NEW BRIGHTON SCHOOL OF THE PHILIPPINES, Inx`C.

Module No. 10
Subject: Intermediate Accounting 2 Date of Submission: ____________
Name of Student: __________________________________________________
Course and Year: __________________________________________________
Semester and School Year: __________________________________________

Introduction
The lessor in a sale type lease is actually a manufacturer or dealer that uses the lease as a means of facilitating the sale
of product. The accounting for a sales type lease exhibits many similarities to that for a direct financing lease.

However a sales type lease involves the recognition of a manufacturer or dealer profit on the transfer of the asset to the
lessee in addition to the recognition of interest income.

Accounting consideration

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 unguaranteed. Recall that this is the same gross investment in a direct financing lease.

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 – This 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 sales type lease as component of cost of goods sold.

Illustration

Lessor Company is a dealer in machinery

On January 1, 2020, a machinery was leased a Lessee Company with the following provisions:

Annual rental payable at the end of each year 400,000

Lease term 5 years
Useful life of machinery 5 years
Cost of machinery 1,000,000
Implicit interest rate 12%
Present value of annuity of 1 for 5 years at12% 3.60

Computation

Gross rentals (400,000 x 5) 2,000,000

Present value of rentals (400,000 x 3.6) 1,440,000
Unearned interest income 560,000

Present value of rentals – sales 1,440,000

Cost of machinery – cost of goods sold 1,000,000

Module for Intermediate Accounting 2, Jonard S. Baloyo, CPA Page 1

 Gross profit on sale 440,000

A manufacturer or dealer lessor shall recognize selling profit or loss in income for the period in accordance with the
policy followed by the entity for outright sale.

Journal entries
On the books of the Lessor Company, the sales type lease is recorded as follows:

1. To record the sale:

Lease receivable 2,000,000

Sales 1,440,000
Unearned interest income 560,000

The gross profit of P440,000 is not separately recorded because it is included already in the sales revenue.

2. To record the cost of goods sold, assuming the perpetual system is used:

Cost of goods sold 1,000,000

Inventory 1,000,000

3. To record the collection of the annual rental:

Cash 400,000
Lease receivable 400,000

4. To record the interest income for 2020:

Unearned interest income 172,800

Interest income 172,800

Present value – January 1, 2020 1,440,000

December 31, 2020:
Payment 400,000
Interest for 2020 (12% x 1,440,000) (172,800) 227,200
Balance – December 31, 2020 1,212,800

Sales type lease with residual value

Lessor Company is a dealer in machinery

On January 1, 2020, a machinery is leased to another entity with the following provisions:

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

Lease term 5 years
Useful life of machinery 5 years
Cost of Machinery 2,000,000
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 10% 3.7908
Present value 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.

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The perpetual inventory system is used.

Residual value guarantee

Gross rentals (800,000 x 5) 4,000,000

Residual value guarantee 200,000
Lease receivable – gross investment 4,200,000

Present value of gross rentals (800,000 x 3.7908) 3,032,640

Present value of residual value guarantee (200,000 x .6209) 124,180
Total present value – net investment 3,156,820

Lease receivable 4,200,000

Total present value (3,156,820)
Unearned interest income 1,043,180

Sales equal to total present value 3,156,820

Cost of goods sold – cost of machinery (2,000,000)
Initial direct cost ( 100,000)
Gross income 1,056,820

Journal entries on January 1, 2020

Lease receivable 4,200,000

Cost of goods sold 2,000,000
Sales 3,156,820
Unearned interest income 1,043,180
Inventory 2,000,000

Cost of goods sold 100,000

Cash 100,000

The initial direct cost is charged directly to cost of goods sold.

Unguaranteed residual value

Gross rentals (800,000 x 5) 4,000,000

Unguaranteed residual value 200,000
Lease receivable – gross investment 4,200,000

Present value of gross rentals 3,032,640

Present value of residual value unguaranteed residual value 124,180
Total present value – net investment 3,156,820

Lease receivable 4,200,000

Total present value (3,156,820)
Unearned interest income 1,043,180

Observe that the lease receivable and unearned interest income are the same whether the scenario is guaranteed or
unguaranteed residual value. However, there is a difference in the computation of the sales and cost of goods sold.

Under the residual value guarantee scenario, the present value of the residual value is included in the sales revenue
because the lessor knows that the entire asset has been sold.

However, under the unguaranteed residual value scenario, the present value of the unguaranteed residual value is not
included in the sales revenue.

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Accordingly, the present value of the unguaranteed residual value is deducted from the cost of the underlying asset in
computing cost of goods sold. The reason is that this portion of the leased asset is in effect “not sold” in the sense that
the lessor will be receiving back at the end of the lease term the underlying asset with unguaranteed residual value of
P200,000 and present value of P124,180.

Moreover, the unguaranteed residual value is not considered lease payment as far as the lessee is concerned.

Computation
Cost of machinery 2,000,000
PV of unguaranteed residual value ( 124,180)
Cost of goods sold 1,875,820

Sales equal to present value of gross rentals only, excluding the present value of
the unguaranteed residual value 3,032,640
Cost of goods sold (1,875,820)
Initial direct cost ( 100,000)
Gross income
1,056,820

Note that the gross income must be the same under the guaranteed and unguaranteed residual value scenario.

Journal entries

The journal entries to record the sale and initial direct cost on January 1, 2020 under the concept of unguaranteed
residual value are:

Lease receivable 4,200,000

Cost of goods sold 1,875,820
Sales 3,032,640
Unearned interest income 1,043,180
Inventory 2,000,000

Cost of goods sold 100,000

Cash 100,000

Table of amortization

The table of amortization of the lease receivable may appear as follows:

Date Payment Interest Principal Present value

1/1/2020 3,156,820
12/31/2020 800,000 315,682 484,318 2,672,502
12/31/2021 800,000 267,250 532,750 2,139,752
12/31/2022 800,000 213,975 586,025 1,553,727
12/31/2023 800,000 155,373 644,627 909,100
12/31/2024 800,000 90,900 709,100 200,000

December 31, 2020

Payment 800,000
Applicable to interest (10% x 3,156,820) (315,682)
Applicable to principal 484,318

Net lease receivable – January 1, 2020 3,156,820

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 Payment on December 31, 2020 (484,318)
Carrying amount – December 31, 2020 2,672,502

Whether guaranteed or unguaranteed, the entries for the collection of the annual rental and the interest income are the
same.

Journal entries – December 31, 2020

Cash 800,000
Lease receivable 800,000

Unearned interest income 315,682

Interest income 315,682

Return of asset to lessor

When the lease expires on December 31, 2024, the machinery will revert to Lessor Company. Whether “guaranteed”
or “unguaranteed” residual value, the entry on the books of the lessor will be the same.

Inventory (machinery) 200,000

Lease receivable 200,000

To complete the illustration, assume on December 31, 2024, end of lease term, the fair value of the machinery is only
P150,000

Under the residual value guaranteed scenario, the lessee will make up for the deficiency by paying the difference.

Cash 50,000
Inventory 150,000
Lease receivable 200,000

Under the unguaranteed scenario, the lessor shall recognize a loss for the difference.

Loss on finance lease 50,000

Inventory 150,000
Lease receivable 200,000

It is to be pointed out that in the illustration the sales type lease provides that the underlying asset will revert to the
lessor upon termination of the contract. However, if the underlying asset will not revert to the lessor, the residual value
is completely ignored by the lessor in the computation of unearned interest income and gross profit on the sale.

The underlying asset will remain with the lessee if the lease provides for either a purchase option that us reasonably
certain to be exercised or transfer of title to the lessee upon the lease expiration.

Sales type lease with purchase option

An entity is a dealer in equipment. On January 1, 2020, an equipment is leased to another entity with the following
provisions:

Annual rental payable at the end of each year 500,000

Lease term 4 years
Useful life of equipment 5 years
Cost of equipment 1,000,000
Initial direct cost paid by lessor 100,000
Purchase option 200,000
Implicit interest rate 8%
PV of an ordinary annuity of 1 at 8% for 4 periods 3.312

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 PV of 1 at 8% for 4 periods 0.735

It is reasonably certain that the lessee will exercise the purchase option on December 31, 2023.

Computation
Gross rentals (500,000 x 4) 2,000,000
Purchase option 200,000
Gross investment – lease receivable 2,200,000

Present value of goods rental (500,000 x 3.312) 1,656,000

Present value of purchase option (200,000 x .735) 147,000
Total present value – net investment 1,803,000

Gross investment 2,200,000

Net investment (1,803,000)
Unearned interest income 397,000

Sales (equal to total present value) 1,803,000

Cost of goods sold 1,100,000
Gross income 703,000

Cost of equipment 1,000,000

Initial direct cost 100,000
Cost of goods sold 1,100,000

Journal entry – January 1, 2020

If the perpetual system iss used, the journal entry to record the sale is:

Lease receivable 2,200,000

Cost of goods sold 1,100,000
Sales 1,803,000
Unearned interest income 397,000
Inventory 1,000,000
Cash 100,000

Table of amortization

The table of amortization of the net lease receivable may appear as follows:

Date Payment Interest Principal Present value

Jan. 1, 2020 1,803,000
Dec. 31, 2020 500,000 144,240 355,760 1,447,240
Dec. 31, 2021 500,000 115,779 384,221 1,063,019
Dec. 31, 2022 500,000 85,042 414,958 648,061
Dec. 31, 2023 500,000 51,939 448,061 200,000

Payment represent the annual rental.

Interest is equal to the preceding present value times the interest rate.

Thus, for 2020, P1,803,000 times 8% equals P144,240, and so on.

Principal is the portion of the annual rental payment after deducting the interest.

Thus, for 2020, P500,000 minus P144,240 equals P355,760 and so on.

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Present value is the balance of the preceding value after deducting the principal payment.

Thus, on December 31,2020 P1,803,000 minus P355,760 equals P1,447,240.

Journal entries
2020
Dec. 31 Cash 500,000
Lease receivable 500,000

31 Unearned interest income 144,240

Interest income 144,240

2021
Dec. 31 Cash 500,000
Lease receivable 500,000

31 Unearned interest income 115,779

Interest income 115,779
2022
Dec. 31 Cash 500,000
Lease receivable 500,000

31 Unearned interest income 85,042

Interest income 85,042
2023
Dec. 31 Cash 500,000
Lease receivable 500,000

31 Unearned interest income 51,939

Interest income 51,939

Exercise of purchase option

At this point on December 31, 2023, if the entries are properly posted, the lease receivable has balance of P200,000
equal to the purchase option and the unearned interest income has a zero balance.

The purchase option is exercised by the lessee on December 31, 2023.

Journal entry
Cash 200,000
Lease receivable 200,000

Nonexercise of purchase option

The purchase option is not exercised by the lessee and the fair value of the underlying asset is P100,000 only.

Journal entry
Inventory 100,000
Loss on finance lease 100,000
Lease receivable 200,000

Actual sale of underlying asset

When a lessor actually sells an asset that it has been leasing under a finance lease, the difference between the sale price
and the carrying amount of the lease receivable is recognized in profit or loss.

The carrying amount of the lease receivable is equal to the balance of the lease receivable minus the unearned interest
income.

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Illustration
An entity actually sold an equipment that it had been leasing under a lases type lease for P3,500,000. The following
balances are associated with the finance lease on the books of the lessor on the date of sale:

Lease receivable 5,000,000

Unearned interest income 1,200,000

Computation
Sale price 3,500,000
Carrying amount of lease receivable:
Lease receivable 5,000,000
Unearned interest income (1,200,000)3,800,000
Loss on sale of leased equipment ( 300,000)

Journal entry to record the actual sale

Cash 3,500,000
Unearned interest income 1,200,000
Loss on sale of leased equipment 300,000
Lease receivable 5,000,000

Disclosure

A lessor shall disclose the following amount for the reporting period:

1. For finance lease:

a. Selling profit or loss
b. Finance income on the net investment in the lease
c. Income relating to variable lease payments not included in the measurement of the net investment in the
lease

2. For operating lease, lease income, separately disclosing income relating to variable lease payments that do not
depend on an index or rate.

References

Valix, C. & Valix, C.A. (2018). Practical Accounting 1 vol 2. GIC Enterprises and Co., Inc. Manila, Philippines

Valix, C. & Valix, C.A. (2013). Theory of Accounts 2013 edition. GIC Enterprises and Co., Inc. Manila, Philippines

Valix, C. Valix, C.A. (2019). Financial Accounting and Reporting vol 2. GIC Enterprises and Co., Inc. Manila,
Philippines

Robles, N. & Empleo P. (2016). The Intermediate Accounting Series Vol 2. Millenium Books, Inc., Mandaluyong City

Uberita, C. (2012). Practical Accounting 1 2013 Edition. GIC Enterprises and Co, Inc. Manila, Philippines

Testbanks and CPA Examination Reviewers

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