CHAPTER

BLUE NOTES
32 S
L
Lease is defined as an agreement whereby the lessor conveys to the lessee in return for a payment or series of
payments the right to use an asset for an agreed period of time. (PAS 17, par. 4)
2 Kinds of Lease: Operating Lease and Finance Lease

Operating Lease
Operating Lease on the part of the lessee Operating Lease on the part of the lessor
Recognition and Measurement Recognition and Measurement
 Rent Expense  Rent Income
Lease payments under an operating lease shall be Lease income from operating lease on the part of the
recognized as an expense on a straight line basis over the lessor shall be recognized on a straight line basis over the
lease term unless another systematic basis is more lease term unless another systematic basis is more
representative of the time pattern of the user’s benefit. representative of the time pattern in which use benefit
(PAS 17, par. 33) derived from the leased asset is diminished.
(PAS 17, par. 33)
 Leasehold Improvement  Lease Asset
The lessee shall present the leasehold improvement under The lessor shall present the leased asset as noncurrent
property, plant and equipmentin its statement of financial asset held for hiring out in its statement of financial
position. position according to nature of asset.
 Depreciation  Depreciation
Any leasehold improvement is depreciated over the life of For depreciable leased asset, the depreciation policy
the improvement or remaining lease term, whichever is shall be consistent with the lessor’s normal depreciation
shorter. The residual value is ignored in computing for similar asset.
depreciation because legally, the improvement becomes Initial direct costs incurred by the lessor in an operating
property of the lessor upon the lease term expiration. lease shall be added to the carrying amount of the leased
Note: For a lease with a renewal option and the likelihood of the asset. However, it shall be recognized as an expense over
renewal option is highly probable, the remaining lease term is the lease termon the same basis as the lease income.
extended.
 Lease Bonus (paid)  Lease Bonus (received)
It is treated as prepaid rent expense to be amortized over It is treated as unearned rent income to be amortized
the lease term. over the lease term.
 Refundable Security Deposit  Refundable Security Deposit
Any security deposit refundable upon the lease expiration Any security deposit refundable upon the lease
is accounted for as an asset under long-term receivables. expiration is accounted for as a liability under long-term
 Lease Incentives payables.
(Rent-free periods, upfront cash payments or lessor’s  Lease Incentives
contribution to relocation costs) The aggregate cost of incentives is treated as a reduction
The aggregate benefit of incentives is treated as a in rent income (same basis) over the lease term.
reduction in rent expense (same basis) over the lease Note: PAS 17 is silent about incentives. SIC 15 Operating Leases –
term. Incentives was issued to provide guidance on accounting.
This approach assumes that all incentives are the same.

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Treatment of unequal rental payments

The total rental payments for the lease term shall be amortized uniformly on a straight line basis or another systematic
basis as either rent expense (lessee) or rent income (lessor) over the lease term.

Disclosures Disclosures
1. The total of future minimum lease payments 1. Future minimum lease payments under
under noncancelable operating lease for each of noncancelable operating leases in the aggregate
the following periods: and for each of the following periods:
a. Not later than one year a. Not later than one year
b. Later than one year and not later than 5 years b. Later than one year and not later than 5
c. Later than 5 years years
2. The total of future minimum lease payments c. Later than 5 years
expected to be received under noncancelable 2. Contingent rent recognized as income in the
subleases at the end of reporting period. period.
3. Lease and sublease payments recognized as 3. A general description of the lessor’s leasing
expense in the period, with separate amounts for arrangements.
minimum lease payments, contingent rents and
sublease payments.
4. A general description of the lessee’s significant
leasing arrangements.

Illustrative Problems
1. On December 1, 2013, Casio Company leased office space for five years at a monthly rental of P60,000. On the same
date, Casio Company paid the lessor the following amounts:

First month’s rent 60,000

Last month’s rent 60,000
Security deposit (refundable at lease expiration) 80,000
Installation of leasehold improvement 360,000

Additional Information:
a. The useful life of leasehold improvement is 15 years.
b. Amount to be recovered from the sale of improvement at the end of its useful life is 50,000.
c. The improvement becomes the property of the lessor at the end of the lease term.
The lease has a renewal option with additional 5 years and the likelihood of renewal option to be exercised by the
lessee is highly probable.

What total amount of the expenses relating to utilization of the office space should be reported for 2013?
Solution:
Rent expense for December 60,000
Depreciation on Improvement for December
(360,000/ 10) x 1/12 3,000
Total December 2013 expenses 63,000
2. Roland Company leases and operates a retail store. The operating lease will only last for 20 years. The following
relates to the lease for the year ended December 31, 2013.
a. The store lease calls for a base monthly rent of P15,000 on the last day of each month. However, as an

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118 USL Blue Notes Chapter 32 – Lease

inducement for Roland to enter into the lease, the lessor permitted Roland to occupy the premises rent-free for the
first year.
b. Roland paid executory costs to the lessor for property taxes of P120,000 and insurance of P50,000.
c. Bonus to obtain lease, P30,000.
d. Contribution by the lessor to the Roland’s relocation costs, P10,000.
What total amount of expenses relating to the store lease should be reported for 2013?
Solution:
Average Annual Rent
[(15,000 x 228 remaining months) – 10,000] / 20 years 170,500
Amortization of Lease Bonus
(30,000 /20 years) 1,500
Property Taxes 120,000
Insurance 50,000
Total 2013 expenses 342,000

3. On January 1, 2013, Yamaha Company sold an equipment with useful life of 10 years and simultaneously leased back
the equipment for 5 years.
Sale price 7,500,000
Carrying amount 5,000,000
Fair value of equipment on the date of sale 6,000,000

What amount of gain should be reported in 2013?

Solution:
Outright Gain (6,000,000 – 5,000,000) 1,000,000
Amortization of Deferred Gain
(7,500,000 – 6,000,000) / 5 300,000
Total gain recognized in 2013 1,300,000

Finance Lease – Lessee

Finance lease is a lease that transfers substantially all the risks and rewards incident to ownership of an asset. Title
may or may not eventually be transferred. (PAS 17, par. 4)
It is equivalent to capital lease under US GAAP.

Finance Lease Classification Criteria

A. Major Criteria(PAS 17, par. 10) – Any of the following:
1. Transfer of ownership of the leased asset to the lessee at the end of lease term
2. The lessee has bargain purchase option.
Note: The purchase option price must be sufficiently lower than the FV of the asset at the date the option becomes exercisable and
it is reasonably certain at the lease inception that the option will be exercised.
3. Even if ownership is not transferred, the lease term is for the major part of the economic life of the asset.
a. PAS 17 – No definition
b. US GAAP – at least 75% of the economic life of the asset
Note: US GAAP should be followed until a clear guidance is provided by Philippine standard or IAS.
4. PV of minimum lease payments = substantially all of the FV of the leased asset at lease inception
a. PAS 17 – No definition
b. US GAAP –at least 90% of the FV of the leased asset
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Note: US GAAP should be followed until a clear guidance is provided by Philippine standard or IAS.
B. Other Criteria (PAS 17, par. 10& 11) – Any or combination of the following:
1. The leased asset is of a specialized nature – only the lessee can use it without major modification.
2. The lessor’s losses associated with the cancelation are borne by the lessee.
3. Gains or losses from fluctuation in the FV of the residual fall to the lessee.
4. The lessee has the ability to continue the lease for a secondary period at a rent which is substantially lower
than market rent.
C. Noncancelable Lease versus Cancelable Lease
a. Noncancelable lease shall be classified as a finance lease.
b. Cancelable lease shall be classified as either operating lease (when the lessee is likely to exercise an option to
cancel at any time) or finance lease (when it is deemed noncancelable).
Cancelable lease is deemed noncancelable when: (PAS 17, par. 4)
1. The cancelation is only upon the occurrence of a remote contingency.
2. The cancelation is only with the permission of the lessor.
3. Upon cancelation, the lessee enters into a new lease for the same or equivalent asset with the same lessor.
4. The cancelation is only upon payment of an additional amount or penalty of such magnitude that the
lessee shall be discouraged from canceling the lease.
D. Land and Building Lease
a. An entity normally considers the land and building elements separately when classifying a lease.
b. Even if title will not pass to the lessee at the end of the lease term, a land lease with a lease term of several
decades or longer may be classified as finance lease.
c. When a lease includes land and building, separate classification of the land lease and building lease should be
determined based on classification criteria.
d. When only one element is classified as a finance lease, the minimum lease payments are allocated between
land and building elements in proportion to the relative FV of the leasehold interests at lease inception. The
entire lease is classified as a finance lease when the minimum lease payments cannot be allocated unless it is
clear that both elements are operating leases.
When the lessee’s interest in land and building is classified as investment property, separate measurement is not
required.

Inception of the Lease is the earlier of the date of the Commencement of the Lease is the date from which
lease agreement and the date of commitment by the the lessee is entitled to exercise its right to use the leased
parties to the principal provisions of the lease. asset.
This is the date when: This is the date of initial recognition of the assets,
a. When a lease is classified as either an operating liabilities, income or expenses resulting from the lease.
lease or a finance lease.
b. When the amounts to be recognized at the
commencement of the lease are determined for a
finance lease.

Measurement
Asset and lease liability = FV of leased property at lease inception or PV of minimum lease payments, whichever is
lower.
 Initial direct costs directly attributable to activities of the lessee = Added to Leased Asset
Minimum lease payments include:
a. Rental payments required during the lease term
b. Any payment under a bargain purchase option

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120 USL Blue Notes Chapter 32 – Lease

c. If there is no bargain purchase option, any guaranteed residual value

 Contingent rent and executor costs – expensed immediately when incurred
Rate in computing PV:
a. Implicit interest rate – when known to the lessee
It is the discount rate that causes (PV of MLP) + (PV x URV) = (FV of leased asset) + (IDC of lessor).
MLP = Minimum lease payments; URV = Unguaranteed residual value; IDC = Initial direct costs
b. Otherwise, the lessee’s incremental borrowing rate may be used.
Depreciation of Leased Asset (PAS 17, par. 28)
a. If the finance lease qualifies under the “transfer of ownership” and “bargain purchase option” criteria,
depreciation is based on the useful life of the asset.
b. If the finance lease qualifies under the “75%” and “90%” criteria, the leased asset is depreciated over the
useful life of the asset or lease term, whichever is shorter.

Disclosures
1. The net carrying amount of each class of asset at the end of the reporting period.
2. A reconciliation between the total future minimum lease payments at the end of reporting period and their
present value.
3. The total future minimum lease payments at the end of reporting period and their present value for each of
the following periods:
a. Not later than one year
b. Later than one year and not later than 5 years
c. Later than 5 years
4. Contingent rent recognized as expense in the period.
5. The total minimum sublease payments expected to be received under noncancelable subleases at the end of
reporting period.
A general description of the lessee’s material leasing arrangements.

Illustrative Problems
1. Makita Company is asset rich but cash poor. In an attempt to alleviate its liquidity problem, it entered into an
agreement on July 1, 2013 to sell its processing plant to Bosch Company at P467,100. At the date of sale, the plant had
a carrying amount of P400,000 and a future useful life of five years. Bosch Company immediately leased the processing
plant back to Makita Company. The terms of the lease were:
Lease Term 3 years
Economic life of the plant 5 years
Annual rental payment, in arrears (Commencing June 30, 2014) P165,000

Residual value of the plant at the end of the lease term P90,000
Residual value guaranteed by Makita P60,000
Interest implicit in the lease 5%
Incremental borrowing rate of Makita 6%
The lease is cancellable, but only upon the occurrence of a remote contingency. The implicit interest rate is not known
to Makita. At the end of the lease term, the plant is to be returned to Bosch. In setting up the lease agreement, Bosch
incurred P9,414 in legal fees and stamp duty. Annual rental payment includes P15,000 to reimburse Bosch for
maintenance costs incurred on behalf of Makita.

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How much is the total lease-related expenses to be recognized by Makita during the fiscal period ended June 30, 2014?
How much is the gain on sale and leaseback to be recognized by Makita during the fiscal period ended June 30, 2014?
Assuming the carrying amount of the plant is P500,000, how much is the loss on sale and leaseback during the fiscal
period ended June 30, 2014?
Solution:
PV of minimum lease payments – lower
PV of annual lease payments [(165,000 – 15,000) x 2.6730] 400,950
PV of guaranteed residual value (60,000 x 0.8396) 50,376
Total 451,326

Reimbursement of maintenance costs 15,000

Depreciation of leased asset (451,326 – 60,000) / 3 years 130,442
Interest expense (451,326 x 6%) 27,080
Total lease-related expenses 172,522

Gain on sale and leaseback to be recognized (67,100 / 3 years) 22,367

Loss on sale and leaseback to be recognized (467,100 – 500,000) 32,900

2. On December 31 of the current year, Korg Company purchased a machinery that it had been leasing under a finance
arrangement. The leased asset and lease liability were originally recorded at P2,000,000. At the time of the purchase,
the accumulated depreciation on the leased asset was P800,000 and the remaining balance of the lease liability was
P1,300,000. The leased asset was purchased for P1,440,000 cash. What amount is debited as cost of the machinery on
the date of purchase?
Solution:
Cash payment 1,440,000
Carrying amount of leased asset 1,200,000
Total consideration 2,640,000
Balance of lease liability (1,300,000)
Cost of machinery purchased 1,340,000

Finance Lease – Lessor

Direct Financing Lease Sales Type Lease

 Interest Income Recognition  Interest Income Recognition
 Dealer Profit Recognition  Dealer Profit Recognition
 Gross Investment  Gross Investment
= (Gross Rentals of Entire Lease Term) + (Absolute = (Gross Rentals of Entire Lease Term) +
Residual Value Amount whether guaranteed or (Absolute Residual Value Amount whether
unguaranteed) guaranteed or unguaranteed)
= Lease Receivable = Lease Receivable
 Net Investment  Net Investment
= (Cost of Asset) + (Initial Direct Cost by Lessor*) = (PV of Gross Rentals) + (PV of Residual Value
whether guaranteed or unguaranteed)

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 Unearned Interest Income  Unearned Interest Income

= (Gross Investment – Net Investment) = (Gross Investment – Net Investment)
 Initial Direct Cost  Initial Direct Cost
= *It is added to the cost of asset in computing net = It is an outright expense as a component of
investment in the lease. cost of sales.
= It reduces the amount of interest income to be
earned because it increases net investment,
thereby decreasing unearned interest income.
 Sales  Sales
 Cost of Sales = (FV of Asset) or (Net Investment) whichever is
 Gross Profit lower
 Cost of Sales
= (Cost of Asset Sold) + (Initial Direct Cost by
Lessor)
 Gross Profit
= (Sales) – (Cost of Sales*)
Note: *Cost of Sales should include Initial Direct Cost by
Lessor. It is synonymous to the computation of
net investment under direct financing lease.

Actual Sale of the Leased Asset

 SP – (CA of Lease Receivable) = Outright Gain
 (CA of Lease Receivable) – SP = Outright Loss

Disclosures
1. A reconciliation between the gross investment in the lease and the present value of the minimum lease
payments receivable at the end of reporting period.
2. The gross investment in the lease and the present value of the minimum lease payments receivable at the end
of reporting period for each of the following periods:
a. Not later than one year
b. Later than one year and not later than 5 years
c. Later than 5 years
3. Unearned finance income or unearned interest income.
4. Unguaranteed residual value accruing to the benefit of the lessor.
5. Accumulated allowance for uncollectible minimum lease payments receivable.
6. Contingent rent recognized as income in the period.
7. A general description of the lessor’s material leasing arrangements.

Sale and Leaseback

Sale and Leaseback

 An arrangement whereby one party sells a property to another property and then immediately leases the
property back from its new owners.
 Seller-lessee ; Purchaser-Lessor

Actual Purchase of the Leased Asset

Cost of Asset Purchased = CA of Leased Asset + Cash Payment – Lease Liability Balance
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Leaseback as an Operating Lease

Sales Price = Fair Value Sales Price < Fair Value Sales Price > Fair Value
Gain or loss shall be Gain or loss shall be The excess over the fair value is deferred
recognized immediately. recognized immediately. and amortized over which the asset is
expected to be used.
If the loss is The excess of fair value over the carrying
compensated by future amount is an outright gain.
lease rental at below fair
value, the loss is deferred
and amortized over
which the asset is
expected to be used.

Leaseback as a Finance Lease

 Any gain on sale and leaseback is deferred and amortized over the lease term.
 Any loss on sale and leaseback is recognized immediately.

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