LEASE ACCOUNTING

LECTURE NOTES

Lease - 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 (IFRS #16)

Requisites:
 Right to control the use – obtain substantially all of the economic benefits from the
use of an identified asset

 Identified asset – explicitly specified in a contract (e.g, a building, equipment, etc.)

Lessee – the entity that obtains the right to use an underlying asset for a period of time
in exchange for consideration

Lessor – the entity that provides the right to use an underlying asset for a period of time in
Exchange for consideration

Two types of Lease:

1. Operating lease - periodic rental is recognized as rent expense (normal rental)

Rent Expense Pxxxx

Cash or AP Pxxxx

- There is no transfer of ownership at the end of the lease period

2. Finance lease - transfers substantially all of the risks and rewards incidental to
ownership of an underlying asset.

Right of use asset Pxxxx

Lease liability Pxxxx

- There is a transfer of ownership at the end of the lease period

ACCOUNTING FOR LEASES - LESSEE

Note: The new standard (IFRS16) requires that all leases shall be accounted by the lessee
as finance lease.

Prior to the new standard, the lessee can record lease as either as an operating lease
(if there is no transfer of ownership at the end of the lease term) or a finance lease
(if there is a transfer of ownership at the end of the lease term).

However, under the new standard, the lessee is permitted to apply operating lease
accounting under two exemptions (optional):

- Short term lease - if lease term is not more than 12 months (1 year)

- Low value – it is based on the value of the asset when it is new regardless whether
 the asset being leased is already old

Ex: computers, office furniture and equipment.

Initial measurement of right of use asset

The cost of right of use asset comprises:

- The present value of lease payments or the initial measurement of the lease liability

- Lease payments made to lessor at or before commencement date, such as lease

bonus, less any lease incentives received

- Initial direct costs incurred by the lessee

- Estimate cost of dismantling, removing and restoring the underlying asset for which
the lessee has a present obligation.

Subsequent measurement of right of use asset

Right of use asset is subsequently measured under the cost model, that is:

Cost minus Accumulated depreciation

Right of use asset is to be depreciated over its useful life if:

 There is a transfer of ownership to the lessee after the lease term

Or

 There is a reasonable certainty that the lessee will exercise a purchase option**

** Purchase option - the right given to a lessee that he may purchase the asset
after the lease term. He may or may not exercise the
purchase option

If the there is no transfer of ownership or there is no reasonable certainty that the lessee
will exercise the purchase option, right to use asset is to be depreciated over its useful
life or lease term, whichever is shorter

Initial measurement of Lease liability

Measured at the present value of the lease payments at the commencement date.

Lease payments include the following:

1. Fixed payments less incentive receivables, if any

2. Variable lease payments
 3. Exercise price of a purchase option (if the lessee is reasonably certain to exercise the
option)
4. Amount expected to be payable by the lessee under a residual value guarantee
5. Termination penalties if the lease term reflects the exercise of a termination option.

COMPREHENSIVE EXAMPLE:

On January 1, 2020, XYZ Corp leased a machine with the following provisions:

Annual lease payments at the end of

each year, starting January 31, 2020 1,000,000
Lease term 10 yrs
Useful life of machine 15 yrs
Implicit interest rate in the lease 12%
PV of an ordinary annuity of 1% at 12% for 10 periods 5.650
PV of an annuity of 1 in advance at 12% for 10 periods 6.328
PV of 1 at 12% for 10 periods 0.322
Residual value – at the end of 15-year useful life 300,000

The entity has an option to purchase the machine on January 1, 2030 by paying
P200,000.

At the commencement date, it is reasonably certain that the purchase option will
be exercised.

Solution:

1. Compute first for PV of the annual rent:

PV of lease payment (P1M x 5.650) 5,650,000
PV of purchase option (P200k x 0,322) 64,400
Total lease liability 5,714,400

2. Construct an amortization table:

Date Payment Interest Principal Present Value

Jan 1, 2020 5,714,400
Dec 31, 2020 1,000,000 685,728 314,272 5,400,128
Dec 31, 2021 1,000,000 648,015 351,985 5,048,143
Dec 31, 2022 1,000,000 605,777 394,223 4,653,920
Dec 31, 2023 1,000,000 558,470 441,530 4,212,390
Dec 31, 2024 1,000,000 505,487 494,513 3,717,877
Dec 31, 2025 1,000,000 446,145 553,855 3,164,022
Dec 31, 2026 1,000,000 379,683 620,317 2,543,705
Dec 31, 2027 1,000,000 305,245 694,755 1,848,950
Dec 31, 2028 1,000,000 221,874 778,126 1,070,824
Dec 31, 2029 1,000,000 128,499 870,824 200,000

Journal entries:
 Date Debit Credit
Jan 1, 2020 Right of use asset 5,714,400
Lease liability 5,714,400

Dec 31, 2020 Interest Expense 685,728

Lease liability 314,272
Cash 1,000,000
Depreciation Exp. 360,960
Acc. Dep. 360,960
PV - 5,714,400
Less: RV 300,000
Net 5,414,400
Divided by 15 yrs
Annual Dep 360,960

Dec 31, 2021 Interest Expense 648,015

Lease liability 351,985
Cash 1,000,000

Depreciation exp. 360,960

Acc. Dep. 360,960

Continue the same entries until the end of the lease, Dec. 31,
2029

Case 1 : If the purchase option is exercised, and the XYZ purchased the
equipment for P2.5M, the entry at the end of the lease term
would be:

Jan 1, 2030 Lease liability 200,000

Cash 200,000

Equipment 4,604,800
Acc. Dep 3,609,600
Right of use asset 5,714,400
Cash 2,500,000
 Case 2: If the purchase option is NOT exercised, the entry would be:

Jan 1, 2030 Accumulated depreciation 3,609,600

Lease liability 200,000
Loss on finance lease 1,904,800
Right of use asset 5,714,400

Right of use asset 5,714,400

Acc. Dep (360,960 x 10years) 3,609,600
Carrying amount – Jan 1, 2030 2,104,800
Lease liability – Jan 1, 2030 200,000
Loss on finance lease 1,904,800

Note: Purchase option not exercised simply mean, the equipment will
be returned back to the lessor as the lease has already expired.

Residual value guaranteed:

Using the same problem, let us assume that the residual value of P200,000
is guaranteed. In cases where residual value is guaranteed, there
should be no more purchase option as the equipment will be returned
back to the lessor after the lease term. The residual value will be part in
determining the
cost of right of use asset:

PV of lease payments (P5M x 5.650) 5,650,000

PV of residual value guarantee (P300k x 0.322) 96,600
Cost of right of use asset and lease liability 5,746,600

Do this Create the same amortization table using the above amount,
P5,746,600

Important: The annual depreciation will now be based on the lease term
(10 yrs) instead of the useful life (15 years) because it is
certain that the equipment will be returned back to the lessor.

Cost P5,746,600
Residual value 300,000
Net P5,446,600
Divided by 10 yrs (lease term)
Annual depreciation 544,660

At the end of the lease term, the entry then would be:

Accumulated depreciation P5,446,600

Lease liability 200,000
Right of use asset 5,746,600

Note that the debit to lease liability should equal to the residual value
If for example, the fair value of the equipment at the end of the lease term is
less than the residual value guarantee, then the lessee should pay the lessor
for the difference:

Example: The fair value of the equipment on Dec 31,2030 is P160,000:

Loss on finance lease P40,000

Cash P40,000
( RV – FV = P200k – P160k)