4 320 Chapter 1g Ro Chapter Chapter 13 Leases Learning Objectives 1. Differentiate between a finance 2. Account for finance leases by lessees and by lessors- and by lessors. lease and an operating lease, 3.__ Account for operating leas Introduction Lease is an agreement whereby the lessor conve return for a payment or series of payments, the right to use an asset for an agreed period of time. Leases include hire purchase contracts (i.e, contracts for the hire of an asset which contain a provision giving the hirer an option to acquire title to the asset upon the fulfillment of agreed conditions) ys to the lessee, in Classification of Leases 1. Finance lease - is a lease that transfers substantially all the risks and rewards incidental to ownership of an asset. 2. Operating lease — is a lease that does not that transfer substantially all the risks and rewards incidental to ownership of an asset. The classification of a lease depends on the substance of the transaction rather than the form of the contract. Finance lease Any of the following would lead to a finance lease classification: a. The lease transfers otonership of the asset to the lessee by the end of the lease term.Leases Bett. p, The lessee has the option to Purcha, expected to be sufficiently lower <. : the option becomes exercisable fort at the inception of the lease, that the (‘bargain purchase option’), «The ae ate for the major part of the economic life of the ass ¢ Is not transferred, A lease ualifies to be accounted for as finance lease if the a i" cancellable contract. Sonlegcts ie a!inen d. At the inception, of the lease, the present value of the minimum lease payments amounts to at least substantially all of the fair value of the leased asset. e, The leased assets are of such a specialized nature that only the lessee can use them without major modifications. f, The leased assets cannot easily be replaced by another asset. g. If the lessee can cancel the lease, the lessor’s losses associated with the cancellation are borne by the lessee. h. Gains or losses from the fluctuation in the fair value of the residual (leased asset) accrue to the lessee (for example in the form of a rent rebate equalling most of the sales proceeds at the end of the lease). The lessee has the ability to continue the lease for a secondary period at a rent that is substantially lower than market rent. (GAM for NGAs, Chapter 13, Sec. 5) he asset at a price that is the fair value at the date to be reasonably certain, option will be exercised i, Lease of Land and Building When a lease includes both land and buildings elements, each element shall be classified separately as either operating or finance lease, The minimum lease pa relative fair values of the leaseht buildings elements at the inception o! If the lease payments cann entire lease is classified as a finance lease, ments are allocated based on the ‘old interests in the land and f the lease. ot be allocated reliably, the unless it is clear that322 Chapter 13 Bert both elements are operating leases, in which case the entire lease jg classified as an operating lease. If the land element is immaterial, the land and buildings may be treated as a single unit and classified as finance oy operating lease. In such case, the economic life of the buildings js | Tegarded as the economic life of the entire leased asset. | > Inception of the lease - is the earlier of the date of the lease agreement and the date of commitment by the parties to the principal provisions of the lease. It is on this date that: a. A lease is classified as either an operating or a finance lease; and b. Inthe case of a finance lease, the amounts to be recognized at the commencement of the lease term are determined. > Commencement of the lease term — is the date from which the lessee is entitled to exercise its right to use the leased asset. It is on this date that any asset or liability resulting from the lease is initially recognized. Accounting for Finance lease by Lessees At the commencement date, a lessee recognizes the asset acquired under a finance lease and the related lease liability measured at the lower of the: a. fair value of the leased property at inception date; and b. present value of the minimum lease payments at inception date Minimum lease payments include the following: a. Rentals, excluding contingent rent, costs for services and taxes reimbursable to the lessor; b. Bargain purchase option; and c. 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 (e.g, percentage of futur? llwee 323 sales, amount of future use, fu i * Future price indices, fu i , Fut rates of interest), Contingent Tent is recognized ire market the period incurred, gnized as expense in The mi imum lease Payments are discounted using the interest rate implicit in the lease, if this is determinable; if . th Jessee’s incremental borrowing rate is used. + if not, the Initial direct costs, such as costs incurred in negotiating and securing leasing arrangements, are capitolized as part of the asset recognized. ; The lease liability is subsequently measured similar to an amortized cost financial liability, Accordingly, the minimum lease payments are apportioried between interest expense and a reduction of the outstanding liability. Interest expense in each period reflects a constant periodic rate of interest on the remaining balance of the liability. The leased asset is accounted for similar to an owned asset, e.g:, as PPE or investment property. Accordingly, the leased asset is depreciated using the entity's existing depreciation policies. If there is no reasonable certainty that the lessee will obtain ownership by the end of the lease term, the asset shall be depreciated over the shorter of its useful life and the lease term. Accounting for Finance lease by Lessors A lessor recognizes the lease payments receivable under a finance lease at an amount equal to the net investment in the lease. Initial direct costs are included in the initial measurement of the finance lease receivable and reduce ‘the amount of revenue Tecognized over the lease term. The interest rate implicit in the lease is defined in such a way that the initial direct costs are induded automatically in the finance lease receivable. Therefore, there iso need to add the initial direct costs separately. ~ is the discount rate that, at the » ‘ oop Interest rate implicit in the lease epee oft inception of the lease, causes the aggregal324 Chapter 13 | 1. The minimum lease payments; and 2. The unguaranteed residual value, ed to be equal to the sum of (a) the fair value of the leased asset ang (b) any initial direct costs of the lessor. The lease receivable (net investment inthe lease) ag Subsequently measured similar to an amortized cost financial asset. Accordingly, the lease payments are applied against the gross investment in the lease to reduce both the principal and the ‘uneamed finance revenue. Mllustration: On January 1, 20x1, Lessee enters into a 4-year lease of machinery with Lessor. Ownership of the machinery will be transferred to Lessee at the end of the lease term. Annual rental payable at the end of each year is 100,000. 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 1,000,000 and accumulated depreciation of #683,013 in the books of 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 Ux Leased Assets, Machinery and Equipment 316,987 Finance Lease Payable 316,987 UUx1 Finance Lease Receivable 400K" Accumulated Depreciation 683,013 Déferred Finance Lease Revenue ® m3ails 1a 300,000 annual rent x 4 yrs. = 499099 jqvestment in the lease) Finance Lease Receivable (Gross #) 400,000 Gross investment in the lease - 31 . - 316,987 Net i i 1.93013 Deferred Finance Lease Revenue (Uneamed * investment inte lease > Subsequent measurement: Amortization table: oD 1/1/« 1731/x1 100,000 31,699 68,301 ee 1/1/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 wilt 12311 | | Interest Expense 31,699 Cash-Collecting Officers. 100K Finance Lease Payable 68,301 Deferred Finance Lease” Cash-Modified Disbursement Revenue 31699 100K Interest Income 31,699 System (MDS), Regular Finance Lease Receivable 100K LA Depreciation-Leased Assets, . Machinery & Equipment 63,397" ‘Accumulated Depreciation- Leased Assets, Machinery & Equipment 63,397 The leased asset is annual depreciation. oe le certainty that the because there is reasonabl the end of the lease term “ (316,987 + 5 yrs.) = depreciated over its useful life lessee will obtain ownership by sequent periods follow the same Journal entries in ‘sub: Pattern,326 Chapter 13 Operating lease : A lessee (lessor) under an operating lease recognizes the lease Payments as expense (income) on a straight line basis over the lease term, unless another systematic basis is more representative of 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 recognized 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 recognized as expense on the same basis as the lease expense. Illustration: On January 1, 20x1, Lessor acquires a machine for 1M and immediately leases it out to Lessee under a 3-year non-cancellable lease. Lessor incurs initial direct costs of 90,000 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 Divide by: Lease term 5 Annual lease incomelexpense 120,000peast8 Books of Lessor ot i Machinery and Equipment 109M) Cash-Modified Disbursement system (MDS), Regular 4.994 327 —— ia Books of Lessee | No entry (IM cost of machine + 90,000 inital a irect costs) = 1,090,000 Books of Lessor Books of Le quad of Lessee Cash-Collecting Officer 145K uel Rent/Lease Income 120K Peratine Expense 120K Other Unearned Re: ent 25K venue 25K Cash Modi Disbursement _System (MDS), Regul: sted ¥ D311 ) Regular __145K Depreciation-Machinery and Noentry Equipment 130K® ‘Accumulated Depreciation- [__ Machinery and Equipment _ 130K ® Cost of machine 1,000,000 Divide by: Useful life of machine 10 Depreciation of machine 100,000 Initial direct costs 90,000 Divide by: Lease term 3 Amortization of initial direct costs 30,000 Total depreciation 130,000 \ Books of Lessor Books of Lessee 131/x2 123122 Cash-Collecting Officer 115K Rent/Lease Expense 120K Other Unearned Revenue 5K Cash-Modified Disbursement Rent/Lease Income 120K| System (MDS), Regular Prepaid Rent SK Rex 143Ux2 Depreciation-Machinery and Noentry Equipment 130K Accumulated Depreciation- L_Machinery and Equipment 150K) | Journal eritries in subseq ent periods follo .w the same pattern.4 328 Chapter 13 Chapter 13 Summary: : * A lease that transfers substantially all the risks and rewards incidental to ownership of an asset is a finance lease; a lease that does not is an operating lease. : * Any of the following would lead to a finance lease classification: 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 PV of the lease payments is at least substantially all of the fair value of the leased asset (‘90% criterion’). 5. The leased asset is specialized nature. * Inception of the lease is the earlier of the date of the lease agreement and the date of commitment by the parties to the principal provisions of the lease. Classification and measurement are done on this date. ¢ Commencement of the lease term is the date from which the lessee is entitled to exercise its right to use the leased asset. Initial recognition of any asset or liability is made on this date. * A lessee recognizes an asset and a liability from a finance lease. ¢ Lease payments are discounted using the interest rate implicit in the lease, if this is determinable; if not, the lessee’s ihcremental borrowing rate is used. © Initial direct costs are generally capitalized. * The lessee depreciates the leased asset under a finance lease over the shorter of the asset’s useful life and the lease term if there is no reasonable certainty that the lessee will obtain ownership over the asset by the end of the lease term. e A lessor recognizes the lease payments receivable under a finance lease at an amount equal to the net investment in the lease. «A lessee (lessor) under an operating lease recognizes the lease payments as expense (income) on a straight line basis over the lease term, unless ; ‘another systematic basis is more representative of the time pattern of the user’s benefit.pense 329 proBLems pROBLEM 13-1: TRUE OR FALSE jf a lease transfers ownershi; ip Of the property to th the end of the lease term, it will be tana, : e lessee by by the lessor. s a finance lease Minimum tease payments include any amount to be paid for bargain purchase options and guaranteed residual values. Any lease that contains a purchase option must be treated as a finance lease by the lessor. The lessee depreciates the leased asset under a finance lease. The inception of the lease is defined as the date of the lease agreement or the date of an earlier written commitment. The commencement of the lease term is defined as the di which the leased property is actually transferred to the lessee. late on 7. A lessor under a finance lease recognizes a net investment in the lease measured at the present value of the lease payments and unguaranteed residual value, if any- cit in the lease is the discount rate that, at the se, causes the aggregate present value of the minimum lease payments and the unguaranteed residual sum of the fair value of the leased value to be equal to the asset and any initial direct costs of the lessor. 8. Interest rate impli inception of the lea ion for the next two questions: ; / A 10-year finance lease with Entity B. are due at the start of each year. The is 10%. Use the following informa Entity A (lessor) enters int ime payments of ®100 rest rate implicit in the leaseChapter 13 St Entity A will recognize a ne 9. date, At the commencement da das 9100 x PV of ordinary investment in the lease compute annuity @10%, n=10. ncome in Year 1 computed as 10. Entity A wi ze interest i r ty A wil recog payments, — first payment) y follows: (present ,value of lease 10%, PROBLEM 13-2: MULTIPLE CHOICE ; 1. A government entity, which is a lessee under a finance lease, recognizes an asset acquired under a finance lease, and the related lease liability, measured at a. the fair value of the leased property at inception date b. the present value of the minimum lease payments at inception date c. the lower of a and b d. the higher of aandb 2. Entity A acquires an asset under a finance lease. The lease does not transfer ownership or contain any purchase option. Which of the following statements is correct? a. The lease cannot qualify for accounting as finance lease. b. Entity A will depreciate the leased asset over the shorter of the asset’s useful life arid the lease term. c. Entity A will depreciate the leased asset over its useful life. d. Entity A will not depreciate the asset. 3. In accounting for finance leases, lease payments ale discounted using a. the interest rate implicit in the lease, b. lessee’s incremental borrowing rate. c. aorb d. a, if this is determinable; if not, then b.eat 4. Op December 30; 20x85, Entity A lease Gregg Corp. The following date hn @ new machine from at the inception of the lease: to the lease transaction Lease term 0 Annual rental payable at the end oftach years Useful life of machine ch lease year Pingo00 years Implicit interest rate Fair value of the machine wie P700,000 qhe lease has no renewal option, and the Possession of the machine reverts to Gregg when the lease terminates. At the inception of the lease, Entity A should record a lease liability of a 0 c. 630,000 b. 615,000 d. 676,000 (ara) 5. On January 2, 20x6, Entity A entered into a ten-year non- cancellable lease requiring year-end payments of P100,000. Entity A's incremental borrowing rate is 12% while the lessor's implicit interest rate, known to Entity A, is 10%. Ownership of the property remains with the lessor at expiration of the lease. There is no bargain purchase option. The leased property has an estimated economic life of 12 years. What amount should Entity A capitalize for this leased property on January 2, 20x6? a, 1,000,000 _ cc. 565,000 b. 614,500 do Wepa) 6 Entity A entered into a nine-year finance lease on a warehouse on December 31, 20x1. Lease payments of P52,000, which include real estate taxes of P2,000, are due annually, beginning on December 31, 20x1, and every December 31 thereafter. Entity A does not know the interest rate implicit in the lease Entity A's incremental borrowing rate is 9%. sie amount should Entity A report as finance lease liability at 31, 20x17 @” 280,000 c. 450,000332 Chapter 13 b, d, 468,000 (AICPA) 291,200 7 On January 2, 20x9, Entity A (lessee) entered into a 5-yeay lease for drilling equipment. Entity A accounted for the acquisition as a finance lease for P240,000, which includes a P10,000 bargain purchase option. At the end of the lease, Entity ‘A expects to exercise the bargain purchase option, Entity A estimates that the equipment's fair value will be 20,000 at the end of its 8-year life. Entity A regularly uses straight-line depreciation on similar equipment. For the year ended December 31, 20x9, what amount should Entity 4 recognize as depreciation expense on the leased asset? a. 48,000 c. 30,000 b. 46,000 d. 27,500 (icra) 8. Entity A leases computer equipment to customers under direct-financing leases. The equipment has no residual value at the end of the lease and the leases do not contain bargain purchase options. Entity A wishes to earn 8% interest on a five-year lease of equipment with a fair value of P323,400. The first rental payment is due at the lease commencement. What is the total amount of interest revenue that Entity A will eam over the life of the lease? a. 51,600 ¢. 129,360 b. 75,000 d. 139,450 (AICPA) 9. On June 1, 20x0, Entity A entered into a five-year nonrenewable lease, commencing on that date, for office space and made the following payments to Cant Properties: Bonus to obtain lease 30,000 First month's rent 10,000 Last month's rent 10,000 In its statement of financial performance for the year ended June 30, 20x0, what amount should Entity A report as rent expense? a. 10,000 b. 10,500 c. 40,000 d. 50,000 (AICPA)pases ye 8 10. On July 1, 20x6, Entity A leased under a 3-year Operating lease. Jease will be P36,000, payable as 12 months at P 500 = P 6,099 12 months at P 750 = 9,000 12 months at P1,750 = 21,000 ‘ a delivery truck from Entity B Total rent for the term of the follows: all payments were made when due. In Entity B’s June 30, 20x8, palance sheet, the accrued rent receivable should be reported as a0 ¢. 12,000 b. 9,000 d. 21,000 (arora) PROBLEM 13-3: FOR CLASSROOM DISCUSSION 1, Entity A entered into two lease contracts. Lease #1 transfers substantially all the risks and rewards incidental to ownership of the leased asset. Lease #2 does not transfer substantially all the risks and rewards incidental to ownership of the leased asset. How should Entity A classify the leases? (Lease #1); (Lease #2) a. Finance, Operating c. Finance, Finance b. Operating, Finance d. Operating, Operating 2 Any asset or liability arising from a lease is initially recognized at the a. inception of the lease b. conception of the lease ¢. commencement of the lease term d. aorc the recognition of an asset and a ate. ¢. Operating lease by lessors d. Operating lease by lessees 3. This lease gives rise to liability at the commencement d a. Finance lease by lessors b. Finance lease by lesseesa | 334 Chapter 13 —_—_—_— _—MSOa OO oh Fact pattern: On January 1, 20x1, Lessor leases out a machinery to Lessee unde, @ 3-year lease. Annual rent of 50,000 is payable at the end of eag, year. The implicit interest rate, known to Lessee, is 12% Thy machinery has a remaining useful life of 4 years and a historica) Cost of 400,000 arid an accumulated depreciation of 279,908 jn the books of Lessor 4. The entry in the books of Lessee to initially recognize the lease is a. Leased Assets, Machinery & Equipment 120,092 Finance Lease Payable 120,092 b. Leased Assets, Machinery & Equipment 124,391 Finance Lease Payable 124,39] a. Leased Assets, Machinery & Equipment 143,212 Finance Lease Payable 143,212 b. None, the lease is an operating lease 5. The entry in the books of Lessor to initially recognize the lease is a. Finance Lease Receivable 120,092 Deferred Finance Lease Revenue 120,092 b. Finance Lease Receivable 150,000 Accumulated Depreciation 279,908 Deferred Finance Lease Revenue 29,08 Machinery 400,000 c. Finance Lease Receivable 150,000 Accumulated Depreciation 279,908 Deferred Finance Lease Revenue 25,609 Machinery 400,000 d. None, the lease is an operating lease 6. The entry in the books of Lessee to recognize the first rental payment is a. Interest Expense 16,329 Finance Lease Payable 33,671 Cash-Modified Disbursement System (MDS), Regular 50,000Lasts 335 pb. Interest Expense Finance Lease Payable Cash-Modified Disbursement System (MDS), Regular 50,000 c. Interest Expense 50,000 Cash-Modified Disbursement System (MDS), Regular 50,000 d. Rent/Lease Expense 50,000 Cash-Modified Disbursement System (MDS), Regular 50,000 14,411 35,589 7. The entry in the books of Lessor to recognize the first rental collection is a. Cash-Collecting Officers 50,000 Deferred Finance Lease Revenue 14,411 Interest Income 14,411 Finance Lease Receivable 50,000 b. Cash-Collecting Officers 50,000 Deferred Finance Lease Revenue 16,329 Interest Income 16,329 Finance Lease Receivable 50,000 c. Cash-Collecting Officers 50,000 Interest Income -50,000 d. Cash-Collecting Officers 50,000 Rent/ Lease Income 50,000 8. The entry in the books of Lessee to recognize the depreciation on the leased asset after the end of the first year of the lease is a. Depreciation-Leased Assets, Machinery & Equipment Accumulated Depreciation-Leased Assets, Machinery & Equipment 40,031 b. Depreciation-Leased Assets, Machinery & Back cee eemadited Depreciation-Leased Assets, Machinery & Equipment 40,031 30,023 30,023: 4 Chapter 13 ce d. Depreciation-Leased Assets, Machinery & Equipment 31,098 Accumulated Depreciation-Leased Assets, Machinery & Equipment 31,008 9. Assume the lease is an operating lease, the entry in the books Of Lessee to recognize the first rental payment is a. Interest Expense 16,329 Finance Lease Payable 33,671 Cash-Modified Disbursement System (MDS), Regular 50,000 Interest Expense 14411 Finance Lease Payable 35,589 Cash-Modified Disbursement System (MDS), Regular 50,000 Interest Expense 50,000 Cash-Modified Disbursement System (MDS), Regular 50,000 Rent/Lease Expense 50,000 Cash-Modified Disbursement System (MDS), Regular 50,000 10. Which of the following statements is correct? a. Lessee recognizes a higher amount of total expenses over the lease term if the lease is classified as a finance lease rather than an operating lease. Lessee recognizes a lower amount of total expenses over the lease term if the lease is classified as a finance lease rather than an operating lease. | Lessor recognizes a higher amount of net surplus over the lease term if the lease is classified as a finance lease rathet than an operating lease. Regardless of whether the lease is classified as finance lease or operating lease, the net effect of the lease in Lessee’s or Lessor’s surplus or deficit over the lease term iS the same. | | None, Lessor will depreciate the asset.