CHAPTER 3

LEASE ACCOUNTING

LEASE

IFRS 16 is the new lease standard.

Lease is defined as a contract or part of a contract that conveys the right to use the underlying asset for
a period of time in exchange for consideration.

The lessee is the entity that obtains the right to use an underlying asset for a period of time in exchange
for consideration.

The lessor is the entity that provides the right to use an underlying asset for a period of time in
exchange for consideration.

New lease standard provides that to be a lease, a contract must convey the right to control the use of an
identified asset. An asset is typically identified by being explicitly specified in a contract or implicitly
specified when made available to the customer. Example, a physically distinct portion of an asset such as
floor of a building could be considered an identified asset.

Right to control the use of an asset

A contract conveys the right to control the use of an asset if throughout the period of use, the customer
has the right to:

a. Obtain substantially all of the economic benefits from the use of the identified asset.
i. This is by having exclusive use of the asset throughout the period of use.
b. Direct use of the identified asset
i. The customer has the right to direct how and for what purpose the asset is used
throughout the period of use.

Operational lease model for lessee

Provides that a lessee is permitted to make an accounting policy election to apply the operating lease
accounting and not recognize an asset and lease liability in two optional exemptions:

a. Short-term lease
i. Lease that has a term of 12 months or less at the commencement date of the lease
b. Low value lease
i. The new lease standard does not provide for a quantitative threshold for low value
asset. Low value asset is a matter of professional judgment.

Under the operating lease model, the periodic rental is simply recognized as rent expense on the part of
the lessee.

Finance lease model for lessee

Under the new standard, all leases shall be accounted for by the lessee as a finance lease.

The standard provides that at the commencement date, a lessee shall recognize a right of use asset and
a lease liability.
Initial measurement of right to use asset

The lessee shall measure the right to use asset at cost at commencement date. Cost of right of use asset
comprises:

a. The present value of lease payments or the initial measurement of the lease liability.
b. Lease payments made to lessor at or before commencement date, such as lease bonus, less any
lease incentives received.
c. Initial direct costs incurred by the lessee.
d. Estimate of cost of dismantling, removing and restoring the underlying asset for which the
lessee has a present obligation.

Lease incentives are payment made by the lessor to the lessee associated with a lease or the
reimbursement or assumption by the lessor of the costs of the lessee.

Initial direct costs are incremental costs of obtaining a lease that would not have been incurred if the
lease had not been obtained.

Leasehold improvements are not initial direct cost but rather recorded separately as property, plant
and equipment.

Security deposit refundable upon the lease expiration is accounting for as an asset by the lessee.

The lessee shall present the right of use of asset as a separate line item in the statement of financial
position. It may also include as part of PPE provided it will disclose that PPE includes right of use of
asset.

Subsequent measurement of right of use asset

To apply the cost model, the lessee shall measure the right of use asset at cost less any accumulated
depreciation and impairment loss.

If a lessee applies the fair value model in measuring investment property, the lessee shall also apply the
fair value model to the right of use asset that meets the definition of investment property.

If the right of use asset relates to of class PPE to which the lessee applies the revaluation model, a lessee
may elect to apply the revaluation model to all of the right of use assets that relate to that class of PPE.

Depreciation of right of use asset

The lessee shall apply normal depreciation policy for right of use asset.

PFRS 16 provides that the lessee shall depreciate the right of use asset over the useful life of the
underlying asset under the following conditions:

1. The lease transfers ownership of the underlying asset to the lessee at the end of lease term.
2. The lessee is reasonably certain to exercise a purchase option

Otherwise, the lessee shall depreciate the right of use asset over the shorter between the useful life of
the asset and the lease term.

Measurement of lease liability

The standard provides that at the commencement date, the lessee shall measure the lease liability at
the present value of lease payments. The lease payments shall be discounted using the interest rate
implicit in the lease. If the implicit interest rate cannot be determined, the incremental borrowing rate
of the lease is used.

Interest rate implicit Interest rate that caused the present value of the lease payments and the
unguaranteed residual value to equal the fair value of the underlying asset
and initial direct costs of the lessor.
Lessee’s incremental The rate of interest that the lessee would have to pay to borrow funds
borrowing rate necessary to obtain a similar asset over a similar term and similar security.

The interest is the difference between the face value of gross fixed payment and the present value of
the lease liability.

Components of lease payments

The lease payments comprise the following payments for the right to use the underlying asset during
the lease term:

a. Fixed lease payments

 Payments made by the lessee to the lessor for the right to use an underlying asset
during the lease term.
b. Variable lease payments
 Payments made by the lessee for the right to use an underlying asset during the lease
term that vary because of changes in facts or circumstances occurring after the
commencement date other than passage of time. Example, payments linked to
consumer price index or benchmark interest rate are included in the lease payments.
c. Exercise price of a purchase option if the lessee is reasonably certain to exercise the option
d. Amount expected to be payable by the lessee under a residual value guarantee
e. Termination penalties if the lease term reflects the exercise of a termination option

Residual value guarantee is the guarantee made to the lessor by a party unrelated to the lessor that the
value of an underlying asset at the end of the lease term will be at least a specified amount.

As long as there is a residual value guarantee, there is no more purchase option because the equipment
will revert to the lessor upon the expiration of the lease on December 31, 2023.

If the equipment is returned to the lessor, the residual value guarantee is not paid by the lessee to the
lessor because the underlying asset is simply transferred by the lessee to the lessor to satisfy the liability
for the residual value guarantee.

If there is a residual value guarantee, the depreciation is based on the lease term.

Unguaranteed residual value is that portion of the residual value of the underlying asset, the realization
of which by the lessor is not assured or is guaranteed solely by a party related to the lessor.

The unguaranteed residual value is ignored in computing the depreciable amount.

Executory costs are ownership expenses such as maintenance, taxes and insurance for the underlying
asset. Such executory costs are expenses immediately when incurred.

Presentation in Statement of Financial Position

The right of use asset is reported as a separate line item under noncurrent assets. The lease liability is
reported as partly current and partly noncurrent.

Actual purchase of underlying asset

An entity can actually purchase an equipment that it has been leasing under a finance lease. The cost of
the asset purchased is equal to the carrying amount of the leased asset plus cash payment minus the
balance of the lease liability.

Other notes

If the fair value of the underlying asset is less than the residual value guarantee, a loss is reported for
the difference and the lessee must make up for the difference with a cash payment. Needless to say, of
the fair value is higher than the residual value guarantee, no additional entry is necessary because there
is no cash settlement.

The initial direct cost and lease incentive received are included in the measurement of the cost of right
of use asset but excluded in the measurement of lease liability. The initial indirect cost is added and the
lease incentive received is deducted in computing the cost of right to use asset.

LEASE MODIFICATION

PFRS 16 provides that the lessee shall account for the lease modification as a separate lease under the
following conditions:

a. The modification increases the scope of the lease by adding the right to use an additional
underlying asset.
b. The rental for the lease modification increase by an amount commensurate with the increase in
scope and equivalent to the current marker rental.

Decrease in scope

PFRS 16 states that a gain or loss should be recognized as a result of the partial termination of the lease.

If the decrease in carrying amount of lease liability is higher than the decrease in carrying amount of
right of use asset, the difference is a termination gain.

If the decrease in carrying amount of right of use asset is higher than the decrease in carrying amount of
lease liability, the difference is a termination loss.

OPERATING LEASE – LESSOR

PFRS 16 provides that a lessor shall classify leases as either an operating lease or a finance lease.

Finance lease – is a lease that transfers substantially all the risks and rewards incidental to ownership of
an underlying asset.

The following situations would normally leas to a lease being classified as a finance lease by the lessor:

a. Transfers ownership at the end of lease term.

b. Option to purchase the asset at a price sufficiently lower that the fair value. At the inception, it
is reasonably certain that the option will be exercised.
c. The lease term is for the major part of the economic life.
 d. 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.

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

- PFRS 16 provides that a lessor shall recognize lease payments from operating lease as income
either on a straight line basis or another systematic basis. If the lease requires unequal cash
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.

- The lessor bears all ownership or executory costs such as depreciation, property taxes,
insurance and maintenance. However, the lessor may pass on to the lessee the payment.

- Initial direct cost incurred by the lessor in an operating lease shall be added to the carrying
amount of the underlying asset and recognized as an expense over the lease term on the same
basis as the lease income.

- Any security deposit refundable upon the lease expiration shall be accounted for as liability by
the lessor.

- Any lease bonus received by the lessor from the lessee is recognized as unearned rent income to
be amortized over the lease term.

DIRECT FINANCING LEASE – LESSOR

On the part of the lessor, a finance lease is either:

- Direct financing lease

- Recognizes only interest income
- Sales type lease
- Recognizes interest income and gross profit on sale.

Direct financing lease

The lessor in a direct financing lease is actually engaged in the financing business. Thus, a direct
financing lease is an arrangement between a financing entity and a lessee. The income of the lessor is
only in the form of interest income. No dealer profit is recognized because the fair value and the cost of
the asset are equal.

Accounting considerations

1. Gross investment this is equal to the gross rentals for the entire lease term
plus absolute amount of the residual value, whether
guaranteed or unguaranteed.
2. (Net investment in the lease) this is equal to the cost of the asset plus any initial cost
paid by the lessor.

The procedure is to divide the net investment in the lease

to be recovered from rental by the present value factor of
 an annuity of 1 of a number of periods using a desired rate
of return to get the annual rental.
3. = Unearned interest income This is the difference between the gross investment and
net investment in the lease

4. Initial direct cost – in a direct financing lease, the initial direct cost paid by the lessor is added to
the cost of the asset to get the net investment in the lease. This would effectively spread the
initial direct cost over the lease term and reduce the amount of interest income.

PFRS 16 states that lessors shall recognize assets held under a finance lease as a receivable at an amount
equal to the net investment in the lease.

The PV of the residual value is deducted from the cost of the asset if the machinery will revert to the
lessor at the end of the lease term. Otherwise, if the machinery will not revert to the lessor at the end of
the lease term, the residual value is completely ignored.

If the machinery will not revert to the lessor at the end of the lease term because the lease provides for
a transfer of title to the lessee, the residual value is completely ignored in the computation of the annual
rental and the unearned interest income.

Sales Type Lease - Lessor

The lessor in a sales 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 considerations

1. Gross investment this is equal to the gross rentals for the entire lease term
plus absolute amount of the residual value, whether
guaranteed or unguaranteed.
2. (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.
3. = Unearned interest income This is the difference between the gross investment and
net investment in the lease
4. Sales The amount equal to the net investment in the lease
(present value of lease payments) or fair value of the
asset, whichever is lower
5. Cost of goods sold This is equal to the net investment in the lease (PV of lease
payments) or fair value of the asset, whichever is lower
6. Gross profit This is the usual formula of sales minus cost of goods sold
7. Initial direct cost This amount is expensed immediately in a sales type lease
as component of cost of goods sold

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.
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 PV of the unguaranteed residual value is not included in the
sales revenue.

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

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.

SALE AND LEASEBACK

A sale and leaseback is an arrangement whereby one party sells an asset to another party and then
immediately leases the asset back from the new owner. Thus, the seller becomes a seller-lessee and the
buyer, a buyer-lessor.

A sale and leaseback transaction may occur when the seller-lessee is experiencing cash flow or financing
problem or because there are tax advantages in such an arrangement in the lessee’s jurisdiction.
Moreover, the seller-lessee would like to avoid the burden of paying the executory costs attendant to
the asset, such as repairs, insurance and taxes.

Transfer of the asset is a sale

PFRS 16 provides that the transfer of an asset must satisfy the requirements for the recognition of sale
in order to be accounted for as sale and leaseback. The important consideration in a sales and leaseback
transaction is the recognition of two separate and distinct transactions. However, it is important to note
that there is no physical transfer of asset.

First – there is a sales; Second – there is a lease agreement for the same asset in which the seller is the
lessee and the buyer is the lessor.

However, the lease rent and the sale price are usually interdependent as they are negotiated as a
package.

Measurement of right of use asset

PFRS 16 provides that the seller-lessee shall measure the right of use asset arising from the leaseback at
the proportion of the previous carrying amount of the asset that relates to the right of use retained by
the seller-lessee. Simply stated, the cost of the right of use asset is equal to a fraction whose numerator
is the present value of lease liability and whose denominator is the fair value multiplied by the carrying
amount of the asset.

Gain or loss to be recognized

PFRS 16 provides that the gain or loss that pertains to the right retained by the seller-lessee is not
recognized. The right retained by the seller-lessee is the proportion of the initial lease liability in relation
to the fair value of the asset.

The gain or loss that pertains to the right transferred to the buyer-lessor is recognized. The right
transferred to the buyer-lessor is the fair value of asset minus the initial lease liability.

Sales price above fair value

PFRS 16 provides that if the sales price does not equal the fair value of the underlying asset, the seller-
lessee shall make adjustment to measure the sale price at fair value. Any excess sale price over fair value
shall be accounted for as additional financing provided by the buyer-lessor to seller-lessee.

Sales price below fair value

PFRS 16 provides that if the sale price does not equal the fair value of the asset, the seller-lessee shall
make adjustment to measure the sale price at fair value. If the sale price is below fair value, the
difference is accounted for as prepayment of rental.

Transfer of asset is not a sale

PFRS 16 provides that if the transfer of an asset by the seller-lessee does not satisfy the requirements
for the recognition of a sale:

a. The seller-lessee shall continue to recognize the transferred asset and shall recognize a financial
liability equal to the transfer proceeds. The entry is debit cash and credit lease liability for the
transfer proceeds. The rental or lease payment is accounted for as part payment of interest
expense and part payment of the principal lease liability. The interest is computed based on the
implicit interest rate using the effective interest method.
b. The buyer-lessor shall not recognize the transferred asset but shall recognize a financial asset
equal to the transfer proceeds. The entry is debit lease receivable and credit cash. The rental or
lease payment from the seller-lessee is accounted for as part of collection of interest income
and part collection of the principal lease receivables.