LEASES (LESSOR)

Topic 2
ACCOUNTING FOR LEASES BY LESSOR

 A lessor classifies each of its leases as either a finance

lease or an operating lease.
 Finance lease (capital lease) is a lease that transfers
substantially all the risk and rewards incidental to
ownership of an underlying asset.
 Operating lease is a lease that does not transfer
substantially all the risks and rewards incidental to
ownership of an underlying asset.
INDICATORS OF A FINANCE LEASE

a. The lease transfers ownership of the asset to the lessee by the end
of the lease term.
b. The lessee has the option to purchase the underlying asset at a
price that is expected to be sufficiently lower than the fair value at
the date the option becomes exercisable for it to be reasonably
certain, at the inception date, that the option will be exercised.
c. The lease term is for the major part of the economic life of the asset
even if title is not transferred.
d. The present value of the lease payments amounts to at least
substantially all of the fair value of the leased asset at the inception
date.
e. The leased asset is of such a specialized nature that only the lessee
can use it without major modifications.
INDICATORS OF A FINANCE LEASE

Other indicators of finance lease

a. If the lessee can cancel the lease, the lessor’s losses
associated with the cancellation are borne by the lessee
(transfer of risk);
b. Gains or losses from the fluctuation in the fair value of the
residual accrue to the lessee (transfer or risk and
rewards); and
c. The lessee has the ability to continue the lease for a
secondary period at a rent that is substantially lower than
market rent (transfer of reward).
INCEPTION AND COMMENCEMENT OF LEASE

 Lease classification is made at the inception date and is

reassessed only if there is a lease modification.
 Changes in estimates, or changes in circumstances do not give
rise to a new classification of a lease for accounting purposes.
 Inception date is the earlier of (a) the date of the lease
agreement and (b) the date of commitment by the parties to the
principal provisions of the lease.
 Commencement date is the date on which a lessor makes an
underlying asset available for use by a lessee. It is on this date
that the lessee is entitled to exercise its right to use the leased
asset.
 The commencement date is the date of the initial recognition.
FINANCE LEASE
INITIAL MEASUREMENT

 A lessor recognizes an asset from a finance lease as

receivable measured at an amount equal to the net
investment in the lease.
 The lessor transfers substantially all the risks and rewards
incidental to ownership over the leased asset to the lessee.
 The receivable is treated as repayment of principal and
finance income to reimburse and reward the lessor for its
investment and services.
FINANCE LEASE
INITIAL MEASUREMENT

 Gross investment in the lease (gross lease receivable) – the sum

of:
a. The lease payments receivable by the lessor under a finance
lease, and
b. Any unguaranteed residual value accruing to the lessor.
 Net investment in the lease (net lease receivable) – the gross
investment in the lease discounted at the interest rate implicit in
the lease.
 Unearned finance income (unearned interest income) – the
difference between:
a. the gross investment in the lease, and
b. The net investment in the lease
FINANCE LEASE
LEASE PAYMENTS

a. Fixed payments, including in-substance fixed payments, less

any lease incentives payable;
b. Variable lease payments that depend on an index or a rate,
initially measured using the index or rate as at the
commencement date;
c. Guaranteed residual value;
d. The exercise price of a purchase option if the lessee is
reasonably certain to exercise that option; and
e. Payments of penalties for terminating the lease, if the lease
term reflects the lessee exercising an option to terminated
the lease.
FINANCE LEASE
DISCOUNT RATE

 The net investment is measured using the interest rate implicit in

the lease.
 Interest rate implicit in the lease is the rate that causes the
present value of (a) the lease payments and (b) the unguaranteed
residual value to equal the sum od (i) the fair value of the
underlying asset and (ii) any initial direct costs of the lessor.
 In case of a sublease, if the interest rate implicit in the sublease
cannot be readily determined, an intermediate lessor may use
the discount rate used for the head lease (adjusted for any initial
direct costs) to measure the net investment in the sublease.
FINANCE LEASE
SUBSEQUENT MEASUREMENT

 The net investment in the lease (net lease receivable) is

subsequently measured similar to an amortized cost financial
asset.
1. Finance income (interest income) is computed using the effective
interest method and recognized in profit or loss. Interest in each
period reflects a constant periodic rate of return on the lessor’s
net investment in the lease.
2. Lease payments are applied against the gross investment in the
lease to reduce both the principal and the unearned finance
income.
FINANCE LEASE
ILLUSTRATION

On January 1, 20x1, A Co. leased equipment to X Inc. Information on

the lease is shown below.
Cost of equipment P303,735
Useful life of equipment 5 years
Lease term 4 years
Annual rent payable at the end of each year 100,000
Interest rate implicit in the lease 12%
FINANCE LEASE
INITIAL DIRECT COSTS

 Initial direct costs are included in the initial measurement of the net
investment in the lease and reduce the amount of income recognized
over the lease term.
 Initial direct costs include commissions, legal fees and internal costs
that are incremental and directly attributable to negotiating and
arranging a lease.
FINANCE LEASE
ILLUSTRATION

On January 1, 20x1, A Co. leased equipment to X Inc. under a finance lease.

Information on the lease follows:
Cost of equipment P320,183
Useful life of equipment 5 years
Lease term 4 years
Annual rent payable at the beginning of each year P100,000

A incurred initial direct costs of P20,000 in negotiating the lease. The implicit
interest rate is 12%.
Compute for the following:
a. Gross investment in the lease on January 1, 20x1
b. Net investment in the lease January 1, 20x1
c. Unearned interest income on January 1, 20x1
FINANCE LEASE
ILLUSTRATION

On January 1, 20x1, A Co. leased equipment to X, Inc. Information

on the lease is shown below:
Cost of equipment P303,735
Useful life of equipment 5 years
Lease term 4 years
Annual rent payable at the beginning of each year P100,000
Compute for the following:
a. Net investment
b. Interest rate implicit in the lease that would give A a fair rate
of return on its net investment.
FINANCE LEASE
ILLUSTRATION

On January 1, 20x1, A Co. leased equipment to X, Inc. under a

finance lease. Information on the lease is shown below:
Cost of equipment P320,183
Useful life of equipment 5 years
Lease term 4 years
Annual rent payable at the beginning of each year P100,000
A incurred initial direct costs of P20,000 in negotiating the lease.

Requirement: Compute for the interest rate implicit in the lease

that would give A a fair rate of return on its net investment.
FINANCE LEASE
ILLUSTRATION

On January 1, 20x1, A Co. leased equipment to X, Inc. under a

finance lease. Information on the lease is shown below:
Cost of equipment P320,183
Useful life of equipment 5 years
Lease term 4 years
Annual rent payable at the beginning of each year ?
A incurred initial direct costs of P20,000 in negotiating the lease.
The implicit interest rate is 12%.

Compute for the annual rent.

CLASSIFICATION OF FINANCE LEASE BY
THE LESSOR
 A lessor classifies a finance lease as either:
a. Direct financing lease. The lessor acquire assets and
leases them with the intention of generating income
through interest.
b. Sales type lease. The lessor is the manufacturer or a
dealer of the asset being leased and uses leasing as
means of marketing its products.
CLASSIFICATION OF FINANCE LEASE BY
THE LESSOR
 A sales type lease is accounted for like a direct financing
lease, except that the manufacturer or dealer recognizes the
following at the commencement date:
a. Sales revenue – measured at lower of the (a) present value
of lease payments, discounted using a market rate of
interest, and the (b) fair value of the asset;
b. Cost of sale – equal to the cost, or carrying amount if
different, of the underlying asset less the present value of the
unguaranteed residual value; and
c. Gross profit – the difference between revenue and cost of
sale.
CLASSIFICATION OF FINANCE LEASE BY
THE LESSOR
Direct financing lease Sales type lease
The fair value of the leased The fair value of the leased
asset is often equal to the cost asset is often greater than the
or carrying amount of the cost or carrying amount of the
leased asset. leased asset.

Net investment is often equal Net investment is often equal to

to the cost/carrying amount of the cash selling price of the
the leased asset plus initial leased asset.
direct costs
ILLUSTRATION: SALES TYPE LEASE

On January 1, 20x1, A Co. leased equipment to XYZ Inc. Information

on the lease is shown below:

Cost of equipment P300,000

Useful life of equipment 5 years
Lease term 4 years
Annual rent payable at the start of each year P100,000
Market rate of interest 10%

A Co. incurred direct costs (broker’s commission) of P20,000 in

negotiating the lease. The lease qualifies as a sales type lease.
ILLUSTRATION

Required: Compute the following

a. Gross investment in the lease on January 1, 20x1.
b. Net investment in the lease on January 1, 20x1.
c. Total interest income to be recognized over the lease term.
d. Gross profit and net profit from the sale.
RESIDUAL VALUE

 Lessors account for both guaranteed and unguaranteed

residual value, provided the leased asset reverts back to the
lessor at the end of the lease term.

 Residual value guarantee is a guarantee made to a lessor by

a party unrelated to the lessor that the value of an
underlying asset at the end of a lease will be at least a
specified amount.
RESIDUAL VALUE

 As to the lessor, a residual value is guaranteed if its is:

a. Guaranteed by the lessee;
b. Guaranteed by a party related to the lessee; or
c. Guaranteed by a third party unrelated to the lessor that
is financially capable of discharging the obligations under
the guarantee.
 If the residual value is guaranteed, the present value of
guaranteed residual value is added to sales.
 If the residual value is unguaranteed, the present value of
the unguaranteed residual value is deducted from cost of
sales.
ILLUSTRATION: RESIDUAL VALUE
DIRECT FINANCING LEASE

On January 1, 20x1, A Financing Co. leased equipment to X Inc.

Information on the lease is shown below:
Cost of equipment P330,647
Useful life of equipment 5 years
Lease term 4 years
Annual rent payable at the end of each year P100,000
Interest rate implicit in the lease 10%
Residual value P20,000
ILLUSTRATION: RESIDUAL VALUE
DIRECT FINANCING LEASE

The equipment will revert back to A at the end of the lease

term. The lease is classified as direct financing lease.

Required: Compute for the following assuming the residual

value is (1) guaranteed and (2) unguaranteed:
a. Gross investment in the lease on January 1, 20x1
b. Net investment in the lease on January 1, 20x1
c. Unearned interest income on January 1, 20x1
ILLUSTRATION: RESIDUAL VALUE
DIRECT FINANCING LEASE

Case 1: The actual fair value (residual value) of the equipment

on December 31, 20x4 is P20,000. Provide entry to record the
return of the leased asset to the lessor.

Case 2: The actual fair value (residual value) of the equipment

on December 31, 20x4 is P5,000. Provide entry to record the
return of the leased asset to the lessor.
ILLUSTRATION: RESIDUAL VALUE
SALES TYPE LEASE

On January 1, 20x1, A Financing Co. leased equipment to X Inc.

Information on the lease is shown below:
Cost of equipment P300,000
Useful life of equipment 5 years
Lease term 4 years
Annual rent payable at the end of each year P100,000
Interest rate implicit in the lease 10%
Residual value P20,000
ILLUSTRATION: RESIDUAL VALUE
SALES TYPE LEASE

The equipment will revert back to A at the end of the lease

term. The lease is classified as sales type lease.

Required: Compute for the following assuming the residual

value is (1) guaranteed and (2) unguaranteed:
a. Gross investment in the lease on January 1, 20x1
b. Net investment in the lease on January 1, 20x1
c. Total interest income to be recognized by A over the lease
term.
d. Sales, cost of sales, and gross profit recognized on the
lease.
ILLUSTRATION: COMPUTATION OF ANNUAL
RENTAL
On January 1, 20x1, A leased equipment to X Inc. Information
on the lease is shown below:
Useful life of equipment 5 years
Lease term 4 years
Annual rent payable at the end of each year ?
Guaranteed residual value P20,000

The equipment will revert back to A at the end of the lease

term.
ILLUSTRATION: COMPUTATION OF ANNUAL
RENTAL
Required: Compute for the annual lease payments for the
following independent cases:

Case 1: Direct financing lease

The lease is classified as direct financing lease. The cost of
the equipment if P330,647. The implicit interest rate is 10%.

Case 2: The lease is classified as sales type lease. The cost of

the equipment is P300,000. The market rate of interest is 10%
reflecting the cash selling price of the equipment of P330,647.
ILLUSTRATION: TRANSFER OF OWNERSHIP

On January 1, 20x1, A Financing Co. leased equipment to X Inc.

Information on the lease is shown below:
Cost of equipment P300,000
Useful life of equipment 5 years
Lease term 4 years
Annual rent payable at the end of each year P100,000
Interest rate implicit in the lease 10%
Residual value P20,000
ILLUSTRATION: TRANSFER OF OWNERSHIP

The lease provides that ownership over the equipment will be

transferred to the lessee at the end of the lease term.

Required: Compute for the net investment in the lease.

 ILLUSTRATION: COMPUTATION OF SALES

On January 1, 20x1, A Co. leased equipment to X Inc. Information on the lease is

shown below:
Cost of equipment P300,000
Useful life of equipment 5 years
Lease term 4 years
Annual rent payable at the end of each year P100,000
Market rate 10%
Fair value of equipment P310,000
Requirement: Compute for sales revenue assuming the lease is a sales type
lease.
LEASE MODIFICATIONS

 Depending on its nature, a lease modification is accounted

for as a:
a) Separate lease; or
b) Remeasurement or derecognition of the net investment in the
lease
LEASE MODIFICATIONS

SEPARATE LEASE
 A lease modification is accounted for as a separate lease if
both the scope and consideration in the lease are increased
due to the addition of a right to use one or more underlying
assets and the increase in the consideration reflects the
stand-alone price for the increase in scope.
 No adjustment is made to the existing net investment from
the original contract.
LEASE MODIFICATIONS

NOT A SEPARATE LEASE

 A modification of a finance lease that is not accounted for as a
separate lease is accounted for as follows:
a. If the lease would have been classified as an operating lease had
the modification been in effect at the inception date, the lessor
shall
1. Account for the lease modification as a new lease from the effective date of
the modification; and
2. Measure the carrying amount of the underlying asset as the net investment in
the lease immediately before the effective date of the lease modification.
b. Otherwise, the lessor shall apply the requirements of PFRS 9
Financial instruments
ILLUSTRATION: ACTUAL SALE OF LEASED ASSET

On January 1, 20x1, ABC Co. leased equipment to XYZ Inc.

Information on the lease is shown below.
Cost of equipment P303,735
Useful life of equipment 5 years
Lease term 4 years
Annual rent payable at the end of each year 110,000
Maintenance cost, included in annual rent 10,000
Interest rate implicit in the lease 12%
ILLUSTRATION: ACTUAL SALE OF LEASED ASSET

The maintenance services are considered separate

performance obligation under PFRS 15 Revenue from
Contracts with Customers. The P10,000 cost reflects the
stand-alone selling price of the maintenance services.

The lease is classified as a direct financing lease.

Requirement:
1. Initial measurement
2. Subsequent measurement
OPERATING LEASE

 Operating lease is a lease that does not transfer

substantially all the risks and rewards incidental to
ownership of an underlying asset.

Initial direct cost

-The lessor capitalizes the initial direct costs to the carrying
amount of the underlying asset and recognize those costs as
expense over the lease term.
-Other costs incurred in earning the lease income, including
depreciation, are recognized as expense in the period
incurred. These are not offset from the lease income.
OPERATING LEASE

Depreciation
-The leased asset remains the asset of the lessor. Therefore,
the lessor continues to depreciate it.

Lease bonus
-The lessor accounts for a lease bonus as unearned income
and recognize it as income over the lease term, on the same
basis as the lease income.
OPERATING LEASE

Advance rentals
-Advance rentals are accounted for as unearned income and
recognize it as income only when earned.

Security deposits
-A lessor recognizes a security deposit received from the
lessee as payable, measured as an amortized cost financial
liability.
ILLUSTRATION: OPERATING LEASE

On January 1, 20x1, lessor enters into a 3-year operating lease

of equipment. The annual lease payments, payable at the end
of each year are as follows:

20x1 P8,000
20x2 12,000
20x3 14,000
As an inducement to enter the lease, lessor granted lessee
the first six months of the lease as rent-free.

Compute the annual lease income.

ILLUSTRATION: OPERATING LEASE

On January 1, 20x1, lessor enters into a 3-year operating lease

of furniture.
Annual rent payable at the beginning of each year 100,000
Lease bonus paid to the lessor at commencement date 20,000
Lease term 5 years

Compute for the annual lease income.

ILLUSTRATION: INITIAL DIRECT COSTS

On January 1, 20x1, X Inc. purchased equipment for P1,000,000. the

equipment will be leased out under operating lease. The estimated
useful life is 10 years and the estimated residual value is P120,0000.

On July 1, 20x1 , the equipment was leased to A Co. under a 5-year

operating lease. Annual rent is P200,000. The first annual rent was
made on that date. Initial direct costs incurred on negotiating the lease
amounted to P20,000. other lease-related costs incurred by X in 20x1
amounted to P1,000.

Requirements:
1. How much is the profit earned on the lease transaction in 20x1?
2. How much is the carrying amount of the leased asset at December
31, 20x1?
ILLUSTRATION: LEASE BONUS,
CONTINGENT RENT & SECURITY DEPOSIT
On January 1, 20x1, L enters into an operating lease.
Information follows:

Annual rent payable at the beginning of each year 100,000

Lease bonus paid to the lessor at commencement date 20,000
Security deposit paid by lessee 15,000
Lease term 5 years
ILLUSTRATION: LEASE BONUS,
CONTINGENT RENT & SECURITY DEPOSIT
Additional information:
1. Annual rental payment includes P5,000 to cover for costs of
administration tasks.
2. Additional rent (contingent rent) of 10% is to be paid for any
excess of sales of lessee over P1,000,000. Lessee’s sales for
20x1 are P1,100,00.
3. The security deposit will be returned to the lessee at the end of
the lease term. The appropriate discount rate is 12%.
4. Annual depreciation on the lease asset is P70,000.
5. Other costs related to the earning of lease income are P5,00.

Requirement: Compute for the profit earned on the lease

transaction in 20x1.
LEASE MODIFICATIONS

 A modification to an operating lease is accounted for as a

new lease from the modification date. Prepaid or accrued
lease payments relating to the original lease treated as
payments for the new lease.
SUBLEASES

 Sublease is a transaction for which an underlying asset is re-

leased by a lessee (immediate lessor) to a third party, and the
lease (head lease) between the head lessor and the lessee
remains in effect.
 An immediate lessor classifies a sublease as a finance lease or
an operating lease as follows:
a. If the head lease is a short-term lease that the entity, has
accounted for applying the recognition exemption, the sublease is
classified as an operating lease.
b. Otherwise, the sublease is classified by reference to the right-of-
use arising from the head lease, rather than by reference to the
underlying asset.
ILLUSTRATION: SUBLEASES

Head lease:
On January 1, 20x1, X enters into a 5-year lease of a building
from Y for an annual rent of P100,000 payable at each year-
end. the building has remaining useful life of 20 years. The
interest rate implicit in the lease is 12%. X uses the straight
line method of depreciation.

Requirement:
a. Initial measurement
b. Subsequent measurement
ILLUSTRATION: SUBLEASES

Case 1: Sublease as a finance lease

On January 1, 20x2, X subleases the building to A Co. for 4
years at an annual rent of P120,000 payable at the end of each
year. The market rate of interest is 10%.

Case 2: Sublease as an operating lease

On January 1, 20x2, X subleases the building to A for 2 years
at an annual rent of P120,000 payable at the end of each year.
SALE AND LEASEBACK TRANSACTIONS

 A sale and leaseback transaction occurs when a party sells

an asset and immediately leases it back from the buyer. The
seller becomes the lessee while the buyer becomes the
lessor.
 To account for a sale and leaseback transaction, both the
seller/lessee and the buyer/lessor determine whether the
transfer qualifies as a sale based on the requirements for
satisfying a performance obligation in PFRS 15.
TRANSFER OF ASSET IS A SALE

 If the transfer qualifies as a sales under PFRS 15:

a. The seller/lessee shall:
i. 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; and
ii. Recognize only the amount of any gain or loss that relates to the
rights transferred to the buyer-lessee.
b. The buyer-lessor shall account for the purchase of an asset
applying the applicable standards, and for the lease applying
the lessor accounting under PFRS 16
TRANSFER OF ASSET IS A SALE

Adjustments:
If (a) the sales price is not equal to the fair value of the asset, or if
(b) the lease payments are not at market rates, the following
adjustments shall be made to measure the sale proceeds at fair
value:
a. Any below-market terms shall be accounted for as a
prepayment of lease payments; and
b. Any above-market terms shall be accounted for as additional
financing provided by the buyer-lessor to the seller-lessee.
TRANSFER OF ASSET IS A SALE

The adjustment is measured based on the more readily

determinable of:
a. The difference between the fair value of the consideration for
the sale and the fair value of the asset; and
b. The difference between the present value of the contractual
payments for the lease and the present value of payments for
the lease at market rates.
TRANSFER OF ASSET IS NOT A SALE

If the transfer does not qualify as a sale, the parties shall

account for its as a financing transaction. Accordingly,
a. The seller/lessee continues to recognize the asset and
accounts for the amounts received as a financial liability
under PFRS 9.
b. The buyer/lessor does not recognize the transferred asset
and accounts for the amounts paid as a financial asset
under PFRS 9.
 ILLUSTRATION: SALES AND LEASEBACK

On January 1, 20x1, X sells a building to Y and simultaneously leases it back.

Additional information follows:
Fair value of building 1,000,000
Carrying amount of building 800,000
Remaining useful life of building 10 years
Lease term 5 years
Annual rent payable at the end of each year 100,000
Implicit interest rate equal to market rate 12%

The transfer qualifies as a sale under PFRS 15 Revenue from Contracts

with Customers.
 ILLUSTRATION: SALES AND LEASEBACK

Case 1: Sale established at fair value.

The sale price is P1,000,000 equal to fair value.

Case 2: Above market terms

The sale price is P1,100,000 above fair value.

Case 3: Below market terms

The sale price is P900,000 below fair market value.

Case 4: Transfer is not a sale under PFRS 15.

Assume that the transfer does not qualify as a sale under PFRS 15. The sale price is P1M.

Requirements: Provide for

1. Seller-lessee accounting
2. Buyer-lessor accounting
TBC