OPERATING LEASE

CHAPTER 10
LEASE

■ An agreement whereby the lessor conveys to the lessee in return for a payment or
series of payments the right to use an asset for an agreed period of time.
■ An agreement between one party called the lessor and another party called the
lessee whereby the lessee is granted the right to use the property owned by the
lessor for a specific period of time in consideration for certain payment in the form
of rent.
KINDS OF LEASE

■ Operating Lease
■ Finance or Capital Lease
OPERATING LEASE - LESSEE

■ Lease payments under an operating lease shall be recognized as an expense 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.
■ The periodic rental is recognized as rent expense on the part of the lessee.
■ Also called the rental approach.
■ A lease bonus paid by the lessee to the lessor in addition to the periodic rental is
treated as prepaid rent expense by the lessee to be amortized over the lease term.
■ Leasehold improvement made by the lessee shall be depreciated over the life of the
improvement or lease term, whichever is shorter.
■ The residual value of the leasehold improvement is ignored by the lessee in
computing depreciation because legally the leasehold improvement becomes the
property of the lessor upon the expiration of the lease term.
■ Any security deposit refundable upon the lease expiration is accounted for as an
asset by the lessee.
OPERATING LEASE - LESSOR

■ Lease income from operating lease shall be recognized on a straight line basis over
the lease term, unless another systematic basis is more representative of the time
pattern in which use benefit derived from the leased asset is diminished.
■ The periodic rental received by the lessor in an operating lease is simply recognized
as rent income.
■ A lessor shall present an asset subject to operating lease in its statement of
financial position according to the nature of the asset.
■ The leased property remains as an asset of the lessor and consequently, the lessor
bears all ownership or executory costs such as depreciation of leased property, real
property taxes, insurance and maintenance.
■ The lessor may pass on 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 COSTS

■ Incurred by lessor and include amounts such as commissions, legal fees and
internal costs that are incremental and directly attributable to negotiating and
arranging a lease.
■ Added to the carrying amount of the leased asset and recognized as an expense
over the lease term on the same basis as the lease income.
■ 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.
LESSEE

On January 1, 2019, ABC Company leased an equipment from another entity for
P300,000 annually for 3 years.
Rent expense 300,000
Cash 300,000
On January 1, 2019, ABC Company made a security deposit of P300,000 refundable
upon the lease expiration.
Rent deposit 300,000
Cash 300,000
In addition to the annual rental, ABC Company paid P60,000 to the lessor as a lease
bonus on January 1, 2019.
Prepaid rent 60,000
Cash
60,000
The lease bonus is amortized over 3 years or P20,000 annually.
Rent expense 20,000
Prepaid rent
20,000
LESSOR

On January 1, 2019, DEF 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
On April 1, 2019, DEF 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
On April 1, 2019, DEF Company received a security deposit of P600,000 to be refunded
upon the lease expiration.
Cash 600,000
Liability for rent deposit 600,000
In addition to the rental, DEF Company received from the lessee a lease bonus of
P120,000 on January 1, 2019.
Cash 120,000
Unearned rent income 120,000
On April 1, 2019, DEF Company paid initial direct costs of P300,000. Such costs are
directly attributable to negotiating and arranging the operating lease.
Deferred initial direct costs 300,000
Cash 300,000
During the year, DEF Company paid repair and maintenance of P20,000.
Repair and maintenance 20,000
Cash 20,000
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
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, 2019 and not
from April 1, 2019, date of lease. The reason is that the machinery is acquired for
leasing purposes and therefore available for the intended use, meaning for rental
from January 1, 2019. Idle property is subject to depreciation as long as it is
available for its intended use.
The initial direct costs are recognized as expense over the lease term.
Amortization of initial direct costs 75,000
Deferred initial direct costs
75,000
■ The balance of the deferred initial direct costs shall be presented as an addition to
the carrying amount of machinery.
UNEQUAL RENTAL PAYMENTS

■ Lease payments under an operating lease shall be recognized as an expense on a

straight line basis over the lease term unless another systematic basis is
representative of the time pattern of the user’s benefit.
■ Where the operating lease requires unequal cash payments, the total cash
payments for the lease term shall be amortized uniformly on the straight line basis
as rent expense or rent income.
GHI Company leased office space to JKL Company for a three-year period beginning
January 1, 2019. 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, GHI Company granted JKL Company the first six months
of the lease rent – free.
TOTAL RENTAL FOR THE LEASE TERM

2019 500,000
2020 1,250,000
2021 1,250,000
Total rental for 3 years 3,000,000

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

BOOKS OF GHI COMPANY - LESSOR

2019 Cash 500,000

Rent receivable
500,000
Rent income
1,000,000
2020 Cash
1,250,000
Rent income
1,000,000
Rent receivable
250,000
Rent income for 2018 and 2019 2,000,000
Rent collected (500,000 + 1,250,000) 1,750,000
Rent receivable 250,000

Note that the rent receivable has a zero balance on December 31, 2021 and the
recorded rent income each year is P1,000,000.
BOOKS OF JKL COMPANY - LESSEE

2014 Rent expense 1,000,000

Cash 500,000
Rent payable 500,000
2015 Rent expense 1,000,000
Rent payable 250,000
Cash
1,250,000
2016 Rent expense 1,000,000
Rent payable 250,000
DISCLOSURES FOR OPERATING LEASES
- LESSEE
■ The total of future minimum lease payments under noncancelable operating leases
for each of the following periods:
– Not later than one year
– Later than one year and not later than 5 years
– Later than 5 years
■ The total of future minimum lease payments expected to be received under
noncancelable subleases at the end of the reporting period.
■ Lease and sublease payments recognized as expense in the period, with separate
amounts for minimum lease payments, contingent rents and sublease payments.
■ A general description of the lessee’s significant leasing arrangements.
DISCLOSURES FOR OPERATING LEASES
- LESSOR
■ Future minimum lease payments under noncancelable operating leases in the
aggregate and for each of the following periods:
– Not later than one year
– Later than one year and not later than 5 years
– Later than 5 years
■ Contingent rents recognized as income in the period.
■ A general description of the lessor’s leasing arrangement.