CONCEPT OF INCOME (ACCOUNTING FOR LEASEHOLD IMPROVEMENTS)

ACCOUNTING METHODS
Accounting for Leasehold Improvements
• Any improvement made by the lessee on the leased property, in pursuant to the agreement between the
lessor and the lessee, for which will become the property of the lessor upon the expiration or termination
of the contract of lease.
• The value of such improvement will become an income of the lessor using either of the following
methods.
Outright Method
• Improvement is recognized as income when the improvement is completed
Spread-Out Method
• The estimated book value of the improvement at the end of the lease period is amortized or spread-out
over the term of the lease, and the income computed is reported every year until the lease is over.
EXAMPLE:
Outright Method
• Miguel, the owner of one hectare land, entered into a lease agreement with Luigi for a period of 10 years
beginning January 1, 2018. The terms of the lease provide that:
(1) the lessee shall pay the lessor an amount of P 150,000 as two-year deposit, and P 50,000 annual lease
fee; and
(2) the lessee shall erect a building the ownership of which shall transfer to the lessor upon the expiration
of the term of the lease or upon termination. The advance payment is a security deposit which shall be
paid back to Luigi upon expiration. but in case of default of payment, such amount shall be appropriated.
• The construction of the building began on January 1, 2018, and was completed on August 1, 2018 with a
total cost of P 2,000,000. The cost of construction equates to the fair value of the improvement. The
improvement's useful life is 15 years.
Solutions:
Annual Rent Fee P 50,000
Leasehold Improvement (Completed on August) 2,000,000
Total Income Reported in 2018 P 2,050,000

Spread-Out Method
• First, we need to compute the estimated book value of the improvement at the end of the lease contract
2,000,000 x (120 months – 7months) = 1,255,556
180 months
2,000,000 – 1,255,556 = 744,444
REMINDER:
120 months – 7months = 113months number of months the lessee will use the property
180 months= Useful life
1,255,556 = Accumulated depreciation during the lessee’s use
• Second, we need to compute the apportion or spread the remaining value of the property throughout the
remaining period of the lease.
744,444
(120 months – 7months)
= 6,588
REMINDER:
120 months – 7months = 113months
- The number of months the lessee will use the property. ALSO, the remaining period of the lease.
6,588
- Monthly reportable income from improvement
Annual Rent Fee 50,000
Income from Improvement (6,588 x 5) 32, 940
Total Income Reported in 2018 82,940
REMINDER:
6,588 x 5
- There are only 5 months left to December since the improvement was completed on August 1

What about the Security Deposits?

• Security deposits are refundable to the lessee once the contract is terminated upon maturity.
• They are an insurance or guaranty to the lessor that the lessee will faithfully comply to the contract.
• These are not an income to the lessor.
• In the event of breach of contract, and if the parties agreed for an acceleration clause, such deposits shall
be surrendered in favor of the lessor.
• Therefore, it is only such time that the lessor will recognize an income.
Changes in Fair Value
• If at the end of the lease contract, the fair value of the improvement is greater or lesser than the book
value, the lessor shall recognize an additional income or loss, respectively.
Accounting for Leasehold Improvements
• Always remember that the lessor is a service-oriented party.
• Therefore, income payments to him is recognized on cash basis
• Also, a lessee may be engaged in servicing or merchandising business.
• Therefore, payments made by him is an expense either using cash basis or accrual basis.

CONCEPT OF INCOME (ACCOUNTING FOR LONG-TERM CONTRACTS)

Accounting for Long-term Contracts
• 'Long-term contracts' means building, installation or construction contracts covering a period in excess
of one (1) year.
• Persons whose gross income is derived in whole or in part from such contracts shall report such income
upon the basis of percentage of completion.
EXAMPLE:
Emerald Information Engineering Inc. closed a 30 million-peso deal with Diamond Technologies to
develop a software for Diamond's business analytics. The design and development of the software would
take three (3) years to finish as projected by the lead engineer of Emerald, Zack. The prototype software,
after completion, is still projected to undergo testing and modification.
SOLUTIONS:

2018 2019 2020

Contract Price 30,000,000 30,000,000 30,000,000
Percentage of Completion 60% 85% 100%
Revenue Earned to Date 18,000,000 25,500,000 30,000,000
- - -
Less: Cost Incurred to Date 12,000,000 21,000,000 23,500,000
Gross Income to Date 6,000,000 4,500,000 6,500,000
Less: Income Already
reported 0 -6,000,000 -4,500,000
Gross Income this year 6,000,000 -1,500,000 2,000,000

REMINDER:

6,000,000 -1,500,000 2,000,000

= 6,500,000 TOTAL INCOME FOR 3 YEARS
What about the estimated costs?
• For accounting purposes, estimated costs are necessary to estimate the revenue (conservatism principle).
• However, for taxation purposes, these costs are not necessary since they are not actually incurred.
• Hence, they are ignored in the computation of income.
 CONCEPT OF INCOME (INSTALLMENT BASIS OF REPORTING AND DEFERRED
REPORTING)
Installment Basis of Reporting
• Accounts for income at the time collection rather than the time of sale, for which collection of the
payment from customers extends over several years subsequent to the sale.
• The customers are required to make regular payments with a likelihood that full collection cannot be
made, or customers may default one or few payments in the future.
Selling price is the sum of amount received in exchange of the property sold.

Cash received XXX

Fair market value of the property received XXX
Installation received or collected from the buyer XXX
Mortgage assumed by the buyer XXX
Total selling price XXX
Contract price is the amount the buyer agreed to the seller. More often than not, the selling price and
contract price are equal. But in some cases, the contract price may differ from the selling price computed
as:
Selling Price XXX
Add: Excess of mortgage over cost of property sold XXX
Total XXX
Less: Mortgage assumed by the buyer (XXX)
Contract price XXX
Initial payments means the payments received in cash or property other than evidences of indebtedness
of the purchaser during the taxable period in which the sale or other disposition is made.
Downpayment XXX
Installment received in the year of sale XXX
Total XXX
Add: Excess of mortgage over cost of property sold XXX
Initial payments XXX
Periodic installment payment after the year of sale are the remaining balance collectible on a periodic
basis from the buyer.
Contract price XXX
Less: Initial payments (XXX)
Balance XXX
Divided by remaining periods XXX
Periodic installment XXX
• The income reportable is computed as:
Year of Sale:
Gross Income x Initial Payments = Reportable Income
Contract Price
REMINDER:
Selling Price - Cost Gross Income = Gross Income

The income reportable is computed as:

Subsequent Year:
Gross Income x Collections this year = Reportable Income
 Contract Price

Installment Basis of Reporting

• GM Motors is a regular dealer of vehicles and automobiles. As part of its pricing and marketing scheme,
it accepts old owned vehicles by the buyer for a trade-in value. During the year, it sold two units to two
different buyers with the following terms:

Solutions:
First, we need to compute the selling price and the contract price

Buyer x Buyer Y
Cash 2,500,000 3,200,000
Trade in Value 500,000 600,000 Buyer y
Cost is 1m while mortgage is
Mortgage: Assumed by the buyer 400,000 1,200,000 1.2m
Total selling price 3,400,000 5,000,000
Add: Excess of mortgage over
cost - 200,000 Buyer x
Cost is 900k while mortgage is
Less: Mortgage assumed -400,000 -1,200,000 400k
Contract price 3,000,000 4,000,000

Second, we need to determine the initial and periodic payments

Buyer x Buyer Y
Down payment 100,000 150,000
Trade in Value 500,000 600,000
Excess of mortgage over cost   200,000
Initial payments 600,000 950,000

Buyer x Buyer Y
Contract Price 3,000,000 4,000,000
 Less: Initial Payments -600,000 -950,000
Balance 2,400,000 3,050,000
Divided by remaining period 3 yrs 3 yrs
Periodic installment 800,000 1,016,667

Finally, we can now compute the reportable income during the year of sale and succeeding years.
Year of sale: Reportable Income (Sale to X)
(3,400,000 – 900,000) x 600,000 = 500,000
3,000,000
Years thereafter:
(3,400,000 – 900,000) x 800,000 = 666,667
3,000,000
Year of sale: Reportable Income (Sale to Y)
(5,000,000 – 1,000,000) x 950,000 = 950,000
4,000,000
Years thereafter:
(5,000,000 – 1,000,000) x 1,016,667 = 1,016,667
4,000,000
Applicability of Installment Reporting
In Installment reporting of income may be allowed to the following persons and under certain conditions:
1. Sale of Personal Property (Movable Property)
• The seller is a dealer
• Non-dealers of personal property
• The sale is a casual sale or disposition;
• The property sold is not an inventory:
• The selling price is more than P 1,000.00; and
• Initial payments do not exceed 25% of the selling price.
In Installment reporting of income may be allowed to the following persons and under certain conditions:
2. Sales of Real Property (Immovable Property)
• The seller is a dealer, and:
• The real property sold was included as part of the inventory; and
• Initial payments do not exceed 25% of the selling price.
• Sale of real property classified as capital asset (non-dealer)
• The seller is a non-dealer of realty
• The real property sold is not an inventory nor used in business
• The initial payments do not exceed twenty-five percent (25%) of the selling price
Deferred Reporting
• Applicable if the initial payments exceeds 25% of the selling price, which installment method is not
applicable.
• When deferred reporting is more appropriate, the following rules will apply:
• The note evidencing the obligation shall be converted to its discounted value.
• Interest pertaining to the amortization of the loan or obligation shall be reported as income in the year of
collection.

EXAMPLE:
• Joey is not regular dealer of home appliances on installment basis. However in 2018, he made the
following sales:
Cash Down payment P 40,000
Installment payment evidenced by a note
2019 36,667
2020 36,667
2021 36,667
• The note is non-interest bearing, but the prevailing market interest for similar transactions 10%.
The cost of the property sold is P 45,000. The present value factor applicable is 2.48685.
Solutions:
• To determine whether the taxpayer qualifies for installment reporting, the following computation is
necessary:
Cash Downpayment P 40,000
Installment payment evidenced by a note
2019 36,667
2020 36,667
2021 36,667
Total Selling Price P 150,000 Limit
25% (P 40,000/P 150,000) 26.67%
Solutions:
• Since the taxpayer does not qualify for installment reporting, deferred reporting method shall
apply. First, we need to compute the discounted value of the note.
Discounted Value = Equal Serial Payment x Present Value Factor
Discounted Value = P 36,667 x 2.48685
 Discounted Value = P 91,185.40

Solutions:
The income to be reported is:

2018 2019 2020 2021

Cash downpayment 40,000
Discounted value 91,185      
Total revenue 131,185
Less: cost of property sold -45,000      
Gross profit 86,185
Interest earned - 9,119 6,364 3,332
Total income earned 86,185 9,119 6,364 3,332