Intended Learning Outcomes (ILOs)

At the end of the topic, the students are expected to be able to:    

1. Articulate the nature, recognition, and presentation of Lease.

2. Determine the measurement of Right of use asset and Lease liability (Lessee's point of view).
3. Account for operating lease on the point of view of the lessor.
4. Determine the measurement of Gross investment, net investment, unearned interest income, dealer's gross profit, and other related accounts
under Lessor's Direct financing lease or Sales type lease.
5. Account for sales and leaseback.

1.1 Lease
According to International Financial Reporting Standards (IFRS) 16:                                                                
 
A lease is 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.                                                                      
 
Appendix B9 provides to be a lease, a contract must convey the right to control the use of an identified
asset.                                                                 
 
There is a right to control if the lessee obtains substantially all of the economic benefits from the use of the identified
asset.                                                                   
                                                    
The two-party involve in the contract of the lease are:                                                                           

1. Lessor - the entity that provides the right to use an asset for a period of time in exchange for
consideration.                                                                      
2. Lessee - the entity that obtains the right to use an asset for a period of time in exchange for consideration       

Lessee Accounting
Under IFRS 16, the Lessee shall account lease as a finance lease, however, paragraph 5 of the standard, permit that lessee to apply operating lease
under two optional exemptions:                                 

1. Short-term lease - the lease contract is 12 months or less only.

2. Low-value lease

Two types of Lease under Lessee’s point of view:

1. Operating lease - the lessee will only recognize lease payments as Rent expense on either a straight-line basis over the lease term or
another systematic basis.
2. Finance lease - it is defined as a lease that transfers substantially all of the risks and rewards incidental to ownership of an underlying asset.

Under IFRS 16, all lease shall be accounted as a finance lease by the lessee except for two cases discussed
above.                                                        
Recognition: The Lessee recognizes a Right-of-use asset and Lease liability at the commencement date of the lease.                                           
Presentation: The Lessee under IFRS paragraph 47 provides that the lessee shall present the Right of use asset and a Lease liability as a separate
line item in the Statement of financial position.

Right-of-use asset
Right of use asset is defined as an asset that represents the right of the lessee to use an underlying asset over the lease
term.                                                  
It comprises of the following:

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

Note: Leasehold improvements are accounted separately under PPE.                                                        

Further note, the Unguaranteed residual value is not included in the computation of Right of use asset.           

Depreciation of Right-of-use asset

The Right-of-use asset can be accounted for as property, plant, and equipment (PPE) or Investment property by the lessee.             
Subsequent measurement of Right of use asset:                                                      

1. Cost model - Cost less any accumulated depreciation and impairment loss.
2. Revaluation model - Fair value at the date of revaluation less any accumulated depreciation and impairment loss.
3. Fair value model - any increase or decrease in fair value is recorded as Gain or loss on change in fair value.

If PPE uses a or b and if Investment property uses a or b. Subsequent measurement depends on the lessee's accounting
policy.                                                      
Depreciation of the Right of use asset:                                                      

1. If there is a transfer of ownership of the underlying asset to the lessee at the end of the lease term or it is reasonably certain that the lessee
will exercise the purchase option, then, the Right of use asset is depreciated over the useful life of the underlying asset.
2. If no transfer of ownership, then, the Right of use asset is depreciated over the shorter between the useful life of the asset or the lease
term.    

Lease liability
The lease liability is the present value of the lease payments.                                                        
Lease payment shall be discounted value using the implicit interest rate in the lease.                  
If there is no implicit interest rate, then, it is discounted using the lessee's incremental borrowing rate.
Implicit interest rate is the rate the causes the present value of the lease payments and the unguaranteed residual value to be equal to the fair value of
the underlying asset and initial direct costs of the lessor.                                                 
The incremental borrowing rate is the rate that the lessee would have to pay to borrow funds necessary to obtain a similar asset over a similar term
and similar security.                                                      
The components of lease payments:                                                 
1. Fixed lease payments
2. Variable lease payments - it varies from time to time due to market price index and other related factors.
3. The 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.                                    

Note: As long as there is a residual value guarantee, the equipment will revert to the lessor automatically at the end of the lease
term.                                                     
Hence, there is no more purchase option.
Unguaranteed residual value is not included in the computation of Lease liability.

Journal entries of Lessee's finance lease

Journal entries of Lessee's finance lease
To record the Right of use asset, lease liability, and payment direct costs:                         
                                                Debit   Credit
Right of use asset       xxxxx
Lease liability                                 xxxxx
Cash                                                   xxxxx
 
To record annual lease payment:                              
Lease liability              xxxxx  
Interest expense                     xxxxx
Cash                                               xxxxx
 
To record depreciation of Right of use asset:                                   
Depreciation expense             xxxxx
Accumulated depreciation                  xxxxx 

Lessee Accounting (Illustrative problem)

Let us apply the concepts by solving the illustrative problem (Lessee accounting):
At the beginning of the current year, Namrhata Company entered into a noncancelable lease requiring year-end payments of 1,000,000 with a lease
term of 10 years.
The lessee's incremental borrowing rate is 12% and the Implicit interest rate is 10%.
Present value factors for an ordinary annuity for term periods are 6.145 at 10% and 5.65 at 12%.           
The present value factors of 1 for ten periods are 0.386 at 10% and 0.322 at 12%.
On the same date, the lessee paid an initial direct cost of P200,000.         
A purchase option that is reasonably certain to be exercised by the lessee at the end of the lease term amounts to P180,000.
The estimated life in years of the underlying asset is 12.
Requirements:

1. How much is the Right-of-use asset at the inception of the contract?

2. How much is the annual depreciation?
3. How much is the lease liability at the inception of the contract?
4. How much is the interest expense at the end of year 1?
5. What are the related journal entries from the inception of the contract to the end of year 1?

Solution:

Keynotes:

1. The direct cost incurred by the lessee is not part of the lease liability. It is only included in the Right of use asset.
2. Since the leased property will be transferred to the lessee, the year to be depreciated in 12 years, which is the useful life of the underlying
asset.
3. Interest expense is computed by multiplying the beginning balance of the lease liability to the implicit interest rate.
4. The ending balance of lease liability at year 1 is computed by subtracting the principal payment to the beginning balance of lease liability.
5. The principal payment is computed by deducting the interest payment to the annual payment.

Lessor's Accounting
IFRS 16, paragraph 61, provides that a lessor shall classify the lease as either an operating lease or a finance
lease.                                                  

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

When is lease classified as a finance lease by the lessor?                                                   

Under IFRS 16, paragraph 63, among others, any of the following situations would normally lead to a lease being classified as a finance
lease:                                                   

1. The lease transfers ownership of the underlying asset to the lessee 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 the option
becomes exercisable. At the inception of the lease, it is reasonably certain that the option will be exercised.
3. The lease term is for a major part of the economic life of the underlying asset even if the title is not transferred.

Note: US GAAP determines the major part as at least 75% of the economic life of the asset.       

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.

Note: US GAAP determines "substantially all" implies 90%.             

Lessor's operating lease

IFRS 16, paragraph 81, provides that a lessor shall recognize lease payments from operating lease as income either on a straight-line basis or another
systematic basis.             
With this regards, the lessor under Operating lease will account for the following:                                  

1. Recognize Rent income on a fixed amount regardless, if the actual rental is fluctuating (Total Contract price divided by lease term).
2. The leased property is still an asset of the lessor and is considered as Investment property subject to depreciation and impairment loss (if
Cost model) and subject to changes in fair value (if Fair model).
3. Initial direct costs incurred by the lessor is added on the carrying amount of the Investment property and subject to depreciation.
4. The lease bonus received by the lessor from the lessee is recognized as Unearned rent income and is amortized over the lease term.
5. Security deposit refundable upon the lease expiration shall be accounted for as Liability by the lessor.

Journal entries for Lessor's Operating lease          

                                          
To record average annual rentals:                                                    
                                    Debit   Credit                         
Cash                            xxxxx                                      
Rent receivable                       xxxxx                                      
Rent income                            xxxxx                          
 
To record refundable deposits:                                                         
Cash                            xxxxx                                      
Security deposit                                  xxxxx                          
 
Note that Lessor will present the leased property as an Investment property and the related accounting for Investment property should be accounted for
by the Lessor.
On the other hand, the lessee will not record the leased property as an asset.             

Lessor's operating lease (Illustrative problem)

Let us apply the concepts by solving the Illustrative Problem:                                                         
On January 1, 2020, Sushmita Company leased a building to Aishwarya under an operating lease with a lease term of 5
years.                                                         
Annual rental is P900,000. Aishwarya paid P500,000 to Sushmita as lease bonus and       
a security bonus of P250,000  refundable upon the expiration of the lease contract.                                 
Requirements:                                               
How much is the rental income for the current year?                                                         
What are the related journal entries (Book of the lessor)?  

Keynotes:

1. The lease bonus paid by the lessee to the lessor is added to the total contract price.
2. The straight-line method is used to determine the rental income for the period.
3. At the end of the period, the lease bonus initially recorded as Unearned rent is adjusted.

Lessor's Direct finance lease

Lessor's will treat finance lease as either:                                                    

1. Direct financing lease - Under this method, the lessor is a financing institution and interest income is the only form of income.            
2. Sales type lease - Under this method, the lessor is a dealer and recognizes interest income and gross profit.

Lessor’s Direct financing

Three accounts need to be considered:                                                        
Gross investment - The gross rentals for the entire lease term plus the absolute amount of the residual value, whether guaranteed or unguaranteed. It
is the lease receivable.
Note: If ownership is transferred to the lessee at the end of the lease term, then, the residual value is not included.                  
Net investment - The cost of the leased asset plus any initial direct cost paid by the lessor
Or PV of Annual lease payment + PV of guaranteed residual value                                    
Note: If ownership is transferred to the lessee at the end of the lease term, then, PV of residual value is not included.                                               
Unearned interest - The difference between the gross investment (lease receivable) and net investment (leased asset).
 
Pro-forma journal entries:                                                     
 
To set up lease receivable and unearned interest income:                                                  
                                                                       Debit   Credit                         
Lease receivable                                 xxxxx                                      
Machinery / (Leased property)                     xxxxx                          
Unearned interest income                              xxxxx                          
 
To record annual collection:                                                  
Cash                                                    xxxxx                                      
Lease receivable                                             xxxxx                          
 
To record interest income:                                                    
Unearned interest income       xxxxx                                      
Interest income                                             xxxxx              

Direct finance lease (Illustrative problem)

Zozibini Company is in the business of leasing new sophisticated equipment.
The lessor expects a 14% return on net investment. All leases are classified as a direct financing lease.                                     
At the end of the lease term, the equipment will revert to the lessor.                                            
At the beginning of the current year,  equipment is leased to a lessee with the following information:                                       
Cost of equipment to the lessor                                 P4,370,000     
Residual value - unguaranteed                                   0         
Annual rental payable at the end of each year          800,000          
The initial direct cost incurred by the lessor              150,000          
Useful life and lease term in years                            10       
The implicit interest rate of 14%    
Requirements:                                   

1. How much is the gross investment in the lease?                                          

2. How much is the net investment?                                         
3. How much is the unearned interest over the lease term?                                       
4. How much is the interest income for the current year?                                           

Solution:

Since there is an additional direct cost, the 14% implicit interest rate will be adjusted.
We need to Interpolate for the new implicit interest rate:

Lessor's Sales type lease

Since the lessor is a dealer, aside from interest, we also have to recognize a gross profit.
The accounts to be considered:

1. Gross investment - The gross rentals for the entire lease term plus the absolute amount of the residual value, whether guaranteed or
unguaranteed (if any) plus the Purchase option (if any). It is the lease receivable.

Gross rentals + Residual value + Purchase option = Gross investment                                            

Note: The purchase option should be reasonably certain to be included in the gross investment.                                     

2. Net investment – Present value (PV) of the gross rentals plus PV of residual value whether guaranteed or unguaranteed (if any) plus PV
Purchase option (if any).            
3. Unearned interest - The difference between the gross investment (lease receivable) and net investment.
4. Sales revenue - Net investment in the lease minus PV of unguaranteed residual value or Fair value of asset whichever is lower.
5. Cost of goods sold - Cost of the asset minus PV of unguaranteed residual value plus initial direct cost paid by the lessor.
6. Gross profit = Sales deduct COGS

 
Pro-forma journal entries:                                                     
To set up lease receivable and unearned interest income:                                                  
                                                         Debit   Credit                         
Lease receivable                     xxxxx                                      
Sales                                                             xxxxx                          
Unearned interest income              xxxxx                          
 
To record cost of goods sold:                                                 
Cost of goods sold                  xxxxx                                      
Inventory                                             xxxxx                          
 
To record annual collection:                                                  
Cash                                        xxxxx                                      
Lease receivable                                xxxxx                          
 
To record interest income:                                                    
Unearned interest income   xxxxx                                      
Interest income                                       xxxxx              

Sales type lease (Illustrative problem)

To apply the concepts, let us solve the Illustrative problem:                                    
Mariah Company used leases as a method of selling products.
On January 1, 2020, the ferry was leased to the Celine Company on a contract specifying that ownership of the ferry will                                      
transfer to the lessee at the end of the lease period.                                               
Original cost                                                   P1,000,000     
Lease payment at the end of the year           500,000          
Purchase option                                              200,000          
Initial direct cost                                             100,000          
Implicit interest rate                                       8%      
Lease term (in years)                                      4         
The present value of an annuity due of 1 at 10% for 20 periods  3.312  
The present value of 1 at 12% for 20 periods                               0.735  
Requirements:                                   

1. How much is the gross investment in the lease?                                          

2. How much is the net investment in the lease                                               
3. How much is the gross profit on sale for 2020?                                            
4. How much is the interest income for 2020?                                     
5. What is the related journal entry?       
Keynotes:

1. Since the purchase option is reasonably certain to be exercised by the lessee, then it is included in the computation of gross investment and
net investment.
2. Under a sales-type lease, the lessor will also record sales revenue and cost of goods sold.

Sales and leaseback agreement

Under this type of lease there are two transactions:                                    

1.  A sale
2. A lease agreement                                    

The party involved are:                                              

1. Seller - Lessee
2. Buyer - Lessor

Rationale: Proper cash management on the side of Seller-Lessee and possible tax advantages on the side of Buyer-Lessor.
 
To understand more, let us solve the Illustrative problem:
At the beginning of the current year, Arianna Company sold the building and immediately lease it back. Related
data:                                                 
Sales price                               9,000,000                   
The fair value of building              8,000,000                   
Carrying amount of building  7,200,000                   
Annual rental payable at the end of each year          600,000                      
Lease term (in years)                          4                     
The remaining life of the machine (in years) 20                   
The implicit interest rate of 12%                
PV of an ordinary annuity of 1                        3.037              
Requirements:
How much is the lease liability?
How much is the Right-of-use-asset?
How much is the Gain on right transferred?
What are the related journal entries (Lessor and Lessee)?
 
Solution:

Summary
1. A lease is 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.
2. The two-party involve in the contract of the lease are: a) Lessor - the entity that provides the right to use an asset for a period of time in
exchange for consideration and b) Lessee - the entity that obtains the right to use an asset for a period of time in exchange for consideration
3. Two types of Lease under the Lessee’s point of view: a)Operating lease - the lessee will only recognize lease payments as Rent expense on
either a straight-line basis over the lease term or another systematic basis, and b)Finance lease - it is defined as a lease that transfers substantially
all of the risks and rewards incidental to ownership of an underlying asset.                        
4. Lessor will treat finance lease as either: a) Direct financing lease - Under this method, the lessor is a financing institution and interest income
is the only form of income or b) Sales type lease - Under this method, the lessor is a dealer and recognizes interest income and gross profit.
5. In a sales and leaseback agreement, there are two transactions, a sale, and a lease agreement.

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