ASIAN DEVELOPMENT FOUNDATION COLLEGE

COLLEGE OF BUSINESS AND ACCOUNTANCY

AE 16 - LIABILITIES:
LESSOR ACCOUNTING PART 1

I. OPERATING LEASE

IFRS 16 REQUIREMENT
A lessor shall classify leases as either an operating lease or a finance lease.

OPERATING LEASE
This is a lease that does not transfer substantially all the risks and rewards
incidental to ownership of an underlying asset.

FINANCE LEASE
This is a lease that transfers substantially all the risks and rewards
incidental to ownership of an underlying asset.

WHEN IS A LEASE CLASSIFIED AS FINANCE LEASE?

This depends on the substance of the transaction rather than the form of a
contract.

IFRS 16’s GUIDELENES TO CLASSIFY LEASE AS FINANCE LEASE

The following four major criteria below are “determinative in nature” that would
normally result to a conclusion that the lease contract is a finance lease:

1. The lease “transfers ownership” of the underlying asset at the end of the
lease term.

2. The lessee has an “option to purchase” the asset at a price which is

expected to be sufficiently lower than the fair value at the date of the
option becomes exercisable.

Note!
The option should be reasonably certain to be exercised at the inception of
the lease.

3. The lease term is for the “major part of the economic life” of the
underlying asset even if title is not transferred.

4. The present value of the lease payments amounts to “substantially all” of

the fair value of the underlying asset at the “inception” of the lease.

SUBSTANTIALLY ALL EXPLAINED

Under US GAAP, this means at least 90% of the fair value of the leased
asset.

There is room for debate whether substantially all implies a threshold

lower than or higher than 90%.

OTHER CRITERIA FOR A LEASE TO BE A FINANCE LEASE

The following are more of “suggestive in nature” that could also lead to finance
lease classification:

1. The underlying asset is of such specialized nature that only the lessee can
use it without major modification.

2. If the lessee can cancel the lease, the lessor’s losses associated with the
cancelation are “borne by the lessee”.

3. Gains or losses from the fluctuation in the fair value of the residual
“accrue to the lessee”.

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4. The lessee has the ability to continue the lease for a secondary period at a
rent that is “substantially lower” than market rent.

IFRS 16 MANDATE ON LESSOR ACCOUNTING – OPERATING LEASE

A lessor shall recognize lease payments from lease as “rent income” either:
1. Straight-line basis; or
2. Another systematic basis

OWNERSHIP OR EXECUTORY COSTS

The lessor bears all costs such as:
1. Depreciation expense of the leased property;
2. Real property taxes;
3. Insurance expenses;
4. Maintenance expenses

Note!
The lessor “may pass on” to the lessee the payment for taxes, insurance, and
maintenance costs.

DEPRECIATION EXPENSE OF LEASED PROPERTY

The depreciation policy for depreciable leased asset shall be consistent with
the lessor’s normal depreciation for similar asset.

Note!
The depreciation of leased asset shall start from the moment it is available
for its intended use, not on the inception of the lease term/period.

INITIAL DIRECT COSTS

This is under the account title “Deferred Initial Direct Cost”. This is
amortized as expense over the lease term on same basis as the lease income.

This shall be added to the carrying amount of the underlying asset.

SECURITY DEPOSIT
This is accounted under the account title “Liability for Rent Deposit”. This is
refundable upon lease expiration shall be accounted as liability by the lessor.

LEASE BONUS
This is recognized under the account title “unearned rent income” and to be
amortized over the lease term.

UNEQUAL RENTAL PAYMENTS

The total cash payments for the lease term shall be “amortized uniformly” on the
straight-line basis as rent income over the lease term.

NET REVENUE / PRETAX INCOME FORMULA:

Annual rental income XX

Amortization of lease bonus XX
Total Rent Income XX
Less:
Depreciation Expense XX
Insurance Expense XX
Real Property tax XX
Other lessor Expenses XX (XX)
Pretax Income / Net Revenue XX

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COLLEGE OF BUSINESS AND ACCOUNTANCY

ILLUSTRATIVE PROBLEM 1:
OPERATING LEASE BASIC ACCOUNTING
FIRST YEAR OF LEASE – WHOLE YEAR

On January 1, 2023, Vic Company purchased a machinery for P 6,000,000 cash for
the use of leasing it. The machine is expected to have a 10-year life from the
date of purchase.

On January 1, 2023, the machinery was leased to Lois Company for a three-year
period, at a monthly rental of P 80,000, payable at the end of every month.

Additionally, Lois Company paid P 240,000 to Vic Company on January 1, 2023 as a

lease bonus.

Vic Company paid repairs of P 40,000 relating to 2023.

The company follows the operating lease model to account its leases.

Required:

1. Compute the depreciation expense in 2023.

2. Compute the net rental revenue / pretax income in 2023.

3. Present the machinery in the statement of financial position of Vic Company

on December 31, 2023.

4. Prepare the journal entry to:

a. To record the purchase of machinery.

b. To record the payment of initial direct costs.

c. To record the receipt of lease bonus.

d. To record the collection of total annual rent income.

e. To record the amortization of initial direct costs on December 31, 2023.

f. To record the amortization of lease bonus on December 31, 2023.

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ILLUSTRATIVE PROBLEM 2:
OPERATING LEASE BASIC ACCOUNTING
FIRST YEAR OF LEASE – PARTIAL YEAR

On January 1, 2023, Myrna Company purchased a tractor at a cost of P 3,200,000

for the purpose of leasing it.

The tractor is estimated to have a useful life of 5 years with residual value of
P200,000. Depreciation is on a straight-line basis.

On April 1, 2023, Myrna Company entered into a lease contract for the lease of
the tractor for a term of two years up to March 31, 2025. The lease fee is P
100,000 a month and the lessee paid P 1,200,000, the lease fee for one year.

Myrna Company paid P 240,000 commission associated with negotiating the lease,
P30,000 for minor repairs and P 20,000 transportation of the tractor during 2023.

Required:

1. Compute the depreciation expense in 2023.

2. Compute the net rental revenue / pretax income in 2023.

3. Present the machinery in the statement of financial position of Myrna

Company on December 31, 2023.

4. Prepare the journal entry to:

a. To record the purchase of machinery.

b. To record the payment of initial direct costs.

c. To record the receipt of lease bonus.

d. To record the receipt of lease fee on April 1, 2023.

e. To record the amortization of initial direct costs on December 31, 2023.

f. To record the amortization of lease bonus on December 31, 2023.

g. To recognize the rent income on December 31, 2023 from the lease
collected on April 1, 2023.
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COLLEGE OF BUSINESS AND ACCOUNTANCY

ILLUSTRATIVE PROBLEM 3:
UNEQUAL RENTAL PAYMENTS

On January 1, 2023, Bee Company leased a delivery equipment to Mars Company under
a 3-year operating lease.

Total rent for the term of the lease will be P 5,400,000 payable as follows:

12 months at P 100,000 P 1,200,000

12 months at P 150,000 P 1,800,000
12 months at P 200,000 P 2,400,000

Required:

1. Compute the rent revenue for the year ended December 31, 2023.

2. What should the company report related to its collection of lease payments
and rent income on December 31, 2023?? (What asset or liability account and
how much?)

ILLUSTRATIVE PROBLEM 7:
UNEQUAL RENTAL PAYMENTS

At the beginning of January 1, 2023, Wall E Company leased office premises to

Foxy Company for a five-year term.

Under the terms of the operating lease, rent for the first year is P 1,600,000
and rent for years 2 through 5 is P 2,500,000 per annum payable every year end.

However, as an inducement to enter the lease, Wall E Company granted Fox Company
the first six months of the lease rent-free.

Required:

1. Compute the rent revenue for the year ended December 31, 2023.

2. What should the company report related to its collection of lease payments
and rent income on December 31, 2023?? (What asset or liability account and
how much?)

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II. FINANCE LEASE

DIRECT FINANCING LEASE
KEY FEATURES OF DIRECT FINANCING LEASE

1. The lessor in a direct financing lease is actually engaged in the financing

business.
2. A direct finance lease is an arrangement between a financing entity and a
lessee.
3. A direct finance lease recognizes only interest income.
4. No dealer profit is recognized because the fair value and the cost of the
asset are equal.

ACCOUNTING CONSIDERATIONS IN DIRECT FINANCING LEASE

1. NET LEASE RECEIVABLE

PV of rentals XX
PV of Unguaranteed/Guaranteed Residual Value XX
Net Lease Receivable XX

2. GROSS INVESTMENT
Gross Rentals XX
Absolute Amount of Unguaranteed/Guaranteed Residual Value XX
Gross Investment XX

3. NET INVESTMENT IN THE LEASE

Cost of the asset XX
Initial Direct Cost paid by the lessor XX
Net Investment in Lease XX

Note!
1. The present value of all payments is equal to the cost of the asset.
2. The initial direct cost is added to the cost of the machinery to
determine the net investment in lease.
3. Initial direct cost reduces the implicit rate.

4. UNEARNED INTEREST INCOME

Gross Investment XX
Net Investment in Lease (XX)
Unearned Interest Income XX

5. ANNUAL RENTAL

Cost of Machinery XX
Less: PV of Unguaranteed/Guaranteed Residual Value (XX)
Net investment to be recovered from rental XX
Divided by: PV of an Ordinary Annuity of 1 XX
Annual Rental XX

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COLLEGE OF BUSINESS AND ACCOUNTANCY

ILLUSTRATIVE PROBLEM 1:
DIRECT FINANCING LEASE – ORDINARY ANNUITY

On January 1, 2023, Bettor Company leased an equipment to another entity with the
following details:

Cost of Machinery P 3,037,300

Annual rent payable at the end of each year P 1,000,000
Lease term 4 years
Useful life of equipment 4 years
Implicit rate 12%
PV of an ordinary annuity of 1 for 4 years @ ?
12%

Required:

1. Compute the net lease receivable on January 1, 2023.

2. Compute the gross investment.

3. Compute the net investment in lease.

4. Compute the unearned interest income.

5. Fill up the amortization table below:

Date Payment Interest Principal Present Value

6. Prepare the journal entry in 2023:

a. To record the direct financing lease.

b. To record the collection of annual rental.

c. To record the interest income.

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ILLUSTRATIVE PROBLEM 3:
DIRECT FINANCING LEASE – ANNUITY DUE

On January 1, 2023, Traitor Company leased an equipment to another entity with

the following details:

Cost of Machinery P 3,401,800

Annual rent payable at the beginning of each P 1,000,000
year
Lease term 4 years
Useful life of equipment 4 years
Implicit rate 12%
PV of an annuity due of 1 for 4 years @ 12% ?

Required:

1. Compute the net lease receivable on January 1, 2023.

2. Compute the gross investment.

3. Compute the net investment in lease.

4. Compute the unearned interest income.

5. Fill up the amortization table below:

Date Payment Interest Principal Present Value

6. Prepare the journal entry in 2023:

a. To record the direct financing lease.

b. To record the collection of annual rental.

c. To record the interest income.

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ILLUSTRATIVE PROBLEM 5:
DIRECT FINANCING LEASE – WITH INITIAL DIRECT COST

On January 1, 2023, Dog Company leased an equipment to another entity with the
following details:

Cost of Machinery P 3,695,900

Annual rent payable at the end of each year P 1,000,000
Lease term 5 years
Useful life of equipment 5 years
Implicit rate before initial direct cost 11%
PV of an ordinary annuity of 1 for 5 years @ ?
11%

On January 1, 2023, Dog Company paid initial direct cost of P 193,800.

Required:

1. Compute the new implicit rate.

2. Compute the net lease receivable on January 1, 2023.

3. Compute the gross investment.

4. Compute the net investment in lease.

5. Compute the unearned interest income.

6. Fill up the amortization table below:

Date Payment Interest Principal Present Value

7. Prepare the journal entry in 2023:

a. To record the direct financing lease.

b. To record the collection of annual rental.

c. To record the interest income.

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ILLUSTRATIVE PROBLEM 7:
DIRECT FINANCING LEASE – WITH INITIAL DIRECT COST

On January 1, 2023, Rat Company leased an equipment to another entity with the
following details:

Cost of Machinery P 1,412,520

Annual rent payable at the beginning of each P 400,000
year
Lease term 4 years
Useful life of equipment 4 years
Implicit rate before initial direct cost 9%
PV of an annuity due of 1 for 4 years @ 9% ?

On January 1, 2023, Rat Company paid initial direct cost of P 37,200.

Required:

1. Compute the new implicit rate.

2. Compute the net lease receivable on January 1, 2023.

3. Compute the gross investment.

4. Compute the net investment in lease.

5. Compute the unearned interest income.

6. Fill up the amortization table below:

Date Payment Interest Principal Present Value

7. Prepare the journal entry in 2023:

a. To record the direct financing lease.

b. To record the collection of annual rental.

c. To record the interest income.

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COLLEGE OF BUSINESS AND ACCOUNTANCY

ILLUSTRATIVE PROBLEM 9:
DIRECT FINANCING LEASE – WITH RESIDUAL VALUE
ORDINARY ANNUITY

On January 1, 2023, Lessor Company leased a machinery to another entity with the
following details:

Cost of Machinery P 1,597,205

Residual Value P 250,000
Useful life and lease term 4 years
Implicit interest rate 10%

The annual rental is payable at December 31 each year.

Required:

1. Compute the net investment to be recovered from rental.

2. Compute the annual rental.

3. Compute the gross investment.

4. Compute the unearned interest income.

5. Fill up the amortization table below:

Date Payment Interest Principal Present Value

6. Prepare the journal entry in 2023 to:

a. To record the direct financing lease.

b. To record the collection of annual rental.

c. To record the interest income.

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7. If the fair value of the machinery at the end of its useful life was P
200,000, under the “guaranteed scenario”:

a. Compute the loss on finance lease.

b. Prepare the journal entry of the lessor.

8. If the fair value of the machinery at the end of its useful life was P
200,000, under the “unguaranteed scenario”, prepare the journal entry of the
lessor.

a. Compute the loss on finance lease.

b. Prepare the journal entry of the lessor.

ILLUSTRATIVE PROBLEM 11:

DIRECT FINANCING LEASE – WITH RESIDUAL VALUE
ANNUITY DUE

On January 1, 2023, Lessor Company leased a machinery to another entity with the
following details:

Cost of Machinery P 2,994,420

Residual Value P 300,000
Useful life and lease term 4 years
Implicit interest rate 10%

The annual rental is payable in advance on January 1 of each starting January 1,

2023.

Required:

1. Compute the net investment to be recovered from rental.

2. Compute the annual rental.

3. Compute the gross investment.

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4. Compute the unearned interest income.

5. Fill up the amortization table below:

Date Payment Interest Principal Present Value

6. Prepare the journal entry in 2023 to:

a. To record the direct financing lease.

b. To record the collection of rental on January 1, 2023.

c. To record the interest income.

7. If the fair value of the machinery at the end of its useful life was P
250,000, under the “guaranteed scenario”:

a. Compute the loss on finance lease.

b. Prepare the journal entry of the lessor.

8. If the fair value of the machinery at the end of its useful life was P
250,000, under the “unguaranteed scenario”, prepare the journal entry of the
lessor.

a. Compute the loss on finance lease.

b. Prepare the journal entry of the lessor.

Note!
The residual value is completely ignored in the computation of the annual rental
and the unearned interest income if the asset will not revert to the lessor at
the end of the lease term if the lease provides for a transfer of title to the
lessee.

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 ASIAN DEVELOPMENT FOUNDATION COLLEGE
COLLEGE OF BUSINESS AND ACCOUNTANCY

ILLUSTRATIVE PROBLEM 13:

DIRECT FINANCING LEASE – TRANSFER OF TITLE TO LESSEE
ORDINARY ANNUITY

On January 1, 2023, Dry Company leased a machinery to another entity with the
following details:

Cost of Machinery P 2,980,890

Residual Value P 300,000
Useful life and lease term 4 years
Implicit interest rate 8%

The annual rental is payable at December 31 each year. The lease provides for a
transfer of title to the lessee at the end of lease term.

Required:

1. Compute the net investment to be recovered from rental.

2. Compute the annual rental.

3. Compute the gross investment.

4. Compute the unearned interest income.

5. Fill up the amortization table below:

Date Payment Interest Principal Present Value

6. Prepare the journal entry in 2023 to:

a. To record the direct financing lease.

b. To record the collection of annual rental.

c. To record the interest income.

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ILLUSTRATIVE PROBLEM 15:

DIRECT FINANCING LEASE – TRANSFER OF TITLE TO LESSEE
ANNUITY DUE

On January 1, 2023, Lessor Company leased a machinery to another entity with the
following details:

Cost of Machinery P 2,471,910

Residual Value P 250,000
Useful life and lease term 4 years
Implicit interest rate 9%

The annual rental is payable in advance on January 1 of each starting January 1,

2023. The lease provides for a transfer of title to the lessee at the end of
lease term.

Required:

1. Compute the net investment to be recovered from rental.

2. Compute the annual rental.

3. Compute the gross investment.

4. Compute the unearned interest income.

5. Fill up the amortization table below:

Date Payment Interest Principal Present Value

6. Prepare the journal entry in 2023 to:

a. To record the direct financing lease.

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b. To record the collection of rental on January 1, 2023.

c. To record the interest income.

~end of the chapter~

Sources:
Intermediate Accounting Volume 2, Valix
Practical Accounting 1 Volume 2, Valix

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