NEW BRIGHTON SCHOOL OF THE PHILIPPINES, Inx`C.

Module No. 8
Subject: Intermediate Accounting 2 Date of Submission: ____________
Name of Student: __________________________________________________
Course and Year: __________________________________________________
Semester and School Year: __________________________________________

Introduction
Lessor accounting under the new lease standard is business as usual.

Lessor accounting under IFRS 16 is substantially unchanged from the old lease standard under IAS 17.

IFRS 16, paragraph 16, provides that a lessor shall classify leases as either an operating lease or a finance lease.

Definitions

An operating lease is a lease that does not transfer substantially all the risk and rewards incidental to ownership of an
underlying asset.

When is a lease classified as finance lease?

Whether a lease is a finance lease or an operating lease depends on the substance of the transaction rather than the
form of the contract.

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

a. The lease transfers ownership of the underlying asset to the lessee at the end of the lease term.

b. The lessee as an option to purchase asset at a price which is expected to be sufficiently lower than the value at
the date the option becomes exercisable.

c. At the inception of the lease, it is reasonably certain that the option will be exercised.

d. The lease term is for the major part of the economic life of the underlying asset even if little is not transferred.

e. The present value of the lease payment amount to substantially all of the fair value of the underlying asset at the
inception of the lease.

f. This four major criteria are determinative in nature, meaning any one of this would normally result to a
conclusion that the lease contract is a finance lease.

Major part

What percentage represent a major part?

Is it 60%, 75% or 80%?

It is unfortunate that the new lease standard does not provide a clear-cut definition of a major part.

Under USA GAAP, major part is 75% of the economic life of an asset.

Of course, right thinking person can debate whether the major part implies a proportion lower than 75%, for example,
as little as 51% or implies a higher proportion than 75% , such as 90%.

Substantially all

Under USA GAAP, substantially all means at least 90% of the fair value of the lease asset.

There is a room for debate over whether substantially all implies a threshold lower than higher 90%.

Module for Intermediate Accounting 2, Jonard S. Baloyo, CPA Page 1

Other criteria

Paragraph 63 and 64 provides the other situation that individually or in combination could also lead to a lease being
classified lease are:

a. The underlying is such of specialized nature that only the lessee can use it without major modification.

b. If the lessee can cancel the lease, the lessor’s losses associated with the cancelation are borne by the lessee.

c. Gains or losses from fluctuation in the fair value of the residual accrue to the lessee.

d. The lessee has the ability to continue the lessee for a secondary period at a rent is substantially lower than
market rent.

These other criteria are more suggestive in nature, meaning these could also leads to a finance lease classification.

Land and Building lease

Application guidance B55 provide classifying a lease on land and building, a lessor normally considered the land and
building element separately.

In determining whether the land element is an operating lease or finance lease, an important consideration is that land
normally has an indefinite economic life.

Application guidance B55 provides that the lease payment are allocated between the land and building element in
corporation to the relative fair value of the leasehold interest in the land and building elements at the inception of the
lease.

If the lease payment cannot be allocated reliably between the two elements, the entire lease is classified as a finance
lease, unless it is clear that both element are operating leases.

For lease of a land and building in which the amount for the land element is immaterial to the lease, a lessor may treat
the land and building as single unit for lease classification.

The single lease is classified as a finance lease or an operating lease applying the lease classification criteria for lessor.

In such a case, the economic life of the building is regarded as the economic life of the entire underlying asset.

Operating lease – Lessor

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. The lessor shall apply another systematic basis if this is more
representative of the pattern in which benefit from the use of the underlying asset is diminished.

Otherwise stated, the periodic rental received by the lessor in an operating lease is simply recognized as rent income. A
lessor shall present an underlying asset subject to operating lease in the statement of financial position according to the
nature of the asset.

The underlying asset remains as an asset of the lessor. Consequently, the lessor bears all ownership or executory costs
such as depreciation of leased property, real property taxes, insurance and maintenance. However, the lessor may pass
on to the lessee the payment for taxes, insurance and maintenance cost.

The depreciation policy for depreciable leased asset shall be consistent with the lessor’s normal depreciation for similar
asset.

Initial direct cost incurred by lessor in an operating lease shall be added to the carrying amount of the underlying asset
and recognized as an expense over the lease term on the same basis as the lease income.

Module for Intermediate Accounting 2, Jonard S. Baloyo, CPA Page 2

Any security deposit refundable upon the lease expiration shall be accounted for as liability by the lessor. Any lease
bonus received by the lessor from the lessee is recognized as unearned rent income to be amortized over the lease term.

Illustration

1. On January 1, 2020, Simple Company purchased a machinery for P3,000,000 cash for the purpose of leasing it.
The machine is expected to have a 10-year life and no residual value.

Machinery 3,000,000
Cash 3,000,000

2. On April 1, 2020, Simple Company leased the machine to another entity for 3 years at a monthly rental of P50,000,
payable at the beginning of every month.

Cash (50,000 x 9) 450,000

Rent income 450,000

3. On April 1, 2020, Simple Company received a security deposit of P600,000 to be refunded upon the lease
expiration.

Cash 600,000
Liability for rent deposit 600,000

4. In addition to the rental, Simple Company received from the lessee a lease bonus of P120,000 on January 1, 2020.

Cash 120,000
Unearned rent income 120,000

5. On April 1, 2020, Simple Company paid initial direct cost of P300,000. Such costs are directly attributable to
negotiating and arranging the operating lease.

Deferred initial direct cost 300,000

Cash 300,000

6. During the year, Simple Company paid repair and maintenance of P20,000.

Repair and maintenance 20,000

Cash 20,000

7. The lease bonus is amortized over 3 years or P40,000 annually.

Unearned rent income 30,000

Rent income (40,000 x 9/12) 30,000

8. The machinery is depreciated over 10 years or P300,000 annually.

Depreciation 300,000
Accumulated depreciation 300,000

Note that the depreciation is from the date of acquisition, January 1, 2020 and not from April 1, 2020, date of
lease.

The reason is that the machinery is acquired for leasing purpose and already available for the intended use meaning
for rental from January 1, 2020.

Idle property is subject to depreciation as long as it is available for the intended use.

Module for Intermediate Accounting 2, Jonard S. Baloyo, CPA Page 3

9. The initial direct cost is recognized as expense over the lease term.

Amortization of initial direct cost 75,0000

Deferred initial direct cost (300,000 / 3 x 9/12) 75,000

The balance of the deferred initial direct cost shall be presented as an addition to the carrying amount of machinery.

Unequal rental payment

IFRS 16, paragraph 81, provides that lease payments under an operating lease shall be recognized as income on a
straight line basis or another systematic basis. This simply means that where the operating lease requires unequal cash
payment, the total cash payments for the lease term shall be amortized uniformly on the straight line basis as rent
income over the lease term.

Illustration
Aye Company leased office space to another entity for a three-year period beginning January 1, 2020.

Under the terms of the operating lease, rent for the first year is P1,000,000 and rent for the next two years, P1,250,000
annually. However, as an inducement to enter the lease, Aye granted the lessee the first six months of the lease rent-
free.

Total rental for the lease term

2020 (1,000,000 x 6/12) 500,000

2021 1,250,000
2022 1,250,000
Total rental for 3 years 3,000,000

Average annual rental (3,000,000 / 3) 1,000,000

Books of Aye Company – lessor

2020 Cash 500,000

Rent receivable 500,000
Rent income 1,000,000

2021 Cash 1,250,000

Rent income 1,000,000
Rent receivable 250,000

Rent income for 2020 and 2021 2,000,000

Rent collected (500,000 + 1,250,000) 1,750,000
Rent receivable 250,000

2022 Cash 1,250,000

Rent income 1,000,000
Rent receivable 250,000

Note that the rent receivable has a zero balance on December 31, 2022 and the recorded rent income each year is
P1,000,000.

References

Valix, C. & Valix, C.A. (2018). Practical Accounting 1 vol 2. GIC Enterprises and Co., Inc. Manila, Philippines

Valix, C. & Valix, C.A. (2013). Theory of Accounts 2013 edition. GIC Enterprises and Co., Inc. Manila, Philippines

Module for Intermediate Accounting 2, Jonard S. Baloyo, CPA Page 4

Valix, C. Valix, C.A. (2019). Financial Accounting and Reporting vol 2. GIC Enterprises and Co., Inc. Manila,
Philippines

Robles, N. & Empleo P. (2016). The Intermediate Accounting Series Vol 2. Millenium Books, Inc., Mandaluyong City

Uberita, C. (2012). Practical Accounting 1 2013 Edition. GIC Enterprises and Co, Inc. Manila, Philippines

Testbanks and CPA Examination Reviewers

Module for Intermediate Accounting 2, Jonard S. Baloyo, CPA Page 5