Week 6- Leases

A lease is a contract or part of a contract that conveys the right to use an asset (the
underlying asset) for a period of time in exchange for consideration.

Key terms to Remember in Lease

1. Underlying asset- An asset that is subject to a lease, for which the right to use
that asset has been provided by a lessor to a lessee. (explicitly included in the
lease contract or implicitly specified)
2. Identifying a lease-at the inception of a contract, an entity shall assess whether
the contract is, or contains, a lease
a. A contract is, or contains, a lease if it conveys the right to control the
use of an identified asset for a period of time in exchange for
consideration.
b. To assess whether a contract conveys the right to control the use of an
identified asset for a period of time, an entity shall assess whether,
throughout the period of use, the customer has both of the following:

i. The right to obtain substantially all of the economic benefits

from the use of the identified asset; and
ii. The right to direct the use of the identified asset
c. If the customer has the right to control the use of an identified asset
for only a portion of the term of the contract, the contract contains a
lease for that portion of the term.
3. Lease term- the non-cancellable period for which a lessee has the right to use
an underlying asset, plus:
a. Periods covered by an extension option if the exercise of that option by
the lessee is reasonably certain; and
b. Periods covered by a termination option if the lessee is reasonably certain
not to exercise that option.
i. Relevant dates
1. Inception date- the earlier of the date of a lease agreement
and the date of commitment by the parties to the principal
terms and conditions of the lease. (determination of asset
whether finance lease or operating lease)
2. Commencement date- the date on which a lessor makes an
underlying asset available for use by a lessee. (start of
recording)

Types of Leases
1. Finance lease- is a lease that transfers substantially all the risks and rewards
incidental to ownership of an asset. The title may or may not eventually be
transferred
2. Operating lease- is a lease other than a finance lease.
Lessor Accounting-Operating Lease

Identifying whether the lease is a Finance lease or an Operating Lease.

Leasing of Land and Building

Accounting Considerations

Operating Lease Model

Lessor Accounting-Direct Financing Lease and Sales Type Lease
Accounting for Leases- Lessee
Lessees shall account for all leases as finance leases except for
 Short-term leases (those having a term of 12 months or less)
 Low-value leases (leases for which the underlying asset is low value such as
laptop, computers, small office furniture, and telephones) : the determination
should be at the date of acquisition

Operating lease (if even, the monthly payments will be uniform and recognized over the
lease term but if uneven, add all monthly payments and divide it to the lease term to get
uniform monthly payments)- It was excluded in the new standard.

A lessee accounting for a lease under a finance lease shall

1. Recognize the lease liability at the present value of lease payments.
a. Initial- the lease liability at the commencement date of the lease shall be
the discounted unpaid portion of lease payments computed using either
the:
i. The implicit rate in the lease or
ii. Incremental borrowing rate of the lessee (if implicit rate is not given)
b. Lease payments include *
i. Fixed payments, less any lease incentives receivable;
ii. Variable lease payments dependent on an index or rate.
iii. Residual value guarantees; (Guaranteed if lease, then
unguaranteed if other party)
iv. The exercise price of a reasonably certain purchase options; and
v. Lease term penalties, if a lessee termination option was considered
in setting the lease term
c. Subsequent- the lease liability shall be accounted for using the effective
interest method

*If with transfer of ownership- only i and ii will be used in getting present
value
*If purchase option- i, ii, and iv will be used in getting present value
*If there is no transfer of ownership and no purchase option-i,ii and iii will
be used in getting present value

2. Capitalize the right-of-use asset and account for it under PFRS 16 or PAS 40.
a. Initial- the cost of the ROU asset is the total of:
i. The amount of the lease liability recognized;
ii. Any lease payments made at or before the commencement date,
less any lease incentives;
iii. Any initial direct cost incurred; and
iv. An estimate of costs to be incurred to dismantle and remove an
asset and restore the site based on the terms and conditions of the
lease.
b. Subsequent measurement
 i. The ROU asset shall be presented as a line item in the non-current
asset section separately from other assets or within the same line
item as the underlying asset and accounted for using any of the
following:
1. Apply PAS 16 PPE under the cost model.
2. Apply PAS 16 PPE under the revaluation model
3. Apply PAS 40, Investment property if it meets the definition
of an investment property (only land and building)
ii. Depreciation-
1. there is a transfer of ownership or a purchase option that is
reasonably certain to be exercised.
a. ROU asset is depreciated over its economic life.
b. Residual value will be based on the life of asset.
2. Absence of item (1)
a. ROU asset is depreciated over its economic life or
lease term, whichever is shorter.
b. Residual value will be based on guaranteed over
the lease term.

Exercise-Theory
1. Under IFRS, a lessee is required to account for all leases as finance leases and
recognize
a. Right of use asset and lease liability
b. Right of use asset but not lease liability
c. Lease liability but not right of use asset
d. Neither right of use asset nor lease liability
Answer: A
2. The lessee may apply the operating lease model under whatever condition
a. Short-term lease
b. Low value lease
c. Both short-term lease and low value lease
d. Under all circumstances
Answer C

Exercise-Problem
1. At the beginning of the current year, an entity leased a building from a lessor.
Annual rental payable at the end of each year P1,500,000
Purchase option that is reasonably certain to be exercised 1,000,000
Initial direct cost 405,000
Lease bonus paid to lessor before commencement of the
Lease 300,000
Lease incentive received 50,000
Present value of restoration cost discounted at 8% for 6 periods 945,000
Lease term 6 years
Useful life of the building 10 years
Implicit interest rate 10%
 PV of ordinary annuity of 1 for 6 periods at 10% 4.36
Present value of 1 for six periods at 10% 0.56

a. What amount should be reported as lease liability at year-end?

b. What amount should be reported as cost of the right of use asset?
c. What total amount of interest expense should be reported for the current
year?
d. What amount should be reported as depreciation of the right of use asset
for current year?

2. On January 1, 2023, an entity entered into a 5-year lease with a lease with a
lessor. Annual lease payments of P1,200,000 including annual executory cost of
P200,000 are payable at the end of each year. The entity knows that the lessor
expects an 8% implicit rate on the lease. The entity has a 10% incremental
borrowing rate. The equipment is expected to have a useful life of 10 years. In
addition, a third party has guaranteed to pay the lessor a residual value of
P500,000 at the end of the lease. The present value of an ordinary annuity of 1
for 5 years is 3.99 at 8% and 3.79 at 10%. The present value of 1 at 8% for 5
periods is 0.68 and at 10% for 5 periods is 0.62.
a. On December 31, 2023, what is the principal amount of the lease
obligation?
b. What amount should be reported as interest expense for 2023?

3. On December 31, 2023, an entity leased two automobiles for executive use. The
lease required the entity to make five annual payments of P1,500,000 beginning
December 31, 2023. At the end of the lease term, the entity had a residual value
guarantee of the automobiles at P1,000,000. The interest rate implicit in the
lease is 10% and the present value factors are:
PV of ordinary annuity of 1 for 5 periods at 10% 3.79
PV of an annuity in advance of 1 for 5 periods at 10% 4.17
PV of 1 for 5 periods at 10% 0.62

a. What is the lease liability on December 31, 2024?

b. What is the current portion of the lease liability on December 31, 2024?
c. What is the interest expense for 2024?

4. An entity leased an equipment to a lease for 5 years at an annual

rental of P120,000 payable at the first day of each lease year. The
lease is appropriately classified as operating lease. The lease is
effective starting April 1, 2022. How much is the lease income to be
reported for 2022?

Problem 5
On January 1, 2022, a lessor leased a machinery to another entity with the following
details:
Cost of machinery 3,583,700
Annual rental payable at the end of each year 1,000,000
Residual value 800,000
Lease term and useful life of the machinery 4 years
Implicit rate in the lease
Before considering initial direct cost 12%
After considering the initial direct cost 10%
Present value of OA of 1 at 12% for 4 years 3.0373
Present value of OA of 1 at 10% for 4 years 3.1699
Present value of 1 at 12% for 4 years 0.6355
Present value of 1 at 10% for 4 years 0.6830

Initial direct cost paid by lessor on January 1, 2022 amounted to P132,600. The
machinery will revert back to the lessor when the lease expires on December 31, 2025.

Requirement:
5. What is the gross investment in the lease on January 1, 2022?
6. What is the net investment in the lease on January 1, 2022?
7. What is the unearned interest income on January 1, 2022?
8. What is the interest income for 2022?
9. What is the carrying value of the net investment in the lease on December 31,
2022?