LESSEE ACCOUNTING

IFRS16, paragraph 22, provides that a lessee shall recognize a right of use asset and a lease liability at the
commencement of the lease.

The lease liability is the present value of the lease payments which include the following:
a. Fixed and variable lease payments
b. Purchase option that is reasonably certain to be exercised
c. Residual value guarantee of the lease
d. Termination penalty if the lease term reflects the exercise of a termination option

The annual executory cost is not part of the cost of right of use asset but expensed immediately.

IFRS 16, paragraph 24, provides that the cost of right of use asset comprises:
a. The amount of initial liability
b. Payments to the lessor before the commencement date less any incentive received
c. Initial direct cost incurred by lessee
d. Estimated cost of dismantling, removing and restoring the underlying asset for which the lessee has a
present obligation

IFRS 16, paragraph 32, 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 transfer ownership of the underlying asset to the lessee at the end of the lease term. Or
b. The lessee is reasonably certain to exercise the purchase option.

Otherwise, the right of use asset shall be depreciated over the shorter between the useful life of the asset and
the lease term.

The leasehold improvement is not part of the cost of right use asset but accounted for separately as property, plant
and equipment.

Finance Lease in the books of the Lessee:

Recognition and measurement :
PAS17, par.12 states that “leases should recognize finance leases as assets and liabilities in their balance sheets at
amounts equal at the inception of the lease payments. In calculating the present value of the minimum lease
payments the discount factor is the interest rate implicit in the lease., if this is practicable to determine, if not, the
lessee’s incremental borrowing rate should be used.”

A contract of lease may lead to a finance lease if any of the following criteria is met:
a. The lease transfers ownership of the asset to the lessee by the end of the lease term;
b. The lessee has the option to purchase the asset at a price, which is expected to be sufficiently lower than
the fair value at the date the option becomes exercisable such that, at the inception of the lease, it is
reasonably certain that the option will be exercised;
c. The length is for the major part of the economic life of the asset even if title is not transferred. The length o
lease should include any secondary rental. A secondary rental gives the lessee an option for renewal.
d. At the inception of the lease, the present value of the minimum lease payments amounts to at lease
substantially all of the fair value of the leased asset; and
e. The leased assets of a specialized nature such that only the lessee can use them without major
modifications being made.

Indicators of situations that individually or in combination could also lead to a lease being classified as a finance
lease:
a. If the lessee can cancel the lease, the lessor’s losses associated with the cancellation are borne by the
lessee.
b. Gains or losses from the fluctuation in the fair value of the residual accrue to the lessee (for example, in the
form of a rent rebate equaling most of the sales proceeds at the end of the lease), 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.

PAS 17, par. 20: “ At the commencement of the lease term, lessees shall recognize finance leases as assets and
liabilities in their balance sheets at amounts equal to the fair value of the leased property or, if lower, the present
value of minimum lease payments, each determined at the inception of the leases. The discount rate to be used in
calculating the present value of the minimum lease payments in the interest rate implicit in the lease, if this is
practicable to determine; if not, the lessees incremental borrowing rate shall be used. Any direct costs of the lessee
are added to the amount recognized as an asset”.
The cost of the leased asset acquired on a finance lease should be the present value of future minimum payments.
Minimum lease payments include the rental payments required over the lease term plus any amount to be paid for
the residual value, either through a bargain purchase or a guaranteed of the residual value. Any executory costs such
as insurance, maintenance, and taxes do not form part of the minimum lease payments.

There is no bargain option if the option price is less than the fair value of the asset upon the option exercise date.
Since the option price is estimated to be the same as its fair market value on option exercise date, therefore, the
lease contract has no bargain option.

Depreciation on leased assets will depend on how the lease qualifies as a finance lease:
(a) If the lease transaction met the criterion as either transferring ownership or containing a bargain
purchase option. The asset is depreciated over the estimated useful life of the asset.
(b) If the transaction qualifies as finance lease because it met either the major part of useful life criterion
or because the present value of the minimum lease payments represented substantially all of the fair
value of the underlying asset, it must be depreciated over the lease term or life of the asset, whichever
is shorter.
Since the finance lease meets the criterion, depreciation is based on the useful life of the asset.

The finance lease transaction met the bargain purchase criterion; hence, depreciation is based on the useful life of
the asset.

Problem 1

Lessee Company leased a machinery on January 1, 2023 with the following information:
Annual rental payable at the end of each year 1,000,000
Residual value guarantee 500,000
Payment to lessor to obtain a long-term lease 300,000
Cost of dismantling and restoring the asset as required by contract at
present value 390,000
Annual executory cost paid by lessee 50,000
Lease term 4 years
Useful life of machinery 8 years
Implicit interest rate 10%
Round off present value rate to two decimal places.
10%, 4 years
Present value of annual rental (1,000,000 x 3.17) Php 3,170,000
Present value of residual value guarantee (500,000 x 0.68) 340,000
---------------------------
Lease Liability 3,510,000
Payment to lessor to obtain along-term lease 300,000
Cost of dismantling and restoring the asset as required by
contract at present value 390,000
---------------------------
Total cost of right of use asset Php 4,200,000
===============

January 1, 2023
Right of use asset 4,200,000
Lease liability 3,510,000
Cash 300,000
Estimated liability for dismantling and restoration 390,000

Executory cost 50,000

Cash 50,000

Depreciation expense 925,000

Accumulated depreciation-Right of use asset 925,000
(4,200,000-500,000)/4 yrs = 925,000)

Date Payment Interest Principal Present Value

01/01/23 3,510,000
12/31/23 1,000,000 3,510,000x10%=351,000 649,000 2,861,000
12/31/24 1,000,000 2,861,000x10%=286,100 713,900 2,147,100
12/31/25 1,000,000 2,147,100x10%=214,710 785,290 1,361,810
12/31/26 1,000,000 1,361,810x10%=136,181 863,819 497,991
138,190 861,810 500,000

12/31/23
 Lease liability 649,000
Interest expense 351,000
Cash 1,000,000

12/31/24
Lease liability 713,900
Interest expense 286,100
Cash 1,000,000

12/31/25
Lease liability 785,290
Interest expense 214,710
Cash 1,000,000

12/31/26
Lease liability 861,810
Interest expense 138,190
Cash 1,000,000

Problem 2
On January 1, 2023, Pau Company leased a building from a lessor with the following pertinent information:

Annual rental payable at the end of each year 1,000,000

Initial direct cost 400,000
Lease incentive received 100,000
Leasehold improvement 200,000
Purchase option that is reasonably certain to be exercised 500,000
Lease term 5 years
Useful life of building 8 years
Implicit interest rate 10%

Present value of annual rental (1,000,000x3.79) 3,790,000

Present value of purchase option (500,000x.62) 310,000
--------------
Lease liability 4,100,000
Initial direct cost 400,000
Lease incentive received ( 100,000)
--------------
Cost of right of use asset 4,400,000
========
January 1, 2023
Right of use asset 4,400,000
Lease liability 4,100,000
Cash (400,000-100,000) 300,000

December 31, 2023

Depreciation expense 550,000
Accumulated depreciation-Right of use asset 550,000
4,400,000/8yrs = 550,000

Date Payment Interest Principal Present Value

01/01/23 4,100,000
12/31/23 1,000,000 4,100,000x10%=410,000 590,000 3,510,000
12/31/24 1,000,000 3,510,000x10%=351,000 649,000 2,861,000
12/31/25 1,000,000 2,861,000x10%=286,100 713,900 2,147,100
12/31/26 1,000,000 2,147,100x10%=214,710 785,290 1,368,810
12/31/27 1,000,000 1,368,810x10%=136,181 863,819
131,190 868,810 500,000

12/31/23
Lease liability 590,000
Interest expense 410,000
Cash 1,000,000

12/31/27
 Lease liability 868,810
Interest expense 131,190
Cash 1,000,000

Lease liability 500,000

Cash 500,000
To exercise option

Problem 3
Pau Company entered into a lease of building on January 1, 2017 with the following information:
Annual rental payable at the end of each year 500,000
Lease termination 5 years
Useful life building 20 years
Implicit interest rate 10%
The lease contained an option for the lessee to extend for a further 5 years.

At the commencement date, the exercise of the extension option is not reasonably certain.

After 3 years on January 1, 2020, the lessee decided to extend the lease for further 5 years
New annual rental payable at the end of each year 600,000
New implicit interest rate 8%
PV of an ordinary annuity of 1 at 8% for 5 periods 3.99
PV of 1 at 8% for 2 periods 0.86
PV of an ordinary annuity of 1 at 8% for 2 periods 1.78
Entry to record the above transactions for years 2017, 2018 and 2020.

Problem 4
Pau Company leased an Equipment on January 1, 2017 with the following information:
Fixed annual payment at the end of each lease year 1,000,000
Lease termination 4 years
Useful of equipment 5 years
Implicit interest rate 10%
Present value of an ordinary annuity of 1 for 4 periods at 10% 3.16987
Present value of 1 for 4 periods t 10% 0.683
Pau Company has guaranteed a Php200,000 residual value on December 31, 2020 to the lessor.
Entry to record the above transactions.