CHAPTER 13- LEASES

Learning Objectives:

 Differentiate between a Finance lease and operating lease.

 Accounting for finance leases by lessees and lessors.

 Accounting for operating leases by lessees and lessors

Leases - an agreement whereby the lessor conveys to the lessee, in return for a payment or series of
payments, the rights to use an asset for an agreed period of time.
✓ include hire purchase contract

Classification of Leases
Finance Lease- a lease that transfers substantially all the risk and rewards incidental to ownership
of an assets.
Operating Lease- a lease that does not transfer substantially all the risk and rewards incidental to
ownership of an assets

The following resulted to Finance Lease:

1. Transfer of ownership
2. Bargain purchase option
3. The lease term is for the major part of the economic life of the asset (‘75% criterion’).
4. The present value of the minimum lease payments is at least substantially all of the fair value of
the leased asset (‘90% criterion’).
5. The leased asset is specialized nature.

Lease of Land and Building

 Classified separately as either operating or finance lease.

 Minimum lease payment is allocated based on the relative fair value of leasehold interest.
 If cannot be allocated reliably, entire lease are classified as finance lease. Unless clearly
stated as both are operating lease.
 If land elements are immaterial, both are treated as single unit and classified as finance and
operating lease.
 Inception of lease- earlier of the date of the lease agreement and the date of commitment by the
parties.
 Classified either operating or finance lease.
 If finance lease, amount to be recognized are determined.

 Commencement of lease term- the date from which the lease is entitled to exercise its right to use
the lease asset.
 FINANCE LEASE

 Accounting for Finance lease by lessees

 Fair value of the leased property at inception date

 Present value of the minimum lease payments at inception date

Minimum Lease Payments:

• Rentals, excluding contingent rent, costs for services and taxes reimbursable to the lessor;

• Bargain purchase option; and

• Guaranteed residual value

Contingent rent

-is lease payment that is not fixed in amount but rather based on the future amount of a factor that changes
other than with the passage of time

• Interest rate implicit in the lease- if determinable

• Incremental borrowing rate- if not determinable

 Initial direct cost- are capitalized as part of the asset recognized.

 Accounting for Finance lease by lessors

 Net investment in the lease

• Initial direct cost- are included in the initial measurement of the finance lease receivable and
reduce the amount of revenue recognized over the lease term.

• Interest rate implicit in the lease- is the discount rate that, at the inception of the lease, causes
the aggregate present value of:

 The minimum lease payments

 The unguaranteed residual value

• The lease receivable- is subsequently similar to an amortized cost financial asset.

Illustration:

On January 1, 20x1, Lessee enters into a 4-year lease of machinery with Lessor. Ownership of the
machinery will be transferred to the Lessee at the end of the lease term. Annual rent payable at the end of
each year is P100,000. The implicit interest rate, known to Lessee, is 10%.

Lessee estimates that the remaining useful life of the machinery is 5 years.

The machinery has a historical cost of P1,000,000 and accumulated depreciation of P683,013 in the books
of the Lessor.

 Initial Measurement:
The present value of the lease payments is computed as follows:

Annual rental 100,000

Multiply by: PV ordinary annuity of 1 @10%, n=4 3.169865
PV of lease payments- 1/1/x1 316,987

Books of Lessee Books of Lessor

1/1/x1 1/1/x1
Leased Assets, Machinery Finance Lease Receivable 400K(a)
And Equipment 316,987 Accumulated Depreciation 683,013
Finance Lease Payable 316,987 Deferred Finance Lease
Revenue 83,013(b)
Machinery 1M

(a)
100,000 annual rent x 4 yrs. = 400,000 Finance Lease Receivable (Gross investment in the
lease)

400,000 Gross investment in the lease – 316,987 Net investment in the lease = 83,013 Deferred
(b)

Finance Lease Revenue (Unearned Interest income)

 Subsequent measurement:

Date Payments Interest Amortization Present Value

1/1/x1 316,987
12/31/x1 100,000 31,699 68,301 248,685
12/31/x2 100,000 24,869 75,131 173,554
12/31/x3 100,000 17,355 82,645 90,909
12/31/x4 100,000 9,091 90,909 0

Books of Lessee Books of Lessor

12/31/x1 12/31/x1
Interest Expense 31,699 Cash-Collecting Officers 100K
Finance Lease Payable 68,301 Deferred Finance Lease
Cash-Modified Disbursement Revenue 31,699
System (MDS), Regular 100K Interest Income 31,699
 Finance Lease Receivable 100K
12/31/x1
Depreciation-Leased Assets,
Machinery & Equipment 63,397(c)
Accumulated Depreciation
Leased Assets, Machinery
& Equipment 63,397

(c)
(316,987 ÷ 5 yrs.) = 63,397 annual depreciation. The leased asset is depreciated over its useful life
because there is reasonable certainty that the lessee will obtain ownership by the end of the lease term.

Journal entries in subsequent periods follow the same pattern.

OPERATING LEASE

-Lessee (lessor) recognizes the lease payment as expense (income) on a straight line basis over the lease
term, unless another systematic basis is more representative if the time pattern of the user’s benefit.

-Initial direct costs incurred by lessors are added to the carrying amount of the leased asset and
recognize as expense over the lease term on the same basis as the lease income.

-Initial direct costs incurred by lessees (such as lease bonus paid to the lessor) are treated as prepaid rent
and recognize as expense on the same basis as the lease expense.

Illustration:

On January 1, 20x1, Lessor acquires a machine for P1M and immediately leases it out to Lessee under a
3-year non-cancellable lease. Lessor incurs initial direct cost of P90,000 in negotiating the lease. The
estimated useful life of the machine is 10 years with no residual value. The lease is an operating lease to
both Lessor and Lessee. The lease payments, payable at each year-end, are as follows:

Year Rentals
20x1 145,000
20x2 115,000
20x3 100,000

 The annual lease income (expense) on a straight line basis is computed as follows:
Year Rentals
20x1 145,000
20x2 115,000
20x3 100,000
Total Rentals 360,000
Divided by: Lease Term 3
Annual lease income/expense 120,000
 Books of Lessor Books of Lessee
1/1/x1 1/1/x1
Machinery and Equipment 1.09M(d) No entry
Cash-Modified Disbursement
System (MDS), Regular 1.09M

(d)
(1 M cost of Machine + 90,000 initial direct costs) = 1,090,000.

Books of Lessor Books of Lessee

12/31/x1 12/31/x1
Cash-Collecting Officer 145K Rent/Lease Expense 120K
Rent/Lease Income 120K Prepaid Rent 25K
Other Unearned Revenue 25K Cash-Modified Disbursement
System (MDS), Regular 145K
12/31/x1 12/31/x1
Depreciation-Machinery and No entry
Equipment 130K(e)
Accumulated Depreciation-
Machinery and Equipment 130K
(e)
Cost of Machine 1,000,000
Divided by: Useful life of machine 10
Depreciation of machine 100,000

Initial direct costs 90,000

Divided by: Lease Term 3
Amortization of initial direct costs 30,000
Total Depreciation 130,000

Books of Lessor Books of Lessee

12/31/x2 12/31/x2
Cash-collecting officer 115K Rent/Lease Expense 120K
Other Unearned Revenue 5K Cash-Modified Disbursement
Rent/Lease Income 120K System (MDs), Regular 115K
Prepaid Rent 5K
12/31/x2 12/31/x2
Depreciation- Machinery and No entry
Equipment 130K
Accumulated Depreciation-
Machinery and Equipment 130K

Journal entries in subsequent periods follow the same pattern.