LEASES (PAS 17)

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ISSUES IN ACCOUNTING FOR LEASES: The implicit interest rate in the lease is the discount rate that causes the
1. Objective and scope of PAS 17 aggregate present value of the minimum lease payments and the
2. Definition and classification of leases unguaranteed residual value to equal the fair value of the leased asset and
3. Accounting for an operating lease the initial direct costs of the lessor. (PVofMLP + PVofRV = FV + IDC)
4. Accounting for a finance lease for lessee
5. Accounting for a direct financing lease for lessor The lessee's incremental borrowing rate is the rate of interest that the
6. Accounting for a sales-type lease for lessor lessee would have to pay on a similar lease, or the rate that the lessee
7. Accounting for sale and leaseback would incur by borrowing funds to purchase the asset over a similar term
8. Disclosures and similar security.

OBJECTIVE & SCOPE OF PAS 17 Other situations that could also lead to classification as a finance lease are:

The objective of PAS 17 is to prescribe, for lessees and lessors, the appropriate (5.) The lease assets are of a specialized nature such that only the lessee can use
accounting policies and disclosures to apply in relation to finance and operating them without major modifications being made.
leases.
(6.) If the lessee is entitled to cancel the lease, the lessor's losses associated with
PAS 17 applies to all leases except for: the cancellation are borne by the lessee. In this case, the lease is deemed non-
1. Lease agreements for minerals, oil, natural gas, and similar regenerative cancellable. Furthermore, cancellable lease was deemed noncancellable when:
resources; and (a) the lease can be cancelled only upon the occurrence of some remote
2. Licensing agreements for films, videos, plays, manuscripts, patents, contingency.
copyrights, and similar items. (b) the lease can be cancelled only with the permission of the lessor.
(c) the lessee, upon cancelation, enters into a new lease for the same or
equivalent asset with the same lessor.
Moreover, PAS 17 does not apply as the basis of measurement for the following
(d) the lease can be cancelled only upon payment of an additional amount
leased assets:
or penalty of such magnitude that the lessee shall be discouraged from
1. Property held by lessees that is accounted for as investment property for
cancelling the lease.
which the lessee uses the fair value model set out in PAS 40;
2. Investment property provided by lessors under operating leases (see PAS 40)
(7.) Gains or losses from fluctuations in the fair value of the residual fall to the
3. Biological assets held by lessees under finance leases (see PAS 41)
lessee (for example, by means of a rebate of lease payments).
4. Biological assets provided by lessors under operating leases (see PAS 41)
(8.) The lessee has the ability to continue to lease for a secondary period at a rent
DEFINITION & CLASSIFICATION OF LEASE
that is substantially lower than market rent.
A lease is an agreement whereby the lessor conveys to the lessee in return for a
When a lease includes both land and building, an entity should determine the
payment or series of payment the right to use an asset for an agreed period of
separate classification of the lease of the land and the building based on the
time.
classification criteria taking into account the fact that land normally has an
indefinite economic life. Under the modification, land lease with lease term of
The classification of leases adopted in this standard is based on the extent to
several decades or longer may be classified as finance lease even if the title will
which risks and rewards incident to ownership of a leased asset lie with the
not pass to the lessee at the end of the lease term. It is because in such
lessor or the lessee. Risks include the possibilities of losses from idle capacity or
arrangement, substantially all the risks and rewards are transferred to the lessee
technological obsolescence and of variations in return due to changing economic
and the present value of the leased asset is considered negligible. However,
conditions. Rewards may be represented by the expectation of profitable
separate measurement of the land and buildings elements is not required if the
operation over the asset's economic life and of gain from appreciation in value or
lessee's interest in both land and buildings is classified as an investment property
realisation of a residual value. A lease is classified as a finance lease if it
in accordance with PAS 40 and the fair value model is adopted.
transfers substantially all the risks and rewards incident to ownership even
title may not pass to the lessee. All other leases are classified as operating
leases. Whether a lease is a finance lease or an operating lease depends on the
ACCOUNTING FOR AN OPERATING LEASE
substance of the transaction rather than its form. (substance over form)

Classification is made at the inception of the lease. The inception of the lease is LESSEE LESSOR
the earlier of the date of the lease agreement and the date of commitment by the
parties to the principal provisions of the lease. At this date, the amounts to be
AT COMMENCEMENT OF THE LEASE.
recognized at the commencement of the lease term are determined, in case of a
• Initial direct costs - often incurred by the lessor, such as commissions,
finance lease. The date from which the lessee is entitled to exercise its right to
legal fees, and other direct attributable costs in negotiating and arranging
use the leased asset is the commencement of the lease term. It is the initial
a lease, shall be presented as an addition to the carrying amount of the
recognition of the assets, liabilities, income or expenses resulting from the lease .
leased asset in the statement of financial position and recognized as an
expense over the lease term on the basis as the lease income.
Situations that would normally lead to a lease being classified as a finance lease
include the following:
Deferred IDC XX
Cash XX
(1.)There is transfer of ownership by the end of the lease term.
#
(2.) The lessee has the bargain purchase option at a price which is expected to
be sufficiently lower than fair value at the date the option becomes exercisable • Lease bonus - paid by the lessee to the lessor in addition to the periodic
that, at the inception of the lease, it is reasonably certain that the option will be rentals are treated as prepaid rent by the lessee and unearned revenue by
exercised. the lessor and to be amortized over the lease term.

(3.) The lease term is for the major part of the economic life of the asset, even if Prepaid Rent XX Cash XX
title is not transferred. PAS, unfortunately, didn't specified what percentage Cash XX Unearned Rent Income XX
represents a "major part". But, under USA GAAP, the lease term must be at least # #
75% of economic life of the leased asset. Economic life is either:
(a) the period over which an asset is expected to be economically usable • Refundable security deposits - shall be accounted for as an asset by the
by one or more users; or lessee and a liability by the lessor.
(b) the number of production or similar units expected to be obtained
from the asset by one or more users. Rent deposit XX Cash XX
Cash XX Liability for rent deposit XX
Useful life is the estimated remaining period, from the beginning of the # #
lease term, without limitation by the lease term, over which the
economic benefits embodied in the asset are expected to be consumed AT PAYMENT/RECEIPT OF THE RENT. PAS 17 provides that the lease payment
by the enterprise. should be recognized as an expense (for lessee) or revenue (for lessor) in the
income statement over the lease term on a straight-line basis, unless another
(4.) The present value of the minimum lease payments amounts to at least systematic basis is more representative of the time pattern of the user's benefit.
substantially all of the fair value of the leased asset at the inception of the lease.
Again, PAS 17 didn't set a percentage to define what "substantially all" is. Under Rent expense XX Cash XX
USA GAAP, present value of minimum lease payments must be at least 90% of Cash XX Rent income XX
fair value of the leased property. In general, minimum lease payments are # #
payments which the lessee is required to make in connection with the lease and
consist of: • Unequal rental payments - are not uniform periodic payment of rentals.
a. the total of periodic rental payments; and Such unequal rental payments much be summed and be amortized
b. any bargain purchase option price; or uniformly on the straight line basis as rent expense or income over the
c. any guaranteed residual value lease term. The lessee/lessor must, therefore, record an asset or liability
arising from the difference between the amount paid/received and the
In computing for the minimum lease payments, the discount factor to be amount recognized as lease expense or revenue.
used is the implicit interest rate if it is practically determinable;
otherwise, the lessee's incremental borrowing rate must be used. • Rent incentives - such as rent-free periods or contributions by the lessor
to the lessee's relocation costs, under SIC 15, should be recognized by the
enterprise as a reduction of the rent income or expense over the lease
term, irrespective of the incentive's nature or form, or the timing of
payments.

Leases (PAS 17) Page 1


Total Periodic Rentals
Less: Rent incentives
Total Rent income/expense over the lease term
Divided by: Lease term (in months/years)
Monthly/annual rent expense/income
If there is reasonable certainty that the lessee will obtain ownership of the leased
XX
asset at the end of the lease term, depreciation must be recorded by the lessee
(XX) based on the useful life of the asset. Otherwise, the leased asset must be
depreciated over the lease term or useful life, whichever is shorter. The
XX depreciation policy for depreciable leased assets shall be consistent with that for
XX depreciable assets that are owned, and the depreciation recognised shall be
calculated in accordance with IAS 16 Property, Plant and Equipment and IAS 38
XX Intangible Assets.

(if payment is lower than annual rent): CITERIA BASIS OF DEPRECIATION

Rent expense XX Cash XX
Cash XX Rent receivable XX 1-2 Useful Life
Rent payable XX Rent Income XX 3-8 Useful Life or Lease Term, whichever is shorter
# #

(or if payment is greater than annual rent): Depreciation expense XX

Rent expense XX Cash XX Acc. Depreciation XX
Prepaid rent XX Rent income XX #
Cash XX Unearned rent income XX
# # The accrued interest is a portion of the interest expense from the
commencement of the lease or from the last payment to the date of the next
AT PAYMENT OF OTHER COSTS. payment.
• Leasehold improvements - installed by the lessee shall be capitalized Interest expense XX
by the lessee as an asset and depreciated over the life of the improvement Interest payable XX
or the lease term, whichever is shorter. Any residual value is ignored #
by the lessee in computing the depreciation since the lessor becomes the
legal owner of the leasehold improvement in the end of the lease term. AT ACTUAL PURCHASE OF LEASE ASSET. When a lessee actually purchased
the leased asset under a finance lease, the cost of the asset purchased is equal to
Leasehold improvement XX the carrying amount of the leased asset plus any cash payment and minus the
Cash XX balance of the lease liability.
#
Carrying value of leased asset XX
• Other executory costs - incurred by any party such as real property
taxes, insurance and maintenance shall be recognized immediately as Add: Any cash payment XX
period cost in the books of who is liable for such costs in the Less: Lease liability balance (XX)
agreement.
Cost of the asset purchased XX
(if paid by the lessee):
Expense account XX Asset XX
Cash XX Lease Liability XX
# Acc. Depreciation XX
Asset under finance lease XX
(if paid by the lessor): Cash XX
Expense account XX #
Cash XX
# AT EXERCISE OF THE BARGAIN PURCHASE OPTION. Since the present
value of the minimum lease payment is already inclusive of the bargain purchase
option price, the lessee will only close the lease liability account.
ACCOUNTING FOR A FINANCE LEASE FOR LESSEES
Lease liability XX
AT COMMENCEMENT OF THE LEASE. In this date, the lessee must initially Cash XX
record the leased asset and lease liability equal to the lower of the fair value of #
the leased asset and the present value of the minimum lease payments.
However, if the bargain purchase option is not exercised, the excess of the lease
Asset under finance lease XX liability over the carrying amount of the machinery must be recognized as loss
Lease liability XX on finance lease.
#

Any initial direct costs paid by the lessee must be recognized by the lessee as Carrying value of leased asset XX
part of the leased asset. Less: Lease liability balance (XX)
Asset under finance lease XX Loss on finance lease XX
Cash XX
#
Lease liability XX
Loss on finance lease XX
AT PAYMENT OF RENTAL. In this date, the lessee must apportion its payment
Acc. Depreciation XX
of rental - first to the finance cost and the remaining as payment for the
Asset under finance lease XX
principal lease liability. An amortization table maybe necessary.
#

Date Payments Interest Amortization Carrying Value AT THE END OF THE LEASE TERM. At end of the lease term, the lessee will
Expense of Liability simply close all accounts related to the lease.
At commencement XX
Lease liability XX
At payment XX (CV x (payment - (CV - Acc. Depreciation XX
interest interest) amortization) Asset under finance lease XX
rate) #

However, if the lessee has guaranteed the residual value of the leased asset, any
Interest expense XX cash payment made to compensate the deficiency of the fair value shall be
Lease liability XX accounted for as loss in finance lease. Needless to say, if the fair value (actual
Cash XX residual value) of the leased asset is greater than the amount guaranteed by the
# lessee, no loss or gain shall be recognized since there is no cash settlement
occurred.
AT PAYMENT OF OTHER COSTS. Contingent rents paid by the lessee that is
not fixed in amount but based on factors other than passage of time such as Lease liability XX
percentage of sales, usage, price index, and market rate of interest, are expensed Acc. Depreciation XX
immediately as incurred. Loss on finance lease XX
Asset under finance lease XX
Contingent rent expense XX Cash XX
Cash XX #
#
ACCOUNTING FOR A DIRECT-FINANCING LEASE FOR LESSORS
Any executory costs paid by the lessee must be expensed immediately as
incurred. In the lessor's perspective, a finance lease is either a direct financing lease or a
sales-type lease. A lessor under direct financing lease is actually engaged in
Expense account XX financing business wherein he earns only interest income from the transaction. In
Cash XX direct financing lease, the fair value of the leased asset is equal to its cost;
# therefore, no dealer's profit is to be recognized. (FV = Cost)
AT END OF THE REPORTING PERIOD. At this date, the lessee must record Under sales-type lease, the dealer or manufacturer, in fact, is selling its products
the depreciation of the leased asset and any accrued interest, in case the in the form of lease particularly for buyers who cannot procure the product by
payment of rentals doesn't coincide with the end of the reporting period. single outlay of cash, especially when it costs a lot to buy such asset. Thus, the
dealer-lessor doesn't only recognize interest income, but also a dealer's profit on
sale. In sales-type lease, the fair value of the leased asset does not necessarily
equal to the cost of purchasing the asset. (FV ≠ Cost)

Leases (PAS 17) Page 2

AT COMMENCEMENT OF THE LEASE. At commencement of the lease term,
conceptually, the lessor should record a finance lease receivable in the balance
sheet, at an amount equal to the net investment in the lease. However, practically,
the lease receivable is recorded equal to the gross investment of the lease.
Conceptually, Lease Receivable = Net investment or
LR = Cost + IDC
AT ACTUAL SALE OF LEASED ASSET. When a lessee actually purchased
the leased asset, the lessor must account for the difference between the sales
price and the carrying value of the lease receivable.
Sales price XX
Less: carrying value of lease receivable (or LR - UII) (XX)

Practically, Lease Receivable = Gross investment or Gain (loss) on sale of leased asset XX
LR = GR + RV (or LR = GR + BPO)
Cash XX
Gross investment - the gross rentals for the entire lease term plus the absolute Unearned interest income XX
amount of residual value, whether guaranteed or not; or the absolute value of bargain Lease receivable XX
purchase option. Gain on finance lease XX
#
Net investment - the cost of the asset plus any initial direct cost incurred by the
lessor. AT THE END OF THE LEASE TERM. At end of the lease term, the lessor
will simply close all accounts related to the lease, but any difference
Unearned interest income - the total financial revenue of the lessor which is the between the carrying value of the lease receivable and the fair value of the
difference between the gross investment and net investment. asset shall be accounted for as gain or loss on finance lease.

Gross investment (GR + RV or BPO) XX Fair value of leased asset XX

Less: Net investment (Cost + IDC) (XX) Less: carrying value of lease receivable (XX)

Unearned Interest Income XX Gain (loss) on finance lease XX

Lease Receivable (GI) XX Asset account (@FV) XX

Asset under finance lease (NI) XX Loss on finance lease XX
Unearned interest income (UII) XX Lease receivable XX
# #

AT RECEIPT OF RENTAL PAYMENTS. Since the aggregate present value of the However, if the lessee has guaranteed the residual value of the leased
minimum lease payments and the unguaranteed residual value is equal the cost or asset, the lessor will received cash payment from the lessee to compensate
FV of the leased asset and the initial direct costs of the lessor (PVofGR + PVofRV = the deficiency of the fair value and therefore, no more loss shall be
Cost + IDC), the periodic rental payment can be computed as: recognized.

(If the leased asset will revert back to the lessor): Cash XX
Asset account (@FV) XX
Net investment (or Cost + IDC) XX Lease receivable XX
#
Less: PV of the residual value (XX)
Net investment to be recovered from rentals XX Needless to say, if the fair value (actual residual value) of the leased asset is
greater than the amount guaranteed by the lessee, a gain on finance lease is
Divided by: PV annuity factor of MLP XX to be recognized.
Annual rental XX
Asset account (@FV) XX
Lease receivable XX
(If the lessee obtains ownership at the end of lease term): Gain on finance lease XX
Net investment (or Cost + IDC) XX #
Divided by: PV annuity factor of MLP XX
Annual rental XX ACCOUNTING FOR A SALES-TYPE LEASE FOR LESSORS

AT THE COMMENCEMENT OF THE LEASE. Like under the direct-

Upon the receipt of the rental payment, the lessor will just credit its receipt financing type of lease, the lessor must record a finance lease receivable in
of cash to lease receivable, but need also to recognize the earned portion of its statement of financial position in equal to the gross investment of the
the unearned interest revenue using the scientific method of amortization. lease. Because the lease is accounted for as a sales-type lease, the net
investment is only the aggregate present value of the minimum lease
Date Payments Interest Amortization Present Value payments and the unguaranteed residual value.
income of Receivable
However, aside from the finance revenue to be recognized by the dealer-
At commencement XX lessor over the lease term in connection with the lease, he should include
At payment XX (PV x (payments - (PV - selling profit or loss in the same period as they would for an outright sale.
interest interest) amortization) If artificially low rates of interest are charged, selling profit should be
rate) restricted to that which would apply if a commercial rate of interest were
charged.

Cash XX Gross investment - the gross rentals for the entire lease term plus the
Lease receivable XX absolute amount of residual value, whether guaranteed or not; or the
# absolute value of bargain purchase option. (same in direct-financing)

Unearned interest income XX Net investment - the aggregate present value of the minimum lease
Interest income XX payments and the unguaranteed residual value.
#
Unearned interest income - the total financial revenue of the lessor which
Contingent rents paid by the lessee that is not fixed in amount but based on factors is the difference between the gross investment and net investment.
other than passage of time such as percentage of sales, usage, price index, and
market rate of interest, are recorded by the lessor as lease revenue. Sales - equal to the net investment or the fair value of the asset, whichever
is lower.
Cash XX
Rent Income XX Cost of sales - equal to the coat of the asset sold plus initial direct cost.
#

AT PAYMENT OF OTHER COSTS. Any executory costs paid by the lessor must be
expensed immediately as incurred. Gross investment (GR + RV or BPO) XX
Less: Net investment (PVofGR + PVofRV or PVofBPO) (XX)
Expense account XX
Cash XX Unearned Interest Income XX
#
(If the lessee guaranteed the residual value of the leased asset:
AT END OF THE REPORTING PERIOD. In case the balance sheet date doesn't Sales (Lower of NI and FV of the asset) XX
coincide with the payment date, the lessor must accrue any interest receivable. Less: Cost of sale ( Cost + IDC) (XX)
Interest receivable XX Gross profit on sale XX
Interest income XX
# (If the lessee does not guaranteed the residual value:)
AT EXERCISE OF THE BARGAIN PURCHASE OPTION. When the lessee Sales (Lower of NI and FV of the asset) - PVofURV XX
exercised the bargain purchase option, the lessor must derecognize any lease Less: Cost of sale ( Cost - PVofURV + IDC) (XX)
receivable and unearned interest income thereof.
Gross profit on sale XX
Cash XX
Unearned interest income XX
Lease receivable XX
#

Leases (PAS 17) Page 3

 Lease receivable (GI) XX
Sales (NI) XX
Unearned interest income XX
# carrying amount should be recognized immediately in the profit or
Cost of sales XX
Inventory XX
#
NOTE:
1. That the gross investment under direct financing and sales-type is the same;
2. That the net investment of the lease under direct-financing lease becomes
the cost of sale in sales-type lease;
3. That gross profit on sale under guaranteed residual value and unguaranteed
residual value is just the same; and
4. That in direct financing lease, the aggregate present value of the minimum
lease payments and the unguaranteed residual value is equal the cost or FV of the
leased asset and the initial direct costs of the lessor, but in sales type lease, it
doesn't necesaarily equal.
In direct financing, PVofGR + PVofRV = Cost + IDC
(Net investment) = (Cost of sale)
But in sales-type lease, Net investment ≠ Cost of sale
AT SUBSEQUENT TRANSACTIONS. Same as direct financing lease except for
the asset under finance lease must be accounted for as an inventory.
ACCOUNTING FOR A SALE AND LEASE-BACK
A sale and lease back is an arrangement whereby one party sells a property to
another party and then immediately leases the property back from its new owner.
Thus a seller becomes the lessee and the purchaser becomes the lessor.
The important consideration in the sale and lease back transaction is the
recognition of two separate transactions, the sale and the lease back.
The accounting treatment of a sale depends upon the type of lease involved.
For a sale and leaseback transaction that results in a finance lease, any excess of
proceeds over the carrying amount is deferred gain and amortized over the lease
term and any excess of the carrying amount over the selling price shall be
included as loss immediately.
For a transaction that results in an operating lease, the accounting treatment for
the gain or loss depends upon the selling price and the fair value of the asset.
(a) If the transaction is clearly carried out at fair value, the profit or loss should
be recognized immediately;
(b) If the selling price is below fair value, profit or loss should be recognized
immediately. However, if a loss is compensated for by future rentals at below
market price, the loss it should be amortized over the period of use.
Leases (PAS 17) Page 4
(c) If the sale price is above fair value, the excess over fair value
should be deferred and amortized over the period of use. The
difference between the fair value at the time of the transaction and the
loss.
DISCLOSURES:
FOR LESSEES:
• The net carrying amount of each class of asset at the end of
the reporting period.
• A reconciliation between the total future minimum lease
payments at the end of the reporting period and their present
value.
• The total future minimum lease payments at the end of the
reporting period and their present value for each of the
following periods:
○ Not later than one year
○ Later than one year and not later than 5 years
○ Later than 5 years
• Contingent rents recognize as expense in the period.
• The total future minimum sublease payments expected to be
received under non-cancellable subleases at the end of the
reporting period.
• A general description of the lessee's material leasing
arrangements.
FOR LESSORS:
• A reconciliation between the gross investment in the lease
and the present value of the minimum lease payments
receivable at the end of the reporting period.
• The gross investment in the lease and the present value of the
minimum lease payments receivable at the end of the
reporting period for each of the following periods:
○ Not later than one year
○ Later than one year and not later than 5 years
○ Later than 5 years
• Unearned finance income or unearned interest income.
• Unguaranteed residual value accruing to the benefit of the
lessor.
• Accumulated allowance for uncollectible minimum lease
payments receivable.
• Contingent rents recognized as income in the period.
• A general description of the lessor's material leasing
arrangements.