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University of Makati

College of Business and Financial Science


Department of Accountancy

TOA_Liabilities – Financial Accounting FEN


TOA_19: LEASE LIABILITIES - Part1
(Adapted: IAS17/Financial Accounting Weygandt, et al./Financial Accounting Valix, et al./Etc.)
Lease– A lease is a contractual arrangement between a lessor (owner of the property) and a lessee
(renter of the property). It grants the right to use specific property for a period of time in return for cash
payments. The two most common types of leases are operating leases and capital/finance leases. (Weygant,
et. al.)
Lease - an agreement whereby the lessor conveys to the lessee in return for a payment or series of
payments the right to use an asset for an agreed period of time. (IAS17 par.4)
A finance lease is a lease that transfers substantially all the risks and rewards incidental to ownership of
an asset. Title may or may not eventually be transferred. An operating lease is a lease other than a
finance lease. (IAS17 par.4)
TYPES OF LEASE
A. Operating Leases
The renting of an apartment and the
rental of a car at an airport are
examples of operating leases. In an
operating lease, the intent is
temporary use of the property by
the lessee, while the lessor
continues to own the property. In an
operating lease, the lessee records
the lease (or rental) payments as an
expense. The lessor records the
payments as revenue.
B. Finance/Capital Leases
The lease contract transfers to the lessee substantially all the benefits and risks of ownership. Such a
lease is in effect a purchase of the property. Its name comes from the fact that the company capitalizes
the present value of the cash payments for the lease and records that amount as an asset.
The lessee must record a lease as an asset if any of the following conditions exists — as a finance lease
(IAS 17 par.10):
1. The lease transfers ownership of the property to the lessee.
Rationale: If during the lease term the lessee receives ownership of the asset, the lessee should report the leased
item as an asset on its books.
2. The lease contains a bargain purchase option.
Rationale: If during the term of the lease the lessee can purchase the asset at a price substantially below its fair
value, the lessee will exercise this option. Thus, the lessee should report the leased item as an asset on its books.
3. The *lease term is for the major part of the economic life of the asset even if title is not transferred.
*Under US GAAP: The lease term is equal to 75% or more of the economic life of the leased property.
Rationale: If the lease term is for much of the asset’s useful life, the lessee should report the leased item as an
asset on its books.
Note: Economic life is either the period over which an asset is expected to be economically usable by one or more users; or the
number of production or similar units expected to be obtained from the asset by one or more users. (IAS17 par.4)
Useful life is the estimated remaining period, from the commencement of the lease term, without limitation by the lease term,
over which the economic benefits embodied in the asset are expected to be consumed by the entity. (IAS17 par.4)
4. **Present value of the minimum lease payments amounts to at least substantially all of the fair
value of the leased asset
**Under US GAAP: The present value of the lease payments
equals or exceeds 90% of the fair value of the leased property.

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TOA_19 – Leases FEN

Rationale: If the present value of the lease payments is equal to or almost equal to the fair value of the asset, the
lessee has essentially purchased the asset. As a result, the lessee should report the leased item as an asset on its
books.
5. The leased assets are of such a specialized nature that only the lessee can use them without major
modifications.
Check also IAS 17 par.11: Indicators of situations that individually or in combination could also lead to a lease being
classified as a finance lease.

Accounting for Leases


Lessee Lessor
Risks and rewards remain with lessor (no sale and Operating Lease Operating Lease
purchase of assets)
Risks and rewards remain transfer to lessee (sale and Finance Lease Direct financing lease
purchase of assets) Sales-type lease
A. Operating Lease
Lease payments under an operating lease shall be recognized as an expense on a straight-line basis over
the lease term unless another systematic basis is more representative of the time pattern of the user’s
benefit. (IAS 17 par.33)
Rental approach – periodic rental is simply recognized as rent expense on the part of the lessee and rent
income on the part of the lessor.
LESSEE LESSOR
Debit Credit Debit Credit
PPE xx
No entry Cash xx
(Purchase of asset)
Rent Expense xx Cash xx
Cash xx Rent Income xx
(Recognition of rental exp.) (Recognition of rental income)
Rent deposit xx Cash xx
Cash xx Liability for rent deposit xx
(Refundable security deposits) (Refundable security deposits)
Prepaid rent xx Cash xx
Cash xx Unearned rent income xx
(Lease bonus) (Lease bonus)
Rent expense xx Unearned rent income xx
Prepaid rent xx Rent income xx
(Amortization of lease bonus-straight line/lease term ) (Amortization of lease bonus-straight line/lease term )
Leasehold improvements (L_I) xx
Cash xx No entry
(improvements paid by lessee)
Deferred initial direct costs (IDC) xx
No entry Cash xx
(direct cost initially paid by the lessor)
Depreciation expense – (L I) xx Depreciation expense – (IDC) xx
Accumulated depreciation – (L_I) xx Accumulated depreciation – (IDC) xx
(depreciation of leasehold improvements) (depreciation of initial direct costs)
Depreciation expense – (PPE) xx
No entry Accumulated depreciation – (PPE) xx
(depreciation of initial direct costs)
Rental Approach Notes/Reminders:
1. Free rent/uneven payments - Some lease agreements might call for uneven payments or scheduled rent
increases over the lease term. Other agreements might include, as an incentive to the lessee, several months of

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TOA_19 – Leases FEN

“free rent” during which the lessee may use the asset without owing rent to the lessor. In these cases, rental
revenue (expense) is still recognized by the lessor (lessee) on a straight-line basis and is prorated over the full term
of the lease during which the lessee has possession of the asset. This is due to the matching principle; if physical
usage is relatively the same over the lease term, then an equal amount of benefit is being obtained by both parties
to the lease.
2. Initial direct costs - The lessor may incur costs in setting up the lease agreement (i.e. finder’s fees, appraisal
fees, document processing fees, negotiation fees, and any costs in closing the transaction). Initial direct costs are
amortized on a straight-line basis to expense over the lease term by the lessor, and are shown net of accumulated
amortization on the lessor’s statement of financial position.
3. Lease bonus (fee) - At the inception of the lease, the lessee may pay a nonrefundable lease bonus (fee) to the
lessor in order to obtain more favorable leasing terms (e.g., a lease term of three years instead of five years).
4. Security deposits - Some lease agreements may require that the lessee pay the lessor a security deposit at the
inception of the lease. Security deposits may be either refundable or nonrefundable. A refundable security deposit
is treated as a liability by the lessor and as a receivable by the lessee until the deposit is returned to the lessee. A
nonrefundable security deposit is recorded as unearned revenue by the lessor and as prepaid rent by the lessee
until the deposit is considered earned by the lessor (usually at the end of the lease term).
5. Leasehold improvements - Frequently, the lessee will make improvements to leased property by constructing
new buildings or improving existing structures.

Exercise 1
On July 1, 2016, Uber Rides leased two Toyota-jazz from Grab Car for an initial period of 12 months with
a provision for a continuation on a month-to-month basis. The lease is properly classified as an
operating lease. Lease payments are to be made as follows:
First two months P15,000 per month Third three months P10,000 per month
Second three months 12,000 per month Last four months 8,000 per month
After the first year, the rent continues at P6,000 per month. Provide the entries required to record the
lease payments for the first year on the books of: 1.) Uber Rides; 2.) Grab Car.

B. Finance Lease - Lessee


 If the lease is classified as a finance lease, the lessee must record an asset and a liability based on the
present value of the minimum lease payments as follows:
Dr. Leased asset (***PV of MLP)
Cr. Lease obligation (***PV of MLP)
Note: The above entry reflects recording the transaction “net” (i.e., at present value). If the lease was recorded gross, the lease
obligation would be credited for the total amount of the MLP and there would be a debit to “Discount on lease obligation.”
Dr. Leased asset (***PV of MLP)
Dr. Discount on lease obligation (plug)
Cr. Lease obligation (gross MLP)
***To determine the present value of the MLP, the lessee discounts the future payments using the lesser of
[1] The lessee’s incremental borrowing rate, or [2] The lessor’s implicit rate if known by the lessee.
NOTE: Using a lower interest rate increases the present value.
 Leased assets, however, should not be recorded at an amount greater than the FV of the asset. If the
FV is less than the PV of the MLP, the lease should be recorded at the FV and a new implicit interest rate
calculated to reflect a constant periodic rate applied to the remaining balance of the obligation.
 During the term of the lease, the lessee must use the (effective) interest method to allocate cash paid
between interest expense and reduction of the lease obligation.
 Lessees must amortize leased assets recorded on the books under a capital lease. The amortization
(depreciation) method used should be consistent with the lessee’s normal depreciation policy.
 The lease term does not extend beyond the date of a bargain purchase option.
 When the lease terminates, the balance in the obligation account should equal the bargain
purchase option price or the expected residual value (guaranteed residual value, or salvage value
if lower).

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TOA_19 – Leases FEN

Exercise 2
On January 2, 2016, the Universal Studios leased six computers for use in the animation department.
The lease period is for 13 years and the estimated economic life of the leased property is 15 years. The
lease does not contain automatic title transfer or a bargain purchase option. Lease payments are P9,000
per year, payable each December 31. The incremental borrowing rate for Universal is 12 percent and the
implicit interest rate (known by Universal) is 10 percent. The company uses straight-line depreciation for
this type of equipment.
Required: Provide the necessary journal entries to record the transactions for Universal for the period
January 2, 2016 through December 31, 2017.

Exercise 3
On January 1, 2016, Stark Industries leased equipment on an eight-year term at P15,000 annual rental
payments, paid in advance. There is a bargain purchase option on December 31, 2023 (end of lease), of
P24,000. The economic life of the equipment is estimated to be 15 years. The interest rate is 12 percent.
Required: a. Give the necessary entries for 2016 assuming all payments after the initial payment are
made on December 31.
b. Give the entry at December 31, 2023, assuming the option is permitted to lapse and that there is no
residual value because of obsolescence. Assume 2023 amortization and interest entries have been
made.

Exercise 4
ABSA Retail Stores is negotiating three leases for store locations. ABSA's incremental borrowing rate is
12 percent. Each store will have an economic useful life of 30 years. Lease payments will be made at the
end of each year. Based on the data below, properly classify each of the leases as an operating lease or a
Finance lease. The purchase price for each property is listed as an alternative to leasing.
Location Lease Term Lease Payment Purchase Price
Location A 26 years P1,500,000 P12,000,000
Location B 20 years 1,300,000 10,000,000
Location C 20 years 1,400,000 15,000,000
Determine whether each of the leases should be classified by ABSA as an operating lease or a finance
lease. Show computations and reasons to support your answers.
1. Location A
2. Location B
3. Location C

Exercise 5
Good Distributing entered into a leasing agreement with BAD Rental. The lease qualifies as a finance
lease and calls for payments of P5,000 for 5 years with the first payment being made on January 1, 2016,
and subsequent payments being made on December 31 of each year. Good's incremental borrowing
rate is 12 percent.
Required: Prepare a schedule amortizing Good's lease obligation.

- end -

*** For I know the plans I have for you,” declares the Lord, “plans to prosper you and not to harm you,
plans to give you hope and a future. – Jeremiah 29:11***

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