000
The cost of asset purchased is equal to the  Lease liability 3,800,000
carrying amount of the leased asset plus cash
 Right of use asset
payment minus the balance of the lease liability.
5,000,000
 Illustration: An entity purchased an equipment  Cash 4,000,000
that it has been leasing under a finance lease for  Right of use asset 5,000,000
P4,000,000. The balance of certain accounts on
the date of actual purchase are:  Accumulated depreciation (1,500,000)
 Right of use asset 5,000,000
 Carrying amount 3,500,000
 Cash payment 4,000,000
 Accumulated depreciation 1,500,000
 Total consideration 7,500,000
 Lease liability 3,800,000
 Lease liability (3,800,000)
 Required: Journal entry to record the purchase.  Cost of equipment purchased 3,700,000
 Illustration - Extension option  Re-measurement of lease liability
 An entity entered into a lease of building on January 1,  On January 1, 2023, the lease liability is re-measured
2020 with the following information: using the new implicit interest rate of 8%.
 Annual rental payable at the end of each year 500,000  Annual rental for remaining 2 years of
 Lease term 5 years  old lease term 500,000
 Useful life of building 20 years  Multiply by: PV factor (8% for 2 periods)
 Implicit interest rate 10% 1.783
 The lease contained an option for the lessee to extend  Present value – 1/1/2023 891,500
for a further 5 years. At the commencement date, the  Annual rental for 5 years starting 1/1/2025
exercise of the extension option is not reasonably 600,000
certain. After 3 years on January 1, 2023, the lessee
decided to extend the lease for further 5 years.  Multiply by: PV factor (8% for 5 periods) 3.993
 New annual rental payable at the end  Present value – 1/1/2025 2,395,800
 of each year 600,000  Multiply by: PV factor (8% for 2 periods) 0.857
 New implicit interest rate 8%  Present value – 1/1/2023 2,053,200
 Table of amortization  The present value of the new rentals on January 1, 2025 is
 Date Payment Interest Principal Present value rediscounted for 2 periods on the date of extension on
 01/01/20 1,895,500 January 1, 2023.
 12/31/20 500,000 189,550 310,450 1,585,050  PV of remaining rentals of old lease term 891,500
 PV of rentals of extended lease term 2,053,200
 12/31/21 500,000 158,505 341,595 1,243,555
 Total present value – 1/1/23 2,944,700
 12/31/22 500,000 124,355 375,645 867,910
 Journal entries for 2020:
 Present value – 12/31/22 (see table) (867,910)
 Jan. 1 Right of use asset 1,895,500  Increase in lease liability on 1/1/23 2,076,790
 Lease Liability 1,895,500  Right of use asset – 1/1/20 1,895,500
 Dec. 31 Interest expense 189,500  Accumulated depreciation – 12/31/22
 Lease liability 310,450
 (379,100 x 3 years)
 Cash 500,000
(1,137,300)
 31 Depreciation (1,895,500 / 5) 379,100
 Carrying amount – 12/31/22 758,200
 Accumulated depreciation 379,100
 Increase in liability on 1/1/23 2,076,790
 New carrying amount – 1/1/23 2,834,990
 New table amortization  Journal entries for 2023
 Date Payment Interest Principal PV  1. To re-measure the lease liability on 1/1/2023:
 01/01/23 2,944,700  Right of use asset 2,076,790
 12/31/23 500,000 235,576 264,424 2,680,276  Lease liability 2,076,790
 12/31/24 500,000 214,422 285,578 2,394,698  Note: The increase in lease liability is an
adjustment of the carrying amount of the right of
 12/31/25 600,000 191,576 408,424 1,986,274 use asset
 12/31/26 600,000 158,902 441,098 1,545,176  2. To record the annual rental on 12/31/2023:
 12/31/27 600,000 123,614 476,386 1,068,790  Interest expense 235,576
 12/31/28 600,000 85,503 514,497 554,293  Lease liability 264,424
 12/31/29 600,000 45,707 554,293 -  Cash 500,000
 Note: IFRS 16 provides that the re-measurement of the  3. To record the annual depreciation based on the new
lease liability is an adjustment of the carrying carrying amount:
amount of the right of use asset. Depreciation (2,834,990 / 7) 404,999
 Accumulated depreciation 404,999
 Illustration – Variable payments  Answer:
 On January 1, 2020, an entity entered into an 8-year lease  Annual rental for first 3 years 300,000
of a floor of a building with the following terms:
 Multiply by: PV factor 2.487
 Annual rental for the first 3 years payable
 Present value – 1/1/2020 746,100
 at the end of each year 300,000
 Annual rental for next 5 periods 400,000
 Annual rental for the next 5 years payable
 at the end of each year 400,000
 Multiply by: PV factor 3.791
 Implicit interest rate 10%
 Present value – 1/1/2023 1,516,400
 PV of an ord. annuity of 1 at 10% for 3 periods 2.487  Multiply by: PV factor 0.751
 PV of an ord. annuity of 1 at 10% for 5 periods 3.791  Present value – 1/1/2020 1,138,816
 PV of 1 at 10% for 3 periods 0.751  PV of annual rentals for 3 years 746,100
 The lease provides for neither a transfer of title to the  PV of annual rentals for next 5 years 1,138,816
lessee nor a purchase option. Compute the lease liability.
 Lease liability – 1/1/2020 1,884,916
 Illustration – Lease modification  Journal entries for 2020
 On January 1, 2020, an entity entered into a lease  PV of the lease payments – 1/1/2020
agreement with the following information:  (100,000 x 5.3349) 533,490
 Floor pace 3,000 sq. meters  Jan 1 Right of use asset 533,490
 Annual rental payable at the end of the year  Lease liability 533,490
100,000
 Dec 31 Interest expense (533,490 x 10%) 53,349
 Implicit interest rate in the lease 10%
 Lease liability 46,651
 Lease term 8 years
 Cash 100,000
 On January 1, 2022, the entity and the lessor agreed to
amend the original terms of the lease with the following
 31 Depreciation (533,490/8) 66,686
information:  Accumulated depreciation 66,686
 Additional floor space 4,500 sq. meters  On January 1, 2022, the entity shall account for the
 Increase in rental payable at the modification as a separate lease. The entity shall
recognize the right of use asset and lease liability for
 end of each year 200,000 additional lease space on January 1, 2022.
 Implicit rate in the lease 8%
 Lease modification – increase in  PV of the additional lease payment
scope  on 1/1/2022 (200,000 x 4.6229) 924,580
 Journal entries for 2022 – new separate lease
 IFRS 16, provides that the lease shall
account for the lease modification as a  Jan 1 Right of use asset 924,580
separate lease under the following  Lease liability 924,580
conditions:  Dec 31 Interest expense
 (924,580 x 8%) 73,966
 a. The modification increases the scope
of the lease by adding the right to use  Lease liability 126,034
an additional underlying asset.  Cash 200,000
 Dec 31 Depreciation 154,097
 b. The rental for the lease modification
increases by an amount commensurate  Accumulated depreciation 154,097
with the increase in scope and  (924,580/6 years)
equivalent to the current market rental.
 Lease modification – decrease in scope  Table of amortization for 2020 and 2021
 On January 1, 2020, an entity entered into a lease of office space  Date Payment Interest Principal Lease
with the following information: liability
 Floor space 800 sq. meters  1/1/20 268,404
 Annual rental payable at the end of each year 40,000  12/31/20 40,000 21,472 18,528 249,876
 Lease term 10 years
 12/31/21 40,000 19,990 20,010 229,866
 Implicit rate in the lease 8%
 Since the floor space was reduced to 480 sq. meters, the
 PV of lease payments-1/1/2020 (40,000 x 6.7101) 268,404
scope of the lease was reduced by 40%.
 On January 1, 2022, the lessee and the lessor agreed to amend
the original terms of the lease with the following information:
 Decrease in carrying amount of lease liability
 Floor space 480 sq. meters  (229,866 x 40%) 91,946
 Annual rental payable at the end of each year 30,000  Decrease in carrying amount of right of use asset
 Implicit rate in the lease 10%  (214,724 x 40%) (85,890)
 Termination gain 6,056
 CA of right of use asset (268,404 - 53,680) =
214,724
 Decrease in scope  Lease liability – 1/1/22 (see table) 229,866
 Reduction of lease liability (91,946)
 IFRS 16 states that a gain or loss should be  Remaining old lease liability – 1/1/22 137,920
recognized as a result of the partial termination  PV of lease payments on 1/1/2022 as a result of the decrease in
of the lease. scope
 If the decrease in carrying amount of lease  (30,000 x 5.3349) 160,047
liability is higher than the decrease in carrying  Carrying amount of old lease liability on 1/1/2022 (137,920)
amount of right of use asset, the difference is a  Increase in lease liability 22,127
termination gain.  Journal entries for 2022
 Jan. 1 Lease liability (40% x 229,866) 91,946
 If the decrease in carrying amount of right of
 Accumulated depreciation 21,472
use asset is higher than the decrease in
Right of use asset (268,404 x 40%)
carrying amount of lease liability, the

107,362
difference is a termination loss.  Termination gain 6,056
 Note: The increase in lease liability as a result  Right of use asset 22,127
of lease modification is an adjustment to the  Lease liability 22,127
carrying amount of right of use asset.
 OPERATING LEASE – LESSOR
 IFRS 16 provides that a lessor shall recognize lease payments from operating lease as
income either on a straight line basis or another systematic basis.
 The periodic rental received by the lessor in an operating lease is simply recognized
as rent income.
 Initial direct cost incurred by the lessor in an operating lease shall be added to the
carrying amount of the underlying asset and recognized as an expense over the lease
term on the same basis as the lease income.
 The balance of the deferred initial direct cost shall be presented as an addition to
the carrying amount of the machinery.
 Any security deposit refundable upon the lease expiration shall be accounted for as
liability of the lessor.
 Any lease bonus received by the lessor from the lessee is recognized as unearned
rent income to be amortized over the lease term.
 Illustration:
 1. On April 1, 2020, Simple Company leased the machine to another entity for 3 years
at a monthly rental of P50,000 payable at the beginning of each month.
 Cash (50,000 x 9 months) 450,000
 Rent income 450,000
 2. On April 1, 2020, Simple Company received security deposit of P600,000 to be
refunded upon the lease expiration.
 Cash 600,000
 Liability for rent deposit 600,000
 3. In addition to the rental, Simple Company received from the lessee a lease bonus of
P120,000 on January 1, 2020.
 Cash 120,000
 Unearned rent income 120,000
 4. On April 1, 2020, Simple Company paid initial direct cost of P300,000. Such costs are directly
attributable to negotiating and arranging the operating lease.
 Deferred initial direct cost 300,000
 Cash 300,000
 5. The lease bonus is amortized over 3 years or P40,000 annually.
 Unearned rent income 30,000
 Rent income (40,000 x 9/12) 30,000
 6. The initial direct cost is recognized as expense over the lease term.
 Amortization of initial direct cost 75,000
 Deferred initial direct cost (300,000 / 3 x 9/12) 75,000
 Unequal rental payments
 Where the operating lease requires unequal cash payments, the total cash payments for the
lease term shall be amortized uniformly on the straight line basis as rent income over the lease
term.
 Illustration:  Journal entries for 2020, 2021 and 2022:
 Aye Company leased office space to another  2020:
entity for a three-year period beginning January  Cash 500,000
1, 2020. Under the terms of the operating
lease, rent for the first year is P1,000,000 and  Rent receivable 500,000
rent for the next two years, P1,250,000  Rent Income
annually. However, as an inducement to enter
1,000,00
the lease, Aye granted the lessee the first six
months of the lease rent-free. Total rental for  2021:
the lease term are as follows:  Cash 1,250,000
 2020 (1,000,000 x 6/12) 500,000  Rent income 1,000,000
 2021 1,250,000  Rent receivable 250,000
 2022 1,250,000  2022:
 Total rental for 3 years 3,000,000  Cash 1,250,000
 Average annual rental:  Rent income 1,000,000
 (3,000,000 / 3) 1,000,000  Rent receivable 250,000
 Problem 12-14:  Answer:
 At the beginning of current year, Wren  Rent income
Company leased a building to Brill
500,000
Company under an operating lease for
ten years at P500,000 per year,  Amortization of initial
payable the first day of each lease year.
Wren company paid P150,000 to a real  direct cost (150,000 /10)
estate broker as initial direct cost. (15,000)
 The building is depreciated at P120,000  Depreciation
per year. Wren Company incurred (120,000)
insurance and property tax expense
totaling P90,000 for the current year.  Insurance and property tax
 Required: What is the net income for (90,000)
the current year?  Net rent income
275,000
 Direct Financing Lease - Lessor
 On the part of the lessor, a finance lease is either:
 a. Direct financing lease – recognizes only interest income.
 b. Sales type lease – recognizes interest income and gross profit on sale.
 Accounting considerations
 a. Gross investment – this is equal to the gross rentals for the entire lease term plus the
absolute amount of the residual value, whether guaranteed or not guaranteed.
 b. Net investment in the lease – This is equal to the cost of the asset plus any indirect
cost paid by the lessor.
 c. Unearned interest income – This is the difference between the gross investment and
net investment in thee lease.
 d. Initial direct cost – In a direct financing lease, the initial direct cost paid by the lessor is
added to the cost of the asset to get the net investment in the lease.
 Note: The income of the lessor is only in the form of interest income.
 Illustration – Direct financing lease  Computations
 Gross rental or lease receivable
 On January 1, 2020, Lessor Company leased a
machinery to another entity with the following
 (500,000 x 4 years) 2,000,000
details:  PV of gross rentals (equal to net investment
 in the lease or cost of machinery 1,518,650
 Cost of machinery 1,518,650
 Unearned interest income 481,350
 Annual rental payable at the  Lease receivable (500,000 x 4) 2,000,000
 end of each year 500,000  Machinery 1,518,650
 Lease term 4 years  Unearned interest income 481,350
 The effective interest method is used in recognizing
 Useful life of machinery 4 years
interest income.
 Implicit interest rate 12%  12/31/20 Unearned interest income 182,238
 PV of annuity of 1 3.0373  Interest income (1,518,650 x 12%)
182,238
 Required: What is the gross investment, net
investment and Unearned interest income?
 Direct financing lease – with initial direct cost  Answers:
 Illustration: On January 1, 2020, lessor Company leased  1. Cost of machinery 1,518,650
a machinery to another entity with the following details:
 Cost of machinery 1,518,650
 Initial direct cost 66,300
 Annual rental payable at the end of each year 500,000  Net investment in the lease 1,584,950
 2. Gross rentals (500,000 x 4) 2,000,000
 Lease term 4 years
 Net investment in the lease 1,584,950
 Implicit interest rate before initial direct cost 12%
 Unearned interest income
 PV of annuity of 1 for 4 years at 12% 3.0373 415,050
 On January 1, 2020, Lessor company paid initial direct  3. The new implicit rate is computed by trial and
cost of P66,300. error as follows:
 Required: 1) What is the net investment in the  P500,000 x 3.1699 = P1,584,950
lease 2) How much is unearned interest income 3)
What is the new implicit interest rate after  The PV factor of 3.1699 is obtained using a
payment of initial direct cost? new implicit interest rate of 10%
 Direct financing lease – with residual value  Answers:
 Illustration: On January 1, 2020, Lessor Company  1. Cost of machinery 3,194,410
leased a machinery to another entity with the following  PV of residual value ( 341,500)
details:
 Net invsment to be recovered from rental
 Cost of machinery 3,194,410
2,852,910
 Residual value 500,000  2. Divide by PV of an ordinary annuity of 1
 Implicit interest rate 10%  at 10% for 4 periods 3. 1699
 The machinery will revert to the lessor at the end of the  Annual rental payment 900,000
lease term because there is no transfer of title.
 3. Gross rental (900,000 x 4) 3,600,000
 PV of 1 at 10% for 4 periods .6830
 Residual value 500,000
 PV of an ordinary annuity of 1 at 10%
 Gross investment
 for 4 periods 3.1699 4,100,000
 Required: 1) What is the net investment to be  4. Cost of machinery – net investment 3,194,410
recovered from rental? 2) What is the annual rental  Unearned interest income 905,590
payment? 3) what is the gross investment? 4) How much
is unearned interest income?
 Direct financing lease – with residual value  Answers:
(Guaranteed)  1. Cost of machinery 3,760,100
 On January 1, 2020, Lessor Company leased a machinery to  PV of residual value (400,000 x .683) ( 273,200)
another entity with the following details:
 Net investment to be recovered from rental
 Cost of machinery 3,760,100 3,486,900
 Residual value guarantee 400,000  Divide by: PV of annuity of 1 at 10% for 4 periods 3.4869
 Useful life and lease term 4 years  Annual rental 1,000,000
 Implicit interest rate 10%  2. Gross rentals (1,000,000 x 4) 4,000,000
 The annual rental rate is payable in advance on January 1  Residual value-guaranteed 400,000
of each year starting January 1, 2020.  Gross investment 4,400,000
 PV of 1 at 10% for 4 periods 0.6830  Net investment–cost of machinery 3,760,100
 PV of an annuity of 1 at 10% for 4 periods 3.4869  Unearned interest income
639,900
 Required: 1) What is the annual rental over the lease
term? 2) How much is the Unearned interest income?
 Direct finance lease – Transfer of title to lessee  Answers:
 On January 1, 2020, Lessor Company leased a  1.Cost of machinery to be recovered
machinery to another entity with the following details:  from rental 3,449,600
 Cost of machinery 3,449,600  Divide by: PV of annuity of 1 at 8% 4.312
 Residual value 500,000  Annual rental 800,000
 Useful life and lease term 5 years  2. Gross rental (800,000 x 5) 4,000,000
 Implicit interest rate 8%
 Net investment-cost of machinery 3,449,600
 Unearned interest income 550,400
 The annual rental is payable in advance on January 1 of
each year starting January 1, 2020.  Note: If the machinery will not revert to the lessor at the
end of the lease term because the lease provides for a
 The lease provides for a transfer of title to the lessee at transfer of title to the lessee, the residual value is
the end of the lease term. completely ignored in the computation of the annual
rental and the unearned interest income.
 The PV of an annuity of 1 at 8% for 5 periods 4.312
 3. Interest income on 1/1/221:
 Required: (a) How is annual rental? (b) How much
is unearned interest income (c) How much is  (3,449,600 – 800,000 x 8%) 211,968
interest income on January 1, 2021?
 Problem 13-5
 Desiree Company is in the business of leasing new sophisticated equipment. The lessor expects a 12% return
on net investment. All leases are classified as direct financing lease. At the end of lease term the equipment
will revert to the lessor. At the beginning of current year, an equipment is leased to a lessee with the following
information:
 Cost of equipment to the lessor 5,000,000
 Residual value – unguaranteed 600,000
 Annual rental payable at the beginning of each year 900,000
 Initial direct cost incurred by the lessor 250,000
 Useful life and lease term 8 years
 Implicit interest rate 12%
 Required:
 1. What is the gross investment in the lease?
 2. What is the net investment in the lease?
 3. What is the interest income over the lease term?
 4. What is the interest income for the current year?
 Answer:
 1. Gross rental (900,000 x 8 years) 7,200,000
 Residual value – unguaranteed 600,000
 Gross investment in the lease 7,800,000
 2. Cost of equipment 5,000,000
 Initial direct cost incurred by the lessor 250,000
 Net investment in the lease 5,250,000
 3. Gross investment in the lease 7,800,000
 Net investment in the lease 5,250,000
 Total interest income over the lease term 2,550,000
 4. Net investment in the lease 5,250,000
 Less: 1st annual rental 900,000
 Interest income for the current year 4,350,000 x 12% = 522,000
 Problem 13-6  Answers:
 Oceanic Company is engaged in leasing  1. Cost of equipment 4,361,200
equipment. Such an equipment was delivered to a
lessee at the beginning of the current year under
 Present value of residual value
a direct financing lease with the following  (200,000 x 0.466) ( 93,200)
provisions:
 Net investment in the lease to
 Cost of equipment 4,361,200
 be recovered from rental 4,268,000
 Unguaranteed residual value 200,000
 2. PV of lease payments 4,268,000
 Useful life and lease term 8 years
 Divided by: PVF 5.335
 Implicit interest rate 10%
 Annual rental = 800,000
 The annual rental is payable at the end of each
year. The equipment will revert to the lessor upon  3. Cost of equipment 4,361,200
the lease expiration.  Multiplied by: X 10%
 Required: 1) What is the net investment in the  Interest income for
lease to be recovered from rental? 2) What is the
annual rental over the lease term? 3) What  current year 436,120
amount of interest income should be recognized
for the current year?
 SALES TYPE LEASE – LEASOR
 Accounting considerations:
 Gross investment – is equal to the gross rental for the entire lease term plus the absolute
amount of the residual value, whether guaranteed or unguaranteed.
 Net investment in the lease –this is equal to the present value of the gross rentals plus the
present value of the residual value, whether guaranteed or unguaranteed.
 Unearned interest income – this is the difference between the gross investment and net
investment in the lease.
 Sales – the amount is equal to the net investment in the lease (present value of lease
payments) or fair value of the asset, whichever is lower.
 Cost of goods sold – the amount is equal to the cost of the asset sold minus the present
value of unguaranteed residual value plus the initial direct cost paid by the lessor.
 Gross profit – this is the usual formula of sales minus cost of goods sold.
 Initial direct cost – this amount is expensed immediately in a sale type lease as
component of cost of goods sold
 Illustration:  Answer:
 Lessor Company is a dealer in machinery. On January 1,  1. Gross rentals (400,000 x 5) 2,000,000
2020, a machinery was leased to Lessee Co. with the
following provisions:
 PV of rentals (400,000 x 3.60) 1,440,000
 Annual rental payable at the end of each year 400,000
 Unearned interest income 560,000
 Lease term 5 years
 2. PV of rentals-sales (400,000 x 3.60) 1,440,000
 Useful life of machinery 5 years
 Cost of machinery-cost of goods sold 1,000,000
 Cost of machinery 1,000,000  Gross profit on sale 440,000
 Implicit interest rate 12%  3. Interest income for 2020:
 Present value of annuity of 1 for 5 years at 12% 3.60  (1,440,000 x 12%) 172,800
 Required:  Journal entry to record the sale:
 1. How much is unearned interest income?  Lease receivable (400,000 x 5) 2,000,000
 2. What is the gross profit on sale?  Sales (400,000 x 3.60) 1,440,000
 3. How much interest income should be recognized for  Unearned interest income 560,000
2020?
 Sale type lease with residual value  Residual value guarantee
 Lessor Co. is a dealer in machinery. On January 1, 2020, a  Gross rental (800,000 x 5) 4,000,000
machine is leased to another entity with the following  Residual value guarantee 200,000
provisions:  Lease receivable- gross investment 4,200,000
 Annual rental payable at the end of each year  PV of gross rentals (800,000 x 3.7908) 3,032,640
800,000
 PV of residual value guarantee (200,000 x .6209) 124,180
 Lease term 5 years
 Total present value -net investment 3,156,820
 Useful life of machinery 5 years  Lease receivable-gross investment 4,200,000
 Cost of machinery 2,000,000  Total present value-net investment (3,156,820)
 Estimated residual value 200,000  Unearned interest income 1,043,180
 Initial direct cost paid by lessor 100,000  Sales-total present value 3,156,820
 Implicit interest rate 10%  Cost of goods sold-cost of machinery (2,000,000)
 PV of an annuity of 1 for 5 periods at 10%  Initial direct cost (100,000)
3.7908  Gross income 1,056,820
 PV of 1 for 5 periods at 10% 0.6209
 At the end of the lease term on December 31, 2024, the
machinery will revert to Lessor Company.
 Sales 3,032,640  Unguaranteed residual value
 Gross rental (800,000 x 5) 4,000,000
 Cost of goods sold (1,875,000)
 Unguaranteed residual value 200,000
 Initial direct cost ( 100,000)  Lease receivable –gross investment
 Gross income 1,057,640 4,200,000
 PV of gross rentals- sales 3,032,640
 Under the residual value guarantee scenario, the
present value of the residual value is included in  PV of unguaranteed residual value 124,180
the sales revenue because the lessor knows that  Total present value –Net investment 3,156,820
the entire asset has been sold. However, under  Lease receivable 4,200,000
the unguaranteed residual value scenario, the  Total present value (3,156,820)
present value of the unguaranteed residual value
 Unearned interest income
is not included in the sales revenue. 1,043,180
 Accordingly, the present value of the  Cost of machinery 2,000,000
unguaranteed residual value is deducted from  PV of unguaranteed residual value ( 124,180)
the cost of the underlying asset in computing  Cost of goods sold
cost of goods sold. 1,875,000
 Problem 14-6  Answers:
 On April 1, 2020, Oriental Company leased
 1. Gross rentals (700,000 x 8) 5,600,000
equipment to another entity. The lease is  PV of rentals (700,000 x 5.868) 4,107,600
appropriately recorded as a sales type lease and is  Total financial revenue 1,492,400
for an 8-year period with an implicit interest rate  2. Sales (PV or rentals) 4,107,600
of 10%. The first of 8 equal payments of P700,000
was made on April 1, 2020. The cost of the  Cost of equipment 3,700,000
equipment to oriental Company is P3,700,000. The  Gross profit on sale 407,600
equipment has an estimated useful life of 8 years  3. Lease Receivable 5,600,000
with no residual value. The present value of an
annuity of 1 in advance at 10% for 8 periods is
 Sales 4,107,600
5.868.  Unearned Interest Income 1,492,400
 Required:  Cash 700,000
 Lease Receivable 700,000
 1) Determine the total financial revenue.
 2) Determine the gross profit on sale.
 3) Prepare journal entries on April 1, 2020.
 SALE AND LEASEBACK
 Sale and leaseback – is an arrangement whereby one party sells an asset to another party and then
immediately leases the asset back from the new owner. The seller becomes a seller-lessee and the buyer, a
buyer-lessor.
 IFRS 16, provides that the transfer of an asset must satisfy the requirements for the recognition of sale in
order to be accounted for as sale and leaseback.
 The important consideration in a sale and leaseback transaction is the recognition of two separate and
distinct transactions.
 First – there is a sale
 Second – there is a lease agreement for the same asset in which the seller is the lessee and the buyer is the
lessor.
 The seller-lessee shall account for the leaseback as a finance lease. The lease liability is measured at the
present value of lease payments.
 IFRS 16 provides that the seller-lessee shall measure the right of use asset arising from the lease back at the
proportion of the previous carrying amount of the asset that relates to the right of use retained by the seller-
lessee. Simply stated, the cost of right of use asset is equal to a fraction whose numerator is the present
value of lease liability and whose denominator is the fair value multiplied by the carrying amount of the asset.
 Illustration – Sale price at fair value Books of seller-lessee:
Cash 2,000,000
 At the beginning of the current year, an
entity sold a machinery with a remaining Accumulated Depreciation 1,200,000
life of 10 years for P2,000,000 which is Machinery
equal to the fair value of the machinery. 3,000,000
The entity immediately leased the  Gain on right transferred 200,000
machinery back for 1 year at the prevailing  Rent expense 300,000
annual rental of P300,000. The machinery  Cash 300,000
has a carrying amount of P1,800,000, net  Books of buyer-lessor:
of accumulated depreciation of  Machinery 2,000,000
P1,200,000.
 Cash
 The seller-lessee used the operating lease 2,000,000
model because the lease is short-term or  Cash 300,000
one year only.  Rent income 300,000
 Required: What are the journal entries in  Depreciation 200,000
the books of seller-lessee and buyer-lessor?  Accumulated Depreciation (2,000,000/10)
200,000
 Measurement of lease liability
 The seller-lessee shall account for the leaseback as a finance lease. The lease liability is measured at the
present value of lease payments.
 Measurement of right of use asset – Sale price at fair value
 IFRS 16, paragraph 100, provides that the seller-lessee shall 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.
 Simply stated, the cost of right of use asset is equal to a fraction whose numerator is the present value
of lease liability and whose denominator is the fair value multiplied by the carrying amount of the asset.
 Gain or loss to be recognized
 Paragraph 100 provides that the gain or loss that pertains to the right retained by the seller-lessee is not
recognized. (Right retained by seller-lessee equal to lease liability)
 The gain or loss that pertains to the right transferred to the buyer-lessor is recognized. (Right transferred
to buyer-lessor = Fair value – right retained by seller-lessee)
 Total gain = Sale price at fair value – Carrying amount the asset
 Gain to be recognized = Right transferred to buyer-lessor / Sale price at fair value x Total gain
 Illustration – Sale price at fair value  Answers:
 On January 1, 2020, an entity sold an equipment with  1. Lease liability (800,000 x 3.170)
remaining life of 10 years and immediately leased it 2,536,000
back for 4 years at the prevailing market rental.
 2. Cost of right of use asset:
 Sale price at fair value
6,000,000
 (2,536,000 / 6,000,000 x 4,500,000)
1,902,000
 Carrying amount of equipment
4,500,000  3. Sale price at fair value
6,000,000
 Annual rental payable at the end of each year
800,000  Carrying amount
4,500,000
 Implicit interest rate
10%  Total gain 1,500,000
 PV of an ord. annuity of 1 at10% for 4 periods  Fair value 6,000,000
3.170  Right retained by seller-lessee 2,536,000
 Required:  Right transferred to buyer-lessor 3,464,000
 1. What is the initial lease liability?
 Gain to be recognized:
 2. What is the cost of right of use asset?
 (3,464,000 / 6,000,000 x 1,500,000)
 3. What is the gain on right transferred to buyer-lessor? 866,000
 Sale price above fair value
 IFRS 16, paragraph 101, provides that if the sale price does not equal the fair value of the
underlying asset, the seller-lessee shall make adjustment to measure the sale price at fair
value.
 Any excess sale price over fair value shall be accounted for as additional financing provided
by the buyer-lessor to seller-lessee. In other words, the excess sale price shall be deducted
from PV of lease liability to get PV of lease liability related to rentals.
 PV of lease liability related to rentals (or right retained by seller-lessee) = PV of lease
liability – Additional financing
 Cost of right of use asset = PV of lease liability related to rentals / Fair value of asset x
Carrying amount
 Adjusted total gain = Fair value of asset – Carrying amount
 Right transferred to buyer-lessor = Fair value of asset – Right retained by seller-lessee)
 Gain to be recognized = Right transferred to buyer-lessor /Fair value of asset x Adjusted total
gain
 Illustration – Sale price above fair value  Answers:
 On January 1, 2020, an entity sold a building with remaining life  1. Lease liability (1,500,000 x 3.60)
of 20 years and immediately leased it back for 5 years. 5,400,000
 Sale price 20,000,000  2. Sales price 20,000,000
 Fair value of building 18,000,000
 Fair value of the building 18,000,000
 Carrying amount of building 10,800,000
 Excess sale price over fair value 2,000,000
 Annual rental payable at the end of each year 1,500,000
 PV of lease liability 5,400,000
 Additional financing (excess sale price) 2,000,000
 Implicit interest rate 12%
 PV of lease liability related to rentals 3,400,000
 PV of an ord. annuity of 1 at 12% for 5 periods 3.60
 Cost of right of use asset:
 Required:
 (3,400,000 /18,000,000 x 10,800,000)
 1. What is the initial lease liability? 2,040,000
 2. What is the cost of right of use asset?  3. Adjusted total gain (18,000,000 – 10,800,000) 7,200,000
 3. What is the gain on right transferred to buyer-lessor?  Right transferred (18,000,000 – 3,400,000) 14,600,000
Gain on right transferred to buyer-lessor:
(14,600,000 / 18,000,000 x 7,200,000)
5,840,000
 Sale price below fair value
 IFRS 16 provides that if the sale price does not equal the fair value of the underlying asset,
the seller-lessee shall make adjustment to measure the sale price at fair value.
 If the sale price is below fair value, the difference is accounted for as prepayment of
rental.
 In other words, the difference accounted fro as prepayment of rental shall be added to
present value of rentals to arrive at total lease liability.
 Total lease liability (or right retained by seller-lessee) = Excess fair value + Present
value of rentals
 Cost of right of use asset = Total lease liability / Fair value of asset x Carrying amount
 Total gain = Fair value of asset – Carrying amount
 Right transferred to buyer lessor = Fair value of asset – Right retained by seller-lessee
 Gain to be recognized = Right transferred to buyer-lessor / Fair value of asset x Total gain
 Illustration - Sale price below fair value  Answers:
 On January 1, 2020, an entity sold an equipment with  1. PV of rentals (900,000 x 3.99) 3,591,000
remaining life of 8 years and leased it back for 5 years.  2. PV of rentals 3,591,000
 Sale price 5,000,000  Excess fair value – prepayment of rentals 1,000,000
 Fair value of equipment 6,000,000  Total lease liability
 Carrying amount 4,800,000 4,591,000
 Annual rental payable at the end of each year 900,000  3. Cost of right of use asset:
 Implicit interest rate 8%  (4,591,000 / 6,000,000 x 4,800,000)
 PV of an ordinary annuity of 1 at 8% for 5 periods 3.99 3,672,800
 Required:
 4. Fair value of equipment 6,000,000
 1. What is the initial lease liability?  Right retained by seller-lessee (or total
 2. What is the total lease liability  lease liability) 4,591,000
 2. What is the cost of right of use asset?  Right transferred to buyer-lessor 1,409,000
 3. What is the gain to be recognized?  Gain to be recognized:
 (1,409,000 /6,000,000 x 1,200,000) 281,800
 Note: The buyer-lessor shall apply the operating
lease model.
 Illustration – Sale price at fair value with loss  Answers:
 On January 1, 2020, an entity sold a building with  1. PV of rentals (500,000 x 2.58) 1,290,000
remaining life of 25 years and immediately leased it  2. Cost of right of use asset:
back for 3 years.  (1,290,000 /10,000,000 x 12,000,000) 1,548,000
 Sale price at fair value 10,000,000  3. Sale price 10,000,000
 Carrying amount 12,000,000  Carrying amount 12,000,000
 Annual rental payable at the end of each year 500,000  Total loss 2,000,000
 Implicit interest rate 8%  Fair value 10,000,000
 PV of an ordinary annuity of 1 at 8% for 3 periods 2.58  Right retained by seller – lease liability 1,290,000
 Required:
 Right transferred to buyer-lessor 8,710,000
 Loss to be recognized:
 1. What is the initial lease liability?
 (8,710,000 / 10,000,000 x 2,000,000) 1,742,000
 2. What is the cost of right of use asset?
 4. Interest expense for the current year:
 3. What is the loss to be recognized?
 (1,290,000 x 8%) 103,300
 4. What is the interest expense for the current year?
 Problem 15-4  Answers:
 At the beginning of current year, Pedro Company sold a  1. PV of rentals (800,000 x 3.312)
machine and immediately leased it back. The following data 2,649,600
relate to the sale and leaseback transaction:
 2. PV of lease liability 2,649,600
 Sale price at above fair value 6,000,000
 Additional financing-excess sale price 1,000,000
 Fair value of machine 5,000,000
 PV of lease liability related to rentals 1,649,600
 Carrying amount of machine 4,500,000
 Cost of right of use asset:
 Annual rental payable at the end of each year 800,000
 (1,649,600 / 5,000,000 x 4,500,000)
 Remaining life of machine 10 years
1,484,640
 Lease term 4 years  3. Fair value of machine 5,000,000
 Implicit interest rate 8%  Carrying amount 4,500,000
 Required:
 Total gain 500,000
 1) Compute the initial lease liability.
 Fair value of machine 5,000,000
 2) Compute the cost of right of use asset.
 Right retained by seller-lessee 1,649,600
 3) Determine the gain on right transferred to buyer-lessor
 Right transferred to buyer-lessor 3,350,400
 Gain on right transferred to buyer-lessor:
 (3,350,400 / 5,000,000 x 500,000) 335,040