Leases Part 1(Accounting by Lessees)

LEARNING CONTENT:

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 considerations.

PFRS 16 is the new lease standard.

Right to control the use of an asset >>> if throughout the period of use the lessee has the right to:
 Obtain substantially all of the economic benefits from the use of the identified asset (exclusive use)
Example of economic benefits: using, holding or subleasing the asset

 Direct use of the identified asset >> for what purpose and how the asset is used

Accounting for Leases from the point of view of Lessee

 Finance Lease Model

PFRS 16 provides that all leases shall be accounted for by the lessee as a finance lease under the new
lease standard.

The Lessee is required to make an initial entry at the start of the lease contract as follows:

Debit: Right of use asset >> to recognize the right to use the identified asset
Credit: Lease Liability >>>>> to recognize the obligations to make payments

 Operating Lease Model

PFRS 16 also provides an exception to the general rule as stated above. In other words, the lessee is
permitted to deviate from the policy that all leases should be accounted for using the finance lease model
provided that:
1. Short-term lease
2. Low value lease

Note: The Lessee may recognize the lease payments as rent expense under the two exceptions.

Finance Lease Accounting Explained

Intermediate Accounting 3 | 1
 Finance Lease >>> transfers substantially all of the risks and rewards incidental to ownership of an
identified asset

RIGHT OF USE ASSET

Initial Measurement of Right of Use Asset>>>>> at cost on commencement date

Cost also include the following:

1. Present value of lease payments or initial measurement of the lease liability

2. Lease payments made to lessor before the start of the contract
3. Initial direct costs incurred by the lessee
4. Estimated costs of dismantling, removing and restoring the underlying asset

Exceptions from the initial measurement cost of Right of Use Asset:

 Lease Incentives
 Initial direct costs
 Leasehold Improvements
 Security Deposits Refundable

Subsequent Measurement of Right of Use Asset >> the lessee shall measure right of use asset at cost
less accumulated depreciation and impairment
loss

Presentation >> as a separate line item in the statement of financial position or the lessee has an alternative
Option in the line item where the underlying asset would have been presented if owned
With adequate disclosure.

Depreciation >> Right of Use Asset shall be depreciated over the useful life when:

a) The lease transfers ownership at the end of the lease term to the lessee or
b) The lessee is certain to exercise purchase option

In the absence of the above conditions, the lessee shall depreciate the Right of Use asset:

Over the shorter term between useful life and lease term

Lease Liability

Initial Measurement of Lease Liability >>>>> at the present value of lease payments on commencement
date (PFRS 16.par 26) and subsequently, at amortized cost.

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 Important Notes on the computation of present value ( in the order of priority)

1. The lease payments shall be discounted using the interest rate implicit in the lease
2. Incremental borrowing rate of the lessee is used in the absence of implicit interest rate

Components of lease payments

 Fixed lease payments
 Variable lease payments
 Exercise price of purchase option if the lessee is reasonably certain to exercise the purchase option
 Amount expected to be payable by the lessee under a residual value guarantee
 Termination penalties if the lease term reflects the exercise of termination option

Subsequent Measurement of lease liability >>>> the lessee shall measure lease liability based on
amortized cost

As a general rule:

>>> Interest on the lease liability is computer using the effective interest method
>>> Lease payments are apportioned between interest and a reduction of the lease liability

FIXED PAYMENTS>>>> payments made by lessee to the lessor during the lease term at fixed amounts.

Illustrative Example 1 – FINANCE LEASE (Fixed Payment)

On January 01, 2020, Company A leased a machinery for 4 years having the same useful life as the term of
lease. The annual rental is P100,000 at the end of each year. With an implicit interest rate of 12%, the lease
contract further states that Company A will assume ownership of the machinery at the end of 4 years.

Step 1: Compute for the present value of the annual payment

Present value = P100,000 x present value of an ordinary annuity of 1 for 4 years

= P100,000 x 3.073
= P303,730

***Present value of 3.073 is derived from the mathematical table of present value of an annuity

Journal Entry on January 01, 2020:

Right of Use Asset 303,730.00

Lease Liability 303,730.00

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Step 2: Compute for the depreciation of the Right of use asset
Given that, the lease transfers ownership, depreciation will be computed using useful life(incidentally,
useful life is equal to the lease contract in this example)

Journal Entry on December 31, 2020 to record depreciation:

Depreciation 75,932
Accumulated
Depreciation 75,932
(P303,730/4years)

Step 3: Subsequent Journal Entries after January 01, 2020

Notes:
 The annual rental of P100,000 shall be treated as payment of principal and interest
 The interest is computed as the difference between the face value of gross fixed payments of P400,000
over 4 years and the present value of P303,730 or P96,270

Presented below for a better understanding and as guide for the other subsequent entries is the table of
amortization:

Principa Present
Date Payment Interest l Value
1/1/2020 0     303,730
12/31/2020 100,000 36,448 63,552 240,178
12/31/2021 100,000 28,821 71,179 168,999
12/31/2022 100,000 20,280 79,720 89,279
12/31/2023 100,000 10,721 89,279 0
TOTAL 400,000 96,270 303,730  

Explanations:
Payment = annual rental fixed payments
Interest = present value x 12% or P36,448
Principal = part of rental after deducting interest (for 2020 Interest = P100,000-36,448)
Present Value = is the balance of the lease liability after deducting annual principal
payment. For Dec. 31, 2020, present value is P303,730 less
P63,552 equals P240,178.

The subsequent entries related to the above illustrative case follow:

12/31/202 36,44
0 Interest Expense 8
63,55
Lease Liability 2
Cash 100,000
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 Depreciation Expense
75,932
12/31/202 Accumulated 75,932
0 Depreciation

12/31/202 28,82
1 Interest Expense 1
71,17
Lease Liability 9
Cash 100,000

Same entry and amount to

12/31/202 record depreciation as in
1 12/31/2020

12/31/202 20,28
2 Interest Expense 0
79,72
Lease Liability 0
Cash 100,000

12/31/202 10,72
3 Interest Expense 1
89,27
Lease Liability 9
Cash 100,000

If a Statement of Financial Position will be prepared as of Dec. 31, 2020, the right of use asset will be presented
as a separate line item under noncurrent assets as:

Right of Use Assets P303,730

Less Accumulated Depreciation (75,932)
--------------------------------------------------------------
Carrying Amount (Net Book Value) P227,798
--------------------------------------------------------------

Likewise, the Lease Liability would be reported partly as Current Liabilities for the amount of P71,179 and
partly Noncurrent Liabilities for P168,999 (P79,720 + P89,279)

SECURITY DEPOSITS >>>>>>> do not affect the lease liability of the lessee and right of use asset.
Intended to answer for damages on the leased property, the lessor
returns the amount at the end of the lease term. The lessee records security
deposits as a receivable measured at amortized cost.

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VARIABLE PAYMENTS >>>>>> payments during the lease term that vary during the lease term due to
changes in some facts and circumstances happening after the commencement
date.

Accounting for variable payments depends on the kind of variability:

 Payments based on interest rates or consumer price index are included in the lease payments
 Payments based on the passage of time or future usage are not included in the lease payments

Illustrative Example 2 – Finance Lease (Variable Payments)

On January 01, 2020, Company B entered into an 8-year lease of a floor of a building with the following terms:

Annual Rental for the first 3 years payable at the end of the year P300,000
Annual rental for the next 5 years payable at the end of each year 400,000
Implicit interest rate 10%
PV of an ordinary annuity of 1 at 10% 2.487
PV for an ordinary annuity of 1 at 10% 3.791
PV of 1 at 10% for 3 periods 0.751
The lease does not provide a transfer of title or purchase option to the lessee.

Step 1 – Compute the Present Value for the first 3 years

Annual Rental for the first 3 years 300,000

Multiply by the factor for the first 3 years 2.487
Lease Liability - January 01, 2020 746,100

Step 2 – Compute for the Present Value for the next 5 years

Annual Rental for the last 5 years 400,000

Multiply by the factor for the first 3 years 3.791
1,516,40
Present Value on Jan 01, 2023 0
Multiply by PV factor for the first 3 years 0.751
1,138,81
Present Value on Jan 01, 2020 6

Step 3 – Compute the amount of lease liability to be booked on January 01, 2020:

Present Value of Annual Rentals for 3

years 746,100
Present Value of Annual Rentals for 5 1,138,81
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 years 6
1,884,91
Lease Liability - January 01, 2020 6

Table of Amortizations
PRESEN
PAYME INTER PRINCI T
DATE NT EST PAL VALUE
1/1/202
0 1,884,916
12/31/2
020 300,000 188,492 111,508 1,773,408
12/31/2
021 300,000 177,341 122,659 1,650,748
12/31/2
022 300,000 165,075 134,925 1,515,823
12/31/2
023 400,000 151,582 248,418 1,267,406
12/31/2
024 400,000 126,741 273,259 994,146
12/31/2
025 400,000 99,415 300,585 693,561
12/31/2
026 400,000 69,356 330,644 362,918
12/31/2
027 400,000 37,082 362,918 0

Journal Entries for the year 2020:

1,884,91
1-Jan-20 Right of Use Asset 6
1,884,91
Lease Liability 6

12/31/202
0 Interest Expense 188,492
Lease Liability 111,508
Cash 300,000

12/31/202
0 Depreciation Expense 235,615
Accumulated Depreciation 235,615
(1,884,916/8 years)

End of Lesson

Intermediate Accounting 3 | 7
References: Intermediate Accounting 2 by: Zeus Vernon T. Millan

Philippine Financial Reporting Standards 16 Leases (PFRS 16)

Overview:
The new standard is issued on January 13, 2016. It replaces all previous PFRS provisions on lease
accounting (PAS 17, SIC 15, SIC 27 and IFRIC 4).  PFRS 16 is effective for annual
periods beginning on or after 1 January 2019.  Earlier application is permitted for entities that
apply PFRS 15 Revenue from Contracts with Customers at or before the date of initial application of
PFRS 16.
 
What changes can we expect?
 
  PAS 17 PFRS 16
Lessee Accounting Rental expense is recognized in Profit Recognize a Right-Of-Use Asset and
or Loss a Lease liability for all leases with a term
of more than 12 months, unless the

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 underlying asset is of low value.
Expense at Year In the form of rent expense In the form of depreciation
end expense related to the ROU Asset
and Interest expense  related to the lease
liability
Lessor Accounting Classifies the lease as finance lease if Essentially unchanged
substantially all of the risks and
rewards incidental to ownership of the
leased asset have been transferred to
the lessee, otherwise
 
With the new standard on Leases, the lessee will be required to recognize the majority of leases in its
balance sheet. Lessor accounting will remain essentially unchanged. Lastly, disclosure requirements
will increase significantly.
I.      Identifying a Lease
Assessment of whether a contract contains a lease or not
 
All of the following criteria must be met for a contract to contain a lease.                                                                         
a)          There is an identified asset that the customer has the right to use.
b)         The lessee obtains substantially all the economic benefits.
c)          The lessee has the right to direct the use of the asset.
 Determining Whether an Arrangement Contains a Lease Identified Asset
 The Lease Identified Asset must be explicitly or implicitly identified in the contract.
 There must be no substitution rights, meaning there is no practical ability to substitute the
asset.
 The Leased Asset must be physically distinct.
 Separating Components of a Contract into Lease and Non-Lease
For a contract that is, or contains, a lease, an entity shall account for each lease component within the
contract as a lease separately from non-lease components of the contract.
 
Lessee
Allocate the consideration in the contract to each lease component on the basis of the relative stand-
alone price of the lease component and the aggregate stand-alone price of the non-lease components.
The relative stand-alone price of lease and non-lease components shall be determined on the basis
of the price the lessor, or a similar supplier, would charge an entity for that component, or a similar
component, separately. If not readily available, the lessee shall estimate the stand-alone price,
maximizing the use of observable information.
 
 Lessor
Allocate the consideration in the contract applying paragraphs 73–90 of PFRS 15.
 
II.                  Lease Term
An entity shall determine the lease term by considering the following:
1. non-cancellable period of a lease;
2. periods covered by an option to extend the lease if the lessee is reasonably certain to exercise
that option; and
3. periods covered by an option to terminate the lease if the lessee is reasonably certain not to

Intermediate Accounting 3 | 9
 exercise that option.
III.  Lessee Accounting
 
       Recognition
At the commencement date, a lessee is required to recognize assets and liabilities for all leases with a
term of more than 12 months, unless the underlying asset is of low value.
 
      Initial Measurement
       Right of Use Asset
At the commencement date, a lessee shall measure the right-of-use asset at cost.
The cost of the right-of-use asset shall comprise:
 initial measurement of Lease Liability;
 any lease payments made at or before the commencement date, less any lease incentives
received;
 any initial direct costs incurred by the lessee; and
 estimated dismantling/restoration cost.
 
       Lease liability
 Present value of lease payments that are not paid at that date (using interest rate implicit
in the lease, or if not readily determinable, lessee’s incremental borrowing rate)
 
Lease Payments that are not paid at the commencement date includes the following:
 fixed payments;
o exercise price of a purchase option only if the lessee is reasonably certain to
exercise;
o amounts expected to be payable by the lessee under residual value guarantees;
o variable lease paymentsthat depend on an index or a rate; and
 payments of penalties for terminating the lease, if the lease term reflects the
lessee exercising an option to terminate the lease.
 Subsequent Measurement
 
    Right-of-Use Asset
After the commencement date, a lessee shall measure the right-of-use asset applying a cost model,
unless it applies either of the other measurement models.
 
Measurement models
a)   Cost model
Measure the right-of-use asset at cost less any accumulated depreciation and any accumulated
impairment losses and adjusted for any remeasurement of the lease liability.
b)  Fair Value Model
If a lessee applies the fair value model in PAS 40 Investment Property  to its investment property, the
lessee shall also apply that fair value model to right-of-use assets that meet the definition of
investment property in PAS 40.
c)    Revaluation model
If right-of-use assets relate to a class of property, plant and equipment to which the lessee applies the
revaluation model in PAS 16, a lessee may elect to apply that revaluation model to all of the right-of-
use assets that relate to that class of property, plant and equipment.
   Lease liability
After the commencement date, a lessee shall measure the lease liability by:
Intermediate Accounting 3 | 10
a)          increasing the carrying amount to reflect interest on the lease liability;
b)         reducing the carrying amount to reflect the lease payments made; and
c)         remeasuring the carrying amount to reflect any reassessment or lease modifications or    to
reflect revised in-substance fixed lease payments.
 
      Presentation
    Right-of-use asset
The Right-of-use asset can be presented in the Statement of Financial Position or disclose in the
notes separately from other assets or under the same line item where it would be presented as if the
asset is owned. Disclose in which line items in the statement of financial position include those right-
of-use assets or presented as investment property if it meets the definition of an investment property
 
    Lease Liability
The lease liability can be presented as a separate line item or disclose on which line item in the
liabilities section of the Statement of Financial Position it is included.
 
   Disclosure Requirements
A lessee shall disclose information about its leases for which it is a lessee in a single note or separate
section in its financial statements.
The lessee shall disclose the following:
ü  depreciation charge for right-of-use assets by class of underlying asset;
ü  interest expense on lease liabilities;
ü  the expense relating to short-term leases accounted for applying paragraph 6. This expense need
not include the expense relating to leases with a lease term of one month or less;
ü  the expense relating to leases of low-value assets accounted for applying paragraph 6. This expense
shall not include the expense relating to short-term leases of low-value assets
ü  the expense relating to variable lease payments not included in the measurement of lease liabilities;
ü  income from subleasing right-of-use assets;
ü  total cash outflow for leases;
ü  additions to right-of-use assets;
ü  gains or losses arising from sale and leaseback transactions; and
ü  the carrying amount of right-of-use assets at the end of the reporting period by class of underlying
asset.
      Impact on Financial Metrics
Most commonly used financial ratios and performance metrics will be impacted, such as debt to
equity ratio, current ratio, asset turnover, interest cover, EBIT, operating profit, net income.
 
     Tax Implications
The rules remain unchanged for tax purposes.
 
 For income tax purposes, the lessee may deduct the amount of rent paid or accrued from gross
income, including all expenses under the lease agreement which the lessee is required to pay
to or for the account of the lessor.  The difference between the rent expense and the sum of
depreciation expense and interest expense is treated as future deductible expense and a
deferred tax asset is recognized.
 
 For Value-Added Tax (VAT) purposes, the monthly payments to the lessor are reported
monthly since this is subject to VAT upon payment, and not at the inception of the lease.
 
Intermediate Accounting 3 | 11
  For withholding tax purposes, the transaction remains a lease, which is subject to a 5%
withholding tax.
       Transition Accounting and Effective Date
The effective date of PFRS 16 Leases is 1 January 2019. Early application is permitted but it can’t
be applied before an entity that also adopts IFRS 15 Revenue from Contracts with Customers.
There are two methods to adopt the new leases standard. A lessee may choose between full
retrospective approach or a modified retrospective approach. The selected approach has to be applied
to the entire lease portfolio.
    Full Retrospective Approach
The transition accounting under the full retrospective approach requires entities to retrospectively
apply the new standard to each prior reporting period presented as required by PAS 8 Accounting
Policies, Changes in Accounting Estimates and Errors. Under this transition approach, entities need
to adjust its equity at the beginning of the earliest comparative period presented.
     Modified Retrospective Approach
Under this approach, a lessee does not restate comparative information. The date of initial application
is the first day of the annual reporting period in which a lessee first applies the requirements of the
new lease standard. At the date of initial application of the new lease standard, lessees recognize the
cumulative effect of initial application as an adjustment to the opening balance of equity as of 1
January 2019. Comparative figures for the year ended December 31, 2018 are not restated to reflect
the adoption of PFRS 16 but instead continue to reflect the lessee’s accounting policies under PAS
17 Leases.
 
IV.   Lessor Accounting
PFRS 16 substantially carries forward the lessor accounting requirements in PAS 17. Accordingly, a lessor
continues to classify its leases as operating leases or finance leases, and to account for those two types of leases
differently.
V.       Steps to consider in Transition to PFRS 16
At year-end or before the start of the audit, the following are the steps needed to be taken into consideration to
assess the impact of PFRS 16.
1. Review all lease contracts entered into by the Company as of December 31, 2019 with lease term of
more than twelve (12) months.
2. Assess whether the contract qualifies as a lease.
a. Compute for the right-of-use asset and lease liability to be recognized and provide amortization
for the lease liability.
b. Calculate the deferred tax asset to be recognized at year-end.
1. Consider the pro-forma journal entries for the application of standard as well as for the
restatement of opening balances.

Sample Problem
ABC entered into the contract on 1 January 2017 for 5 years, annual rental payments are P100,000 (exclusive of
VAT and withholding tax) in arrears (that is, 31 December each year) and at the end of the lease term, the
machine will be returned back to the lessor. The economic life of a machine is 10 years.
Use the discount rate of 3% (assumed as incremental borrowing rate at the date of initial application of PFRS 16
and not based on commencement date of the lease.)

Intermediate Accounting 3 | 12
 CORRESPONDENCE LEARNING MODULE
ACCT 1063 (Intermediate Accounting 3)
2nd Semester Academic Year 2020-2021

Week 4: Leases Part 2(Accounting by Lessor)

Topics: a) Indicators of a finance lease

b) Inception date of Lease
c) Initial and subsequent measurement of finance lease
d) Classification of finance lease by lessor
e) Sale and Leaseback transactions

Learning Outcomes: At the end of this module, you are expected to:
1. Understand Lessor accounting in comparison with Lessee accounting
2. Define Operating Lease and Finance Lease from the Lessor’s point of view
3. To identify the criteria in determining a finance lease and prepare journal entries from
the Lessor’s point of view
4. To distinguish between a direct financing lease from a sales type lease

LEARNING CONTENT:

Intermediate Accounting 3 | 13
PFRS 16, par. 61 provides that a lessor shall classify leases as either

 Operating Lease >>>does not transfer substantially all the risks and rewards incidental to ownership
 Finance Lease >>>>transfers substantially all the risks and rewards incidental to ownership

When is a contract of lease classified as Finance Lease?

Answer: By any of the following circumstances:

1. The lease transfers ownership of the underlying asset to the lessee at the end of the term;
2. Option to purchase at a price lower than fair value at the date the option becomes exercisable;
3. Term of lease is for the major part of economic life;
4. Present value of lease payments amounts to substantially all of the fair value of the underlying asset at
the commencement of the lease contract.

Major part >>>is defined at least 75% of the economic life of the asset.

Substantially All >>> means 90% of the fair value of the asset

There are other indicators of a finance lease that are not conclusive. If it is clear that the lease does not transfer
substantially all risks and rewards incidental to ownership, the lease is classified as Operating Lease.

Finance lease Classification

 Direct Financing Lease >>>is agreement between a businessman engaged in financing and a lessee.
The income of the lessor is in the form of Interest Income.

 Sales Type Lease >>>>>>> recognizes Interest Income and Gross profit on Sale in comparison to
Direct Financing lease. The lessor is either a manufacturer or
dealer of assets who uses lease in marketing his products.

Accounting Considerations in a Direct Financing Lease

1. Gross Investment – total gross rentals for the term of lease plus absolute amount of residual value
guaranteed or unguaranteed. Note that residual value is ignored if title
passes to the lessee at the end of the lease term. If the asset will revert to the
lessor, the residual value will be included in the computation of total income.

2. Net Investment in the lease – cost of the asset plus any initial direct cost paid by lessor.

3. Unearned Interest Income – Gross Investment Less Net Investment

Intermediate Accounting 3 | 14
 4. Initial Direct Cost – in a financing lease, the initial direct cost is added to the cost of the asset to get the
net investment of the lessor.

Illustrative Problem 1 – Direct Financing Lease – with residual value

On January 01, 2020, Camia Mchineries, Inc. leased a construction equipment to Company Cee with the
following information:

3,760,10
Cost of Equipment 0
Residual value guarantee 400,000
Useful life and lease term 4 years
Implicit interest rate 10%

The annual rental is payable in advance on January 01 of each year starting January 01, 2020.

The relevant present value factors are:

Present value of 1 at 10% for 4 periods 0.6830
Present value of an annuity of 1 in advance at 10% for 4 periods 3.4869

** Note that the residual value is guaranteed, therefore, the equipment will revert to the lessor at the end of the
lease term
Step 1 : Computation of Annual Rental

Cost of Machinery 3,760,100

Less: Present value of residual value
(400,000x.683) 273,200
Net investment to be recovered from rental 3,486,900
Divide by PV of 1in advance at 10% for 4
periods 3.4869
Annual Rental 1,000,000

Step 2 – Compute the amount of unearned interest income

Gross rentals (1,000,000 x 4 years) 4,000,000
Add: Residual value-guaranteed 400,000
Gross Investment 4,400,000
Less: Net Investment - cost of machinery 3,760,100
Unearned Interest Income 639,900

Table of Amortization
Date Payment Interest Principal Present Value
1/1/2020 3,760,100.00
1,000,00
1/1/2020 1,000,000 0 2,760,100.00
1/1/2021 1,000,000 276,01 723,990 2,036,110.00
Intermediate Accounting 3 | 15
 0
203,61
1/1/2022 1,000,000 1 796,389 1,239,721.00
123,97
1/1/2023 1,000,000 2 876,028 363,693.10
1/1/2024 400,000 36,307 363,693 0.00
Note: The rental payments is in advance, hence, the first year rental is applied to principal alone.

Journal Entries:
4,400,00
Jan. 01, 2020 Lease Receivable 0
Construction 3,760,10
Equipment 0
Unearned Interest
Income 639,900
1,000,00
Jan. 01, 2020 Cash 0
1,000,00
Lease Receivable 0
Dec. 31,
2020 Unearned Interest Income 276,010
Interest Income 276,010

1,000,00
Jan. 01, 2021 Cash 0
1,000,00
Lease Receivable 0
Dec. 31,
2021 Unearned Interest Income 203,611
Interest Income 203,611

Accounting Considerations in a Sales Type Lease

 Gross Investment
Gross rentals for the entire lease term Pxxxx
Add: Absolute amount of the residual value
(guaranteed or not xxxx
PXXX
Gross Investment X
 Net Investment
Present value of gross rentals Pxxxx
Add: Present value of residual value xxxx
Intermediate Accounting 3 | 16
 (guaranteed or not)
PXXX
Net investment in the lease X
 Unearned Interest Income
Gross Investment Pxxxx
Less: Net investment xxxx
Unearned Interest PXX
Income XX

 Sales>>>>>>>>net investment (present value of lease payments) or fair value of the asset, whichever is
lower

 Cost of goods sold

Cost of Asset Sold Pxxxx
Less: Present value of unguaranteed
residual value xxxx
PXXX
Difference X
Add: Initial direct cost paid by lessor xxxx
PXXX
Cost of Goods Sold X

 Gross Profit >>>> follows the usual formula of Sales less Cost of Sales

 Initial Indirect Cost >>>> amount is expensed immediately as component of Cost of Sales

Illustrative Problem 2 – Sales type Lease with residual value

On January 01, 2020, Company Dee, a dealer in machinery leased to Company Eff with the following
information:

Annual rental payable at the every of each year 800,000

Lease term 5 years
Useful life of machinery 5 years
2,000,00
Cost of Machinery 0
Estimated residual value 200,000
Initial direct cost paid by lessor 100,000
Implicit interest rate 10%
Present value of an ordinary annuity of 1 for 5 periods
at 1% 3.7908
Present value of 1 for 5 periods at 10% 0.6209

At the end of the lease term on Dec. 31, 2024, the machinery will revert to the lessor.

Intermediate Accounting 3 | 17
The perpetual inventory system is used,

Step1 – computation for gross investment

Gross rentals (P800,000 x 5 4,000,0

years) 00
200,00
Add: residual value 0
Gross Investment (Lease 4,200,0
Receivable) 00

Step 2 – computation for the net investment

3,032,64
Present value of gross rentals (800,000 x 3.7908) 0
Add: present value of residual value guarantee (200,000 x
0.6209) 124,180
3,156,82
Net investment (total present value) 0

Step 3 – computation of Unearned Interest Income

4,200,
Lease Receivable 000
Less: Total present 3,156,
value 820
Unearned Interest 1,043,
Income 180

Step 4 – computation of gross profit

3,156,82
Sales = total present value 0
Cost of goods sold = cost of (2,000,0
machinery 00)
(100,000
Initial direct cost )
1,056,82
Gross Income 0

Journal Entries on January 01, 2020

4,200,00
Lease Receivable 0
2,000,00
Cost of Goods Sold 0
Sales 3,156,82
Intermediate Accounting 3 | 18
 0
Unearned Interest 1,043,18
Income 0
2,000,00
Inventory 0

Cost of Goods Sold 100,000

Cash 100,000

At the end of the lease term, the machinery will revert to the lessor. The journal entry by then will be:

Inventory 200,000
200,00
Lease Receivable 0
SALE AND LEASEBACK >>>>>> is an arrangement where one party sells and asset and leases the same
asset back from the new owner. The seller becomes the seller- lessee
and the buyer becomes the buyer-lessor.

Transfer of Asset is a Sale >>>> PFRS 16 mentions that in order to be considered as a sale and leaseback,
the transaction must first satisfy the requirements for the recognition
of sale.

Points to ponder on a leaseback transaction:

 There is a sale
 There is a lease agreement for the same asset
 The sale and lease transaction are interdependent as they are negotiated as a package
 Although interdependent, sale and leaseback is the recognition of two and distinct transactions

Illustrative Problem 3 – Sales and Leaseback – Sales price at fair value

On January 01, 2020, Company Gee sold an equipment with remaining useful life of 10 years and immediately
leased back for 4 years at the current market rate.
6,000,0
Sale price at fair value 00
Carrying amount of equipment 450,000
Annual rental payable at the end of each year 800,000
Implicit interest rate 10%
Present value of an ordinary annuity of P1 at 10%
for 4 periods 3.1700

Step 1 – the seller-lessee shall account the leaseback as finance lease

Present value of rentals (800,000 x 3.17) = P2,536,000

Table of Amortization

Intermediate Accounting 3 | 19
 PRESEN
10% T
PAYME INTERE PRINCIP
DATE NT ST AL VALUE
2,536,000
1-Jan-20 .00
31-Dec- 1,989,600
20 800,000 253,600 546,400 .00
31-Dec- 1,388,560
21 800,000 198,960 601,040 .00
31-Dec- 727,416.0
22 800,000 138,856 661,144 0
31-Dec-
23 800,000 72,742 727,416 0.00

Measurement of Right of Use > = Carrying amount X Carrying amount

Sales Value of the Asset
4,500,00
Carrying amount 0 Cost of right of use:
Sales price at fair 6,000,00 (2,536,000 / 6,000,000 x
value 0 4,500,000) 1,902,000

Gain or Loss to be recognized >>>> the right transferred to the buyer-lessor is the fair value of the asset less
the initial lease liability. The gain or loss that pertains to the right
transferred to the buyer-lessor is recognized.

Sales price at fair 6,000,0 6,000,000.

value 00 Fair Value 00
Less: Carrying 4,500,0 Less: right retained by seller- 2,536,000.
amount 00 lessee 00
1,500,0 Right transferred to buyer- 3,464,000.
Gain 00 lessor 00

Gain to be recognized (3,464,000/6,000,000 x

1,500,000) 866,000
Gain not to be recognized (2,536,000/6,000,000 x
1,500,000) 634,000
1,500,00
Total Gain 0

Journal entries in the books of the seller-lessee

1 Cash 6,000,000
Right of Use Asset 1,902,000
Intermediate Accounting 3 | 20
 Equipment 4,500,000
Lease Liability 2,536,000
Gain on right transferred 866,000
To record the sale of the leaseback

2 Interest Expense (10% x 2,536,000) 253,600

Lease Liability 546,400
Cash 800,000
To record the annual rental for the first year

Depreciation expense (1,902,000 /4

3 years) 475,500
Accumulated depreciation 475,500
To record the annual depreciation of right of use asset

Journal entries in the books of the buyer-lessor

**The buyer-lessor will account the transaction following an operating model because the lease term of 4 years
is equivalent to 40% of the 10 years estimated useful life of the asset, Moreover, the value of the rentals of
P2,536,000 is less than 90% of the fair value of P6.00M.

6,000,00
1 Equipment 0
6,000,00
Cash 0
To record the purchase of the equipment

2 Cash 800,000
Rent Income 800,000
To record the annual rental

Depreciation Expense (6,000,000 / 10

3 years) 600,000
Accumulated Depreciation 600,000
To record the annual depreciation of equipment

End of Lesson

Intermediate Accounting 3 | 21
Reference: Intermediate Accounting 2 by: Zeus Vernon T. Millan

Intermediate Accounting 3 | 22