Liabilities

A liability is now defined as “a present obligation of the entity to transfer an economic

resource as a result of past events.” (
Conceptual Framework)

Previously, liability was defined as “a present obligation of the entity arising from past
events, the settlement of which is expected to result in an outflow from the entity of
resources embodying economic benefits”

Three aspects on the definition of liability

1. Obligation
2. Transfer of an economic resource
3. Present obligations as a result of past events

Obligation
An obligation is “a duty or responsibility that the entity has no practical ability to avoid”.
An obligation is either:
1. Legal obligation
2. Constructive Obligation

Transfer of an economic resource-(potential to transfer)

An obligation to transfer an economic resource may be an obligation to:
1. pay cash, deliver goods, or render services;
2. exchange assets with another  party on unfavorable terms;
3. transfer assets if a specified uncertain future events occurred; or
4. issue a financial instrument that obliges the entity to transfer an economic resource.

Present obligations as a result of past events

The obligation must be a present obligation that exists as a result of past events. A
present obligation exists as a result of past events if:
1. the entity has already obtained benefits or taken an action; and
2. As a consequence, the entity will or may have to transfer an economic resource that it
would not otherwise have had to transfer.

Identification of Present Obligation

✧ Intention to acquire goods in the future

✧ An entity operates a nuclear power plant. In the current year, a new law was enacted
penalizing the improper disposal of toxic waste. No similar law existed in prior years.

✧ An entity enters into an irrevocable commitment with another to acquire goods in the
future, on credit.

✧ Although not stated in the sales contract, an entity has a publicly-known policy of
providing free repair services for the goods it sells. The entity has consistently
honored this implied policy in the past.
✧ An entity obtained a loan from a bank. Repayment of the loan is due in 10-years’
time.

✧ An entity has caused environmental damages. Although  no law exists penalizing

such, the entity believes it has an obligation to rectify the damages. However, the
identity of the party to whom the obligation is owed cannot be specifically identified.

✧ An entity employed Mr. Juan.

Recognition of liabilities
An item is recognized as a liability when: (OLD)
1. It meets the definition of a liability;
2. It is probable that an outflow of resources embodying economic benefits will result
from its settlement; and 
3. The settlement amount can be measured reliably. 

An item is recognized as a liability when: (NEW)

1. It meets the definition of a liability;
2. Recognizing it would provide useful information, i.e., relevant and faithfully
presented information

Financial liabilities
A financial liability is any liability that is a contractual obligation :
1. to deliver cash or another financial asset to another entity; or
2. to exchange financial assets or financial liabilities with another entity under
conditions that are potentially unfavorable to the entity; or
3. a contract that will or may be settled in the entity’s own equity instrument and is not
classified as the entity’s own equity instrument.
*variable # of equity instruments in exchange for fixed amount of cash or another FA
*fixed # of equity instruments in exchange for variable amount of cash or another FA

Examples of financial liabilities

● Payables such as accounts, notes, loans, bonds payable and accrued expenses that are
payable in cash.
● Finance lease obligations.

● Liabilities held for trading such as obligations to deliver financial assets borrowed by
a “short seller” (i.e. an entity that sells financial assets it has borrowed and does not
yet own).
● Preference shares issued with mandatory redemption. 

● Security deposits received that are to be returned to tenants at the end of lease term.

● Obligations to deliver a variable number of own shares worth a fixed amount of

cash. 
The following are not financial liabilities
● Unearned revenues and warranty obligations that are to be settled by future delivery
of goods or services, rather than cash.
● Taxes, SSS premiums, Philhealth and other payables arising from statutory
requirements and not from contracts. 
● Commodity contracts that either cannot be settled in cash or which are expected to be
settled by commodity exchange (e.g., coffee beans, gold bullion, oil, and the like). If a
commodity contract is expected to be cash settled, it will be included as financial
liability on the part of the cash payor.
● Constructive obligations. These obligations do not arise from contracts.

Measurement of financial liabilities

Initial measurement – fair value minus transaction costs, except financial liabilities at
FVPL whose transaction costs are expensed immediately.

Subsequent measurement – amortized cost  (except financial liabilities that are classified
as held for trading and those that are designated; these are subsequently measured at fair
value) 

Measurement of Non-financial liabilities

Non-financial liabilities are initially measured at the best estimate of the amounts needed
to settle those obligations or the measurement basis required by other applicable standard.
Examples:
Obligations arising from statutory requirements (e.g., income tax payable)
Unearned or deferred revenues
Warranty obligations
Commodity contracts that either cannot be settled in cash or which are expected to be
settled by commodity exchange

Redeemable preference share vs Callable preference shares

Redeemable preference shares are preferred stocks which the holder has the right to
redeem at a set date.
Callable preference shares are preferred stocks which the issuer has the right to call at a
set date.

Current liabilities
Current liabilities are liabilities that are:
● Expected to be settled in the entity’s normal operating cycle;

● Held primarily for trading;

● Due to be settled within 12 months after the end of the reporting period; or
● The entity does not have the right at the end of the reporting period to defer settlement
of the liability for at least twelve months after the reporting period.

All other liabilities are classified as non-current.

Trade and non-trade payables

Trade payables are obligations arising from purchases of inventory that are to be sold in
the ordinary course of business. Other payables are classified as non-trade.
Trade payables are classified as current liabilities when they are expected to be settled
within the normal operating cycle or one year, whichever is longer. 
On the other hand, non-trade payables are classified as current liabilities only when they
are expected to be settled within one year.

Remember the following: 

General rule: A currently maturing obligation is presented as current even if the
obligation is refinanced on a long-term basis after the balance sheet date. 
Exceptions: The obligation is non-current if: 
● the entity has the right, as of the balance sheet date, to roll over the obligation on a
long-term basis under an existing loan facility; or 
● the rollover on a long-term basis is completed on or before the balance sheet date. 

General rule: An obligation that is payable on demand is presented as current. 

Exception: The obligation is non-current if the lender agreed on or before the balance
sheet date not to collect within the next 12 months (grace period)

Common Issues on Current Liabilities

Unearned Income
● Unearned Revenue

● Deferred Revenue

● Unearned Subscription

● Gift certificates(PFRS 15)

breakage (proportionate and remote method)
● Liability for deposits received
bank deposit, returnable containers, security deposit, escrow,

Accrued Expenses
● Salaries

● Utilities
Dividends payable
Under IFRIC 17, the liability to pay a dividend is recognized when the dividend is
appropriately authorized and is no longer at the discretion of the entity, which is: 
1. the date when the declaration of the dividend (e.g., by management or the board of
directors) is approved by the relevant authority (e.g., the shareholders) if the
jurisdiction requires such approval, or
2. the date when the dividend is declared (e.g., by management or the board of
directors) if the jurisdiction does not require further approval.

Liabilities for remittable collections

tax withheld, SSS contributions, VAT

APPLICATION

1. On December 31, 2021, the bookkeeper of Grand Company provided the following
information:
Accounts payable, including deposits and advances
from customers of P500,000 P 2,500,000
Notes payable, including note payable to bank due
on December 31, 2023 for P1,000,000 3,000,000
Share dividends payable 800,000
Credit balance in customers' accounts 400,000
Serial bonds, payable in semiannual installments
of P1,000,000 X 2 10,000,000
Accrued interest on bonds payable 300,000
Contested BIR tax assessment 600,000
Unearned rent income 100,000
In the December 31, 2021 statement of financial position, how much current liabilities
should be reported?
a) P6,800,000 c) P7,900,000
b) P7,300,000 d) P8,700,000
2. An analysis of Cool Company's liabilities disclosed the following:
Accounts payable, after deducting debit balances in
suppliers' accounts amounting to P22,500 (accounts
payable included non-trade liabilities of P32,500) P105,000 +
22,500
Accrued expenses 15,000
Credit balances of customers' accounts 13,500
Stock dividends payable 70,000
Claims for increase in wages and allowances by
employees of the company, covered in a pending lawsuit 125,000
Estimated liabilities for premiums 60,000
How much should be presented as total current liabilities in the statement of financial
position?
a) P 6,000 c) P183,500
b) P168,500 d) P216,000
3. The balance in Coward Company's accounts payable account at December 31, 2021
was P1,170,000 before any year-end adjustments relating to the following:

● Goods were in transit from a vendor to Coward on December 31, 2021. The invoice
cost was P65,000 and the goods were shipped FOB shipping point on December
29, 2021. The goods were received on January 2, 2022.
● Goods shipped FOB shipping point on December 20, 2021 from a vendor to
Coward, were lost in transit. The invoice cost was P32,500. On January 5, 2022,
Coward filed a P32,5000 claim against the common carrier.
● Goods shipped FOB destination on December 21, 2021, from a vendor to Coward,
were received on January 6, 2022. The invoice cost was P19,500.
What amount should Coward report as accounts payable on its December 31, 2021
statement of financial position?
a) P1,202,500 c) P1,235,000
b) P1,222,000 d) P1,267,500

4. The balance in Stem Corporation's accounts payable account at December 31, 2021
was P1,350,000 before any necessary year-end adjustments relating to the following:

● Goods were in transit to Stem from a vendor on December 31, 2021. The invoice
cost was P75,000. The goods were shipped FOB shipping point on December 29,
2021 and were received on January 2, 2022.
● Goods shipped FOB destination on December 21, 2021, from a vendor to Stem,
were received on January 6, 2022. The invoice cost was P37,500.
● On December 27, 2021, Stem wrote and recorded checks totaling P60,000 which
were mailed on January 10, 2022.
In Stem's December 31, 2021 statement of financial position, how much should be the
accounts payable?
a) P1,410,000 c) P1,462,500
b) P1,425,000 d) P1,485,000

5. Echo Company sells office equipment contracts agreeing to service equipment for a
two-year period. Cash receipts from contracts are credited to unearned service contract
revenue and service contract costs are charged to service contract expense as incurred.
Revenue from service contract is recognized as earned over the lives of the contracts.
Additional information for the year ended December 31, 2021 is as follows:
Unearned service contract revenue, January 1, 2021 P600,000
Cash receipts from service contracts sold 980,000
Service contract revenue recognized 860,000
Service contract expense 520,000
What amount should Echo report as unearned service contract revenue at December 31,
2021?
a) P460,000 c) P490,000
b) P480,000 d) P720,000

6. Offset Co. sells gift certificates as part of its sales promotion. During the year, Offset Co.
sells gift certificates worth ₱500,000, of which ₱360,000 were redeemed. Based on
Offset Co.’s past experience, 10% of gift certificates sold are never redeemed. Under
PFRS 15, what amounts of (1) total revenue and (2) liability should be reported in Offset
Co.’s 2021 financial statements?
a. 400,000; 100,000 c. 410,000; 90,000
b. 360,000; 90,000 d. 360,000; 100,000

7. DULL Co. has a 10%, ₱2,000,000 loan payable as of December 31, 2021 which will be
maturing on July 1, 2022. Interest on the loan is due every July 1 and December 31 and
all the interests that have accrued in 2021 were paid on these scheduled dates. On
February 1, 2022, DULL Co. entered into a refinancing agreement with a bank to
refinance the loan on a long-term basis. Both parties are financially capable of honoring
the agreement's provisions. The contract on the ₱2,000,000 loan payable does not state
any refinancing or roll over option. DULL’s 2021 financial statements were authorized
for issue on March 15, 2022. In DULL’s 2021 financial statements, how much is
presented as current liability in relation to the loan payable?
a. 2,100,000 b. 2,000,000 c. 100,000 d. 0

8. Eliot Corporation’s liabilities at December 31, 2008 were as follows:

Accounts payable and accrued interest 2,000,000
5-year 10% Notes payable – due December 31, 2011 5,000,000

Part of the loan agreement is for Elliot to appropriate a fixed amount out of its accumulated profits
and losses annually until the amount of appropriation has equaled the face amount of the obligation.
Non-compliance will render the note as payable on demand by the lender. As of December 31,
2008, Elliot Corporation has not yet complied with the loan agreement. What amount of
current liabilities should Elliot Corporation report in its December 31, 2008 statement of financial
position?
a. 2,000,000 b. 5,000,000 c. 7,000,000 d. 0

9. FLUNK Co. requires advance payments for custom-built guitar effects, gadgets, and
racks. The records of FLUNK show the following:
● Unearned revenue, January 1, 2021 ₱ 2,000,000
● Advances received during 2021 20,000,000
● Advances applied to orders shipped in 2021 16,000,000
● Advances pertaining to orders cancelled in 2021 600,000

How much is presented as current liability assuming the advance payments received are non-
refundable?
a. 4,500,000 b. 5,400,000 c. 6,000,000 d. 6,600,000

10. WAIVE Co. maintains escrow accounts and pays real estate taxes for its customers.
Escrow funds are kept in interest-bearing accounts. Interest, less a 10% service fee, is
credited to the mortgagee’s account and used to reduce future escrow payments.
Information on escrow accounts are shown below:
Escrow accounts liability, January 1, 2021 400,000
Escrow payments received during 2021 3,000,000
Real estate taxes paid during 2021 1,000,000
Interest on escrow funds during 2021 200,000

How much is the current liability for the escrow accounts on December 31, 2021?
a. 2,580,000 b. 2,600,000 c. 2,400,000 d. 2,420,000
 Provisions, Contingent Liabilities and Contingent Assets

Provisions
A provision is a liability of uncertain timing or amount. 
Provisions differ from other liabilities because of the uncertainty about the timing or
amount of expenditure required in settlement. Unlike for other liabilities, provisions must
be estimated. Although, some other liabilities are also estimated, their uncertainty is
generally much less than for provisions. 
Other liabilities, such as accruals, are reported as part of “Trade and other payables”
whereas provisions are reported separately.

Provision vs. Contingent liability

Provision Contingent liability
●
Present obligation Possible obligation
● ●

● ●
Probable and measured reliably Present obligation but not probable or Present
● obligation but not measured reliably
●

● ●
Recognized (accrued in the Not recognized (not accrued in the statement of
statement of financial position) financial position)
● ●

Recognition of provisions
A provision is recognized when all of the following conditions are met:
1. The entity has a present obligation (legal or constructive) as a result of a past event;
2. It is probable that an outflow of resources embodying economic benefits will be
required to settle the obligation; and
3. A reliable estimate can be made of the amount of the obligation.

Present obligation is probable Present obligation is possible Present obligation is

remote
● ● ●
Recognize or accrue a Disclose only a contingent Do nothing.
 provision if outflow of liability. ●
economic benefits is both●
probable and reliably●
estimable. Do not recognize or accrue a
●
liability.
● ●
Provide appropriate disclosures
●

Measurement
Nature of the outflow Measurement basis
1. General rule Best estimate
●

2. Involves large population of items Expected value (Probability Weighted

Average)
●

3. Each expected outcome in a range is as likely Mid-point

as any other

Provisions for one-off events (restructuring, environmental clean-up, settlement of a

lawsuit) are measured at the most likely amount.
Provisions for large populations of events (warranties, customer refunds) are measured at
a probability-weighted expected value.
PWA
500,000 50% 250,000
300,000 20% 60,000
200,000 25% 50,000
100,000 5% 5,000 365,000

Present value
Where the effect of the time value of money is material, the amount of a provision shall
be the present value of the expenditures expected to be required to settle the obligation.

Expected disposal of assets

Gains from the expected disposal of assets shall not be taken into account in measuring a
provision. Gains shall be recognized only when the assets are actually disposed of.

Reimbursements
Where some or all of the expenditure required in settling a provision is expected to be
reimbursed by another party, the reimbursement is recognized only when it is virtually
certain that reimbursement will be received if the entity settles the obligation. 
The reimbursement shall be treated as a separate asset.
In the statement of profit or loss and other comprehensive income, the expense relating to
a provision may be presented net of the amount recognized for a reimbursement.

Changes in provisions
Provisions shall be reviewed at the end of each reporting period and adjusted to reflect
the current best estimate. 
 If it is no longer probable that an outflow of resources embodying economic benefits will
be required to settle the obligation, the provision shall be reversed.

Product warranties and guarantees

If a customer has the option to purchase a warranty separately (for example, because the
warranty is priced or negotiated separately), the warranty is accounted for in accordance
with PFRS 15 Revenue from Contracts with Customers.
If a customer does not have the option to purchase a warranty separately, the warranty is
accounted for in accordance with PAS 37 Provisions, Contingent Liabilities and
Contingent Assets unless the promised warranty provides the customer with a service in
addition to the assurance that the product complies with agreed-upon specifications.

Liability for premiums

A customer option to acquire additional goods or services for free or at a discount is
accounted for under PFRS 15 if the option provides the customer a material right that
the customer would not receive without entering into that contract. 
A customer option that does not provide the customer with a material right is not
accounted for under PFRS 15; and therefore, accounted for in accordance with PAS 37.

Guarantee for indebtedness of others

A provision for the guarantee for indebtedness of others is recognized when it becomes
probable that the entity will be held liable for the guarantee, such as when the original
debtor defaults on the loan.

Contingent assets
Contingent asset is Contingent asset is Contingent asset is
probable possible remote
● ● ●
Disclose only a Do nothing. Do nothing.
contingent asset. ● ●
●

●
Do not recognize or
accrue.
●

When to recognize a provision?

Restructuring by sale of an operation: A provision would be recognized when a sale of an
operation is probable and the costs associated with the sale can be reliably estimated.

Restructuring by closure or reorganization: A provision would be recognized when a

detailed plan for restructuring has been approved, and it is probable that the company will
carry out the plan.

Warranty: A provision would be recognized for the expected costs of fulfilling the
warranty obligations.

Land contamination: A provision would be recognized for the estimated costs of cleaning
up the contamination.

Customer refunds: A provision would be recognized for the expected costs of providing
the refunds.

Offshore oil rig must be removed and sea bed restored: A provision would be recognized
for the expected costs of removing the rig and restoring the sea bed.

Obligations arising from the production of oil: A provision would be recognized for the
estimated costs of fulfilling the obligations.

Abandoned leasehold, four years to run, no re-letting possible: A provision would be

recognized for the estimated costs of fulfilling the lease obligations.

CPA firm must staff training for recent changes in tax law: No provision is necessary as
this is a current expense, not a provision for a past event.

Major overhaul or repairs: A provision would be recognized for the expected costs of the
overhaul or repairs.

Onerous (loss-making) contract: A provision would be recognized for the expected losses
from the contract.

Future operating losses: No provision is necessary as these are not obligations arising
from past events.
Restructuring
A restructuring is:
● sale or termination of a line of business

● closure of business locations

● changes in management structure

● fundamental reorganization.

Restructuring provisions should be recognized as follows:

Sale of operation: recognize a provision only after a binding sale agreement
Closure or reorganization: recognize a provision only after a detailed formal plan is
adopted and has started being implemented, or announced to those affected. A board
decision of itself is insufficient.
Future operating losses: provisions are not recognized for future operating losses, even in
a restructuring
Restructuring provision on acquisition: recognize a provision only if there is an
obligation at acquisition date

Restructuring provisions should include only direct expenditures necessarily entailed by

the restructuring, not costs that are associated with the ongoing activities of the entity.

Disclosures
● Reconciliation for each class of provision:
opening balance
additions
used (amounts charged against the provision)
unused amounts reversed
unwinding of the discount, or changes in discount rate
closing balance
● A prior year reconciliation is not required.
● For each class of provision, a brief description of:
nature
timing
uncertainties
assumptions
reimbursement, if any.

1. On April 30, 2022, an explosion occurred at TWIST Co.’s plant causing extensive property
damage to area buildings. TWIST’s management and counsel concluded that it is likely that
claims will be asserted and that it is probable that TWIST will be held responsible for
damages. TWIST’s management believed that ₱5,000,000 would be a reasonable estimate of
its liability. TWIST’s ₱20,000,000 comprehensive public liability policy has a ₱1,000,000
deductible clause. TWIST’s financial statements were authorized for issue on March 30,
2022. How should the event above be reported in TWIST’s December 31, 2021 financial
statements?
a. accrue a provision of ₱1M.
b. disclose only ₱1M.
c. accrue and disclose ₱1M.
d. neither accrue nor disclose.

2. In 2021, JUBILEE Co. recognized a provision for a probable loss on a pending lawsuit
amounting to ₱2,000,000. In 2022, the lawsuit remains unsettled and JUBILEE determined
that the provision on the pending law suit must be increased by ₱800,000. In 2023, JUBILEE
 won the lawsuit. Nothing was paid on the settlement. The effect of the settlement on the
2023 profit is: increase (decrease)
a. 2,800,000 c. 2,000,000
b. (2,800,000) d. 0

3. On January 1, 2021, DECRY Co. signed a three year, non-cancelable purchase contract,
which allows DECRY Co. to purchase up to 60,000 units of a microchip annually from
BELITTLE Co. at ₱100 per unit and guarantees a minimum annual purchase of 15,000 units.
At year-end, it was found out that the goods are obsolete. DECRY had 10,000 units of this
inventory at December 31, 2021, and believes these parts can be sold as scrap for ₱20 per
unit. How much is the loss on purchase commitment?
a. 2,400,000 c. 3,200,000
b. 800,000 d. 9,600,000

4. FUNNY Co. provides 3-year warranty for the products it sells. FUNNY estimates that
warranty costs ₱400 per unit sold. As of January 1, 2021, the liability for warranty has a
balance of ₱800,000 for units sold in 2020. During the year FUNNY sold 5,000 units and
actual warranty costs incurred were ₱1,240,000. How much is the warranty expense to be
recognized in 2021?
a. 2,000,000 c. 3,240,000
b. 1,240,000 d. 4,240,000

BEG. 800,000
WARRANTY EXPENSE 2,000,000 5,000 * P400
ACTUAL WARRANTY COST (1,240,000)
END. 1,560,000

5. CANDID Co. launched a sales promotion in 2021. For every five bottles returned to
CANDID, customers will receive a T-shirt. The unit cost of T-shirt is ₱400. CANDID
estimates that 80% of sales will be redeemed. Additional information is as follows:
Units
Sales in 2021 500,000
Sales in 2022 900,000
T-shirts distributed in 2021 60,000
T-shirts distributed in 2022 147,600

PREMIUM EXP 2021 32,000,000

2022 57,600,000
89,600,000

AÇTUAL COST OF 2021 24,000,000

PREMIUM DISTRIBUTED 2022 59,040,00
83,040,000

How much is the liability for premiums as of December 31, 2022?

a. 6,650,000 c. 6,870,000
b. 7,860,000 d. 6,560,000
Leases
PFRS 16 specifies how an PFRS reporter will recognize, measure, present and disclose
leases. The standard provides a single lessee accounting model, requiring lessees to
recognize assets and liabilities for all leases unless the lease term is 12 months or less or
the underlying asset has a low value. Lessors continue to classify leases as operating or
finance, with PFRS 16’s approach to lessor accounting substantially unchanged from its
predecessor, PAS 17.

Identifying a lease
“A contract is, or contains, a lease if the contract conveys the right to control the use of
an identified asset for a period of time in exchange for consideration.” (PFRS 16.9)

Right to Control 
An entity has the right to control the use of an identified asset if it has both of the
following throughout the period of use:
1. the right to obtain substantially all of the economic benefits from use of the
identified asset; and
2. the right to direct the use of the identified asset.

Identified asset
An asset can be identified by being explicitly stated in the contract or by being implicitly
specified at the time the asset is made available for use by the customer.
A portion of an asset can be identified if it is physically distinct.

Substantive substitution rights

A customer does not have the right to use an identified asset if the supplier has the
substantive right to substitute the asset throughout the period of use.

A supplier’s right to substitute an asset is substantive if both of the following conditions

exist:
1. the supplier has the practical ability to substitute alternative assets throughout the
period of use; and
2. the supplier would benefit economically from the exercise of its right to substitute the
asset.

Right to direct the use

The customer has the right to direct how and for what purpose the asset is used
throughout the period of use

Identifying whether a contract is, or contains, a lease

Accounting for leases by Lessee
GENERAL RECOGNITION
Lessee recognizes both:
      1. Lease liability; and
      2. Right-of-use asset

RECOGNITION EXEMPTION 
(for “short-term” and ‘low value’ leases)
Lessee recognizes lease payments as expense over the lease term using straight line
basis, or another more appropriate basis.

GENERAL RECOGNITION
  

Discount rate
Discount rate is the interest rate implicit in the lease; if not determinable, then the
lessee’s incremental borrowing rate.

Separating components of a contract

An entity accounts for each lease component of a contract separately from the non-lease
components of the contract.

A lessee allocates the consideration in the contract to each lease component on the basis
of the relative stand-alone price of the lease component and the aggregate stand-alone
price of the non-lease components.
Payments for activities or costs that do not transfer goods or services to the lessee are not
a separate component of the contract. The payments for these items are included in the
total consideration that is allocated to the separately identified components of the
contract.
 Initial direct costs
A lessee capitalizes initial direct costs as follows:

General recognition Recognition exemption

● ●
Treat as part of the cost of the right- Treat as prepaid rent and recognize as expense
of-use asset and include in under the straight line basis (or another more
depreciation. appropriate basis).
● ●

Lease payments made to lessor at or before commencement date

General recognition Recognition exemption
Advance rent arises when rentals are payable at the treated as prepaid rent and
beginning of each period. recognized as expense under
the straight line basis (or
Excluded from the initial measurement another more appropriate
of lease liability but included in the basis).
initial measurement of right-of-use●
asset.
Lease bonus is an amount, in addition to periodic same accounting as advance
rentals, paid by a lessee to the lessor in rent above.
order to induce granting of leasehold●
rights to the lessee. Lease bonus is the
opposite of ‘lease incentive.’

same accounting as advance rent

above.
Classification of lease by the lessor
1. Finance lease - a lease that transfers substantially all the risks and rewards
incidental to ownership of an asset. Title may or may not eventually be transferred.
2. Operating lease - a lease other than a finance lease

Indicators of a finance lease

● the lease transfers ownership of the asset to the lessee by the end of the lease term

● the lessee has the option to purchase the asset at a price which is expected to be
sufficiently lower than fair value at the date the option becomes exercisable that, at
the inception of the lease, it is reasonably certain that the option will be exercised

● the lease term is for the major part of the economic life of the asset, even if title is not
transferred 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
● the leased assets are of a specialized nature such that only the lessee can use them
without major modifications being made

Accounting for Finance Leases by Lessors

Initial recognition
Lessors recognize assets from a finance lease as receivable measured at an amount equal
to the net investment in the lease.

INCEPTION DATE VS COMMENCEMENT DATE

LEASE RECEIVABLE GI
ASSET NI
UNEARNED INTEREST INCOME GI-NI

Discount rate
The discount rate to be used in calculating the present value of the lease payments is the
interest rate implicit in the lease. 

Interest rate implicit in the lease – the rate of interest that causes the present value of (a)
the lease payments and (b) the unguaranteed residual value to equal the sum of (i) the fair
value of the underlying asset and (ii) any initial direct costs of the lessor.

Initial direct costs

Initial direct costs are capitalized except direct costs incurred by a manufacturer or dealer
lessor under a sales type lease, which are expensed immediately.
The interest rate implicit in the lease is defined in such a way that the initial direct costs
are included automatically in the net investment in the lease; there is no need to add
them separately.
Classification of finance lease as to the lessor
As to the lessor, finance leases may be classified as either:
     a. Direct financing lease, or
     b. Sales type lease

Accounting for operating lease

The accounting for operating leases is straight-forward. The lessor recognizes the lease
payments as rent income on a straight line basis over the lease term, unless another
systematic basis is more representative of the time pattern of user’s benefit. 

Lease bonus
Lease bonus is an amount, in addition to periodic rentals, paid by a lessee to the lessor in
order to induce granting of leasehold rights to the lessee. 

The lessor accounts for the lease bonus as unearned rent to be amortized to rent income
over the lease term.

MULTIPLE CHOICE QUESTIONS

1. Omega made the following journal entry at the end of the first lease year:
Rent expense 1,500 (Dr.)
 Cash 1,500 (Cr.)
Omega must have a(n) (applied):
a. general recognition c. finance lease.
b. operating lease. d. recognition exemption.

2. The accounting concept that is principally used to classify leases into operating and
finance is
a. Substance over form. b. Prudence. c. Neutrality. d. Completeness.

3. Which of the following situations would prima facie lead to a lease being classified as
an operating lease?
a. Transfer of ownership to the lessee at the end of the lease term. -F
b. Option to purchase at a value below the fair value of the asset. -F
c. The lease term is for a major part of the asset’s life. -F
d. The present value of the minimum lease payments is 50% of the fair value of
the asset. -O

4. The basic accounting issue for lessors is:

a. computing depreciation on the leased asset.
b. revenue recognition during the lease term.
c. determination of the cost of the leased asset.
d. expense recognition during the lease term.

5. The classification of a lease as either an operating or finance lease is based on

a. The length of the lease.
b. The transfer of the risks and rewards of ownership.
c. The minimum lease payments being at least 50% of the fair value.
d. The economic life of the asset.

6. Which of the following would lead to finance lease classification?

a. The lease term is 7 years while the remaining economic life of the leased asset is 10
years.
b. The present value of future minimum lease payments is P80,000 while the fair
value of the leased asset as of inception of the lease is P100,000.
c. The lease contains a purchase option which is equal to the fair value of the leased
asset.
d. Ownership over the leased asset will be transferred to the lessee upon lease
expiration

7. Lessees under general recognition recognize

a. interest expense c. interest expense and depreciation expense
b. rent expense d. rent expense and interest expense

8. A lessor under finance lease recognizes all of the following, except

a. Gross investment c. Unearned interest income
b. Net investment d. Depreciation on leased asset

9. If the lease provides for the transfer of ownership over the leased asset or a bargain
purchase option
a. the lessor shall depreciate the leased asset over its useful life
 b. the lessee shall depreciate the leased asset over the shorter of the asset’s useful life
and the remaining lease term
c. the lessee shall depreciate the leased asset over its useful life
d. both the lessee and the lessor shall depreciate the leased asset

10. Net investment in the lease is equal to the

a. Gross investment in the lease plus unearned finance income
b. Present value of gross investment
c. The present value of the minimum lease payment
d. The present value of minimum lease payments less the present value of any
unguaranteed residual value

11. Which of the following statements is incorrect regarding the accounting for the
residual value of a leased asset?
a. A lessee accounts for a residual value only if it is guaranteed.
b. A lessor accounts for a residual value only if it is guaranteed.
c. A lessor accounts for a residual value whether guaranteed or not.
d. Both lessee and lessor will account for a residual value only if the leased asset
reverts back to the lessor

12. Customer X enters into a five-year contract with Supplier Y for the use of a rolling
stock specifically designed for Customer X. The rolling stock is designed to transport
materials used in Customer X’s production process and is not suitable for use by other
customers. The rolling stock is not explicitly specified in the contract, but Supplier Y
owns only one rolling stock that is suitable for Customer X’s use. If the rolling stock
does not operate properly, the contract requires Supplier Y to repair or replace the
rolling stock. Supplier Y does not have a substantive substitution right. Is the rolling
stock an identified asset?
a. Yes, because the rolling stock is implicitly specified in the contract.
b. Yes, because the contract extends beyond 12 months.
c. No, because the rolling stock is not explicitly specified in the contract.
d. No, because I don’t know what a rolling stock is.

13. A lessor’s gross investment in a finance lease is computed as

a. lease payments plus unguaranteed residual value.
b. present value of (a).
c. difference between (a) and (b).
d. sum of (a) and (b).

14. Which of the following statements is false regarding the accounting for leases?
a. The lessor may not use the straight line basis for recognizing lease income under an
operating lease if another systematic basis is more representative of the pattern in
which benefit from the use of the underlying asset is diminished.
b. The amount of lease income recognized each year under an operating lease is
typically constant even though the contractual payments increase every year by a
certain amount specified in the contract.
c. It is possible that the lessor does not depreciate the leased asset even if the lease is
classified as an operating lease.
d. Under an operating lease, the lessor capitalizes initial direct costs. These costs
will increase the lease income each year.
15. Customer X enters into a five-year contract with Supplier Y for the right to
transport oil from Country A to Country B through Supplier Y’s pipeline. The contract
provides that Customer X will have the right to use 60% of the pipeline’s capacity
throughout the term of the arrangement. Is the portion of the pipeline specified in the
contract qualifies as an identified asset for purposes of lease accounting?
a. Yes, because it is physically distinct.
b. Yes, because it represents substantially all of the capacity of the entire pipeline.
c. No, because it is not physically distinct and it does not represent substantially
all of the capacity of the entire pipeline.
d. No, but I don’t know why.

16. Which of the following statements is correct regarding the accounting for leases?
a. The lessor depreciates the leased asset under a finance lease.
b. The lessee depreciates the leased asset under a “short-term” or a “low-valued asset”
lease.
c. When discounting lease payments both the lessor and the lessee use the
interest rate implicit in the lease, unless the lessee cannot determine this rate.
d. An entity can never be both a lessor and a lessee of a same leased asset.

17. Which of the following is not one of the criteria when determining whether a
contract is or contains a lease?
a. Identified asset
b. Identified liability
c. Right to obtain substantially all of the economic benefits from use of an identified
asset throughout the period of use
d. Right to direct the use of the identified asset throughout the period of use.

18. On January 1, 2021, Lebron enters into a 3-year lease of equipment for an annual
rent of P100,000 payable at the end of each year. The equipment has a remaining
useful life of 10 years. The interest rate implicit in the lease is 10% while the lessee’s
incremental borrowing rate is 12%. Lebron uses the straight-line method of
depreciation. The relevant present value factors are as follows:
- PV of an ordinary annuity of P1 @10%, n=3………… 2.48685
- PV of an ordinary annuity of P1 @12%, n=3………… 2.40183

How much is the lease liability to be recognized by Lebron on initial recognition?

a. 240,183 c. 252,314
b. 248,685 d. 0

19. Assume the lease in problem #18 above qualifies for accounting under the
recognition exemption under PFRS 16. Which of the following statements is correct?
a. Lebron recognizes annual depreciation of P80,061 on the right-of-use asset.
b. Lebron recognizes a lease liability of P252,314 at the lease commencement date.
c. Lebron recognizes a lease liability of P200,000 at the lease commencement date.
d. Lebron recognizes lease expense of P100,000 in the first year of the lease.
20. On January 2, 2021, Ashley Company entered into a ten-year non-cancellable lease
requiring year-end payments of P100,000. Ashley's incremental borrowing rate is 12%
while the lessor's implicit interest rate, known to Ashe, is 10%. Ownership of the
property remains with the lessor at expiration of the lease. The leased property has an
estimated economic life of 12 years. What amount should Ashley recognize for this
leased property on January 2, 2021?
a. 1,000,000 c. 565,000
b. 614,500 d. 0

21. Oak Co. leased equipment for its entire nine-year useful life, agreeing to pay
P50,000 at the start of the lease term on December 31, 2028, and P50,000 annually on
each December 31 for the next eight years. The present value on December 31, 2028,
of the nine lease payments over the lease term, using the rate implicit in the lease
which Oak knows to be 10%, was P316,500. The December 31, 2028, present value of
the lease payments using Oak's incremental borrowing rate of 12% was P298,500. Oak
made a timely second lease payment. What amount should Oak report as lease
liability in its December 31, 2029, balance sheet?
a. 350,000 c. 228,320
b. 243,150 d. 0

22. On December 30, 2021, Haber Co. leased a new machine from Gregg Corp. The
following data relate to the lease transaction at the inception of the lease:
Lease term 10 years
Annual rental payable at the end of each lease year P100,000
Useful life of machine 12 years
Implicit interest rate 10%

The lease has no renewal option, and the possession of the machine reverts to Gregg
when the lease terminates. At the inception of the lease, Haber should record a lease
liability of (rounded-off)
a. 0 c. 630,000
b. 615,000 d. 676,000

23. On January 1, 2021, Babson, Inc., leased two automobiles for executive use. The
lease requires Babson to make five annual payments of P13,000 beginning January 1,
2021. Babson expects to pay P10,000 on the residual value guarantee. The interest rate
implicit in the lease is 9%. Babson's recorded lease liability on initial recognition is
a. 48,620 c. 35,620
b. 44,070 d. 31,070
24. On January 1, 2021, Row Co. leased a machine from Boat, Inc. Information on the
lease is as follows:
Annual rent payable at the beginning
of each year P200,000
10
Lease term
years
12
Useful life of machine
years
Implicit interest rate 10%

The lease contract provides Row Co. an option to purchase the machine at the end of the
lease term for P100,000. The option price approximates the machine’s expected fair value
at the end of the lease. Row Co. is reasonably certain to exercise the option. What amount
of interest expense should Row Co. recognize on the lease in 2021?
a. 139,036 b. 135,181 c. 119,036 d. 115,181

25. January 1, 2021, Lock Co. enters into a 4-year lease of office equipment. The rent
in 2021 is P10,000 and this will increase by 10% annually starting on January 1, 2022.
Lock Co. pays the lessor a lease bonus of P5,000 on January 1, 2021. Lock Co. opts to
use the practical expedient allowed under PFRS 16 for leases of low value assets. How
much is the lease expense in 2021?
a. 10,000 c. 11,603
b. 11,000 d. 12,853

26. On January 1, 2021, Day Corp. entered into a 10-year lease agreement with Ward,
Inc. for a piece of industrial equipment. Annual lease payments of P10,000 are
payable at the end of each year. Day knows that the lessor expects a 10% return on the
lease. Day has a 12% incremental borrowing rate. The equipment is expected to have
an estimated useful life of 10 years. In addition, a third party, unrelated to Day, has
guaranteed to pay Ward a residual value of P5,000 at the end of the lease. In Day's
January 1, 2021 balance sheet, the principal amount of the lease obligation was
a. 63,374 c. 58,112
b. 61,446 d. 56,502

Use the following information for the next two questions:

On January 1, 2021, VACILLATE Financing Co. leased equipment to HESITATE, Inc.
Information on the lease is shown below.
Cost of equipment P1,394,740
Useful life of equipment 5 years
Lease term 4 years
Annual rent payable at the start of each year P400,000
Interest rate implicit in the lease 10%

27. How much is the total interest income (finance income) to be recognized by
VACILLATE over the lease term?
a. 400,000 c. 205,260
b. 605,260 d. 365,260
28. How much is the carrying amount of the net investment in the lease as of December
31, 2021?
a. 694,215 c. 735,260
b. 1,094,215 d. 1,165,260

29. On January 1, 2021, OFFICIOUS Financing Co. leased equipment to

MEDDLESOME, Inc. under direct financing lease. Information on the lease is shown
below:
Cost of equipment P1,200,000
Useful life of equipment 5 years
Lease term 4 years
Annual rent payable at the end of each year P440,00
0
Non-lease component included in annual rent P36,196
Initial direct costs 80,000
Implicit rate of interest in the lease 10%

The non-lease component pertains to payment for supplies and other consumables
relating to the operation of the equipment. The stand-alone selling prices are: P36,196 for
the supplies and P403,804 for the rent.

On January 1, 2023, due to cash flow problems, OFFICIOUS agreed to sell the
equipment to MEDDLESOME, Inc. for P600,000. How much is the gain (loss) on the
sale?
a. (100,816) c. 20,816
b. 100,816 d. 0

30. On January 1, 2021, UPPITY Co. leased a piece of equipment to ARROGANT,

Inc. Information on the lease is shown below.
Cost of equipment P1,200,000
Useful life of equipment 5 years
Lease term 4 years
Annual rent payable at the end of each year ?

UPPITY Co. incurred direct costs of P80,000 in negotiating the lease. If UPPITY Co.
desires a fair rate of return of 10%, what amount of annual rental should it charge
ARROGANT, Inc.?
a. 440,000 c. 340,000
b. 403,803 d. 200,000