LEASE ACCOUNTING – LESSOR

No changes in Lease Accounting- Lessor. Under the new standard, IFRS 16, Lessor
accounting remained unchanged, that is, it can be classified as Operating Lease or
Finance Lease.

So, where is the distinction?

LESSEE accounting - straight Finance lease

LESSOR accounting - Finance Lease OR Operating Lease

So, pwede sa isang lease contract, magkaiba ang treatment. Si lessee, finance lease agad
ang treatment, si lessor, operating lease or finance lease, depende sa condition or criteria
present.

What is again the difference between finance lease and operating lease?

An operating lease is the one that DOES NOT transfer substantially all the risk
and rewards incidental to ownership of an underlying asset. Meaning, parang regular
rent lang, na after ng lease contract, babalik ung asset sa may ari (lessor). Usually,
the entry under operating lease.

A finance lease TRANSFERS substantially all the risks and rewards incidental to
ownership of an underlying asset. (Usually, eto ung, after the lease pwede
ma transfer ung ownership nung asset sa lessee after the lease term).

Remember! = Lessee accounting – straight finance lease; Lessor accounting – Finance

Lease or Operating lease

So, when can we classify a lease as a finance lease then?

It depends on the substance (nilalaman) of the contract or transaction. Under IFRS

16, the following can lead to a finance lease:

a. If the lease transfers ownership of the underlying asset to the lessee at the
end of the lease term. So, if there is an indication that Pedro will eventually own
the asset he is renting after the lease term, then, it is a finance lease.

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

Dapat, sa umpisa pa lang ng lease, may certainty na gagamitin ni lessee ung

purchase option nya after the lease term.

c. If the lease term is for the major part of the economic life of the underlying
asset even if tittle is not transferred.

Example, lets say si Pedro nagrent ng bagong bago na equipment kay Juan.
Ang useful life nung equipment is 10 years. Ang lease term is 9 years. So,
 ang economic life nung equipment ay andun sa renta, 1 year na lang ang natira
na pwede pa pakinabangan ang equipment after the lease term. So, pag ganito,
finance lease ang treatment kahit hindi ma pass ang ownership nung equipment
kay Pedro, kasi halos wala naman na pakinabang kay Juan ung equipment
pagkatapos nung rent, kasi lumang luma na.

d. If the present value of the lease payments amounts to substantially all of the fair
value of the underlying asset at the inception of the lease.

Example: Let’s say, on January 1, 2020, Juan bought an equipment for

P200,000. On the same date, he leased the equipment to Pedro for
an annual lease of P50,000 for 5 years. Juan’s expected rate of
return (implicit rate) is 10%.

PV of P50,000@3.7907 = P189,535

The fair value of the equipment on Jan. 1 is P200,000 while the

present value of all the future lease payment is P189,530, that’s
already 95% of the fair value. So,parang binili na rin ni Pedro
ung equipment.

But, when or what percentage can we consider major part or substantially all?

There is no explicit guidelines on this under the new standard, but under US
GAAP, major part means at least 75% and substantially all means at least
90%.

Don’t worry, because problems will specifically mention whether it is major

part or substantially all.

Aside from the 4 items above, there also other criteria or considerations wherein a
lease can be classified as finance lease:

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

Ex: Kung ung underlying asset ay naka design sa operation ni Co. X. Hindi na
pwede
parentahan sa iba, or kailangan pa ng major modification dun sa underlying
asset para ma pa rentahan sa iba after the lease term.

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

Ex: Kung si Juan ay nangutang lang sa bangko para pambili ng equipment na

pa rerentahan nya kay Pedro, then, cancelled ni Pedro yung lease contract,
pero si Juan, tuloy pa rin ang bayad nya sa interest ng loan. Kung sinagot
ni Pedro ung losses ni Juan sa pagbayad ng interest, finance lease ang
treatment.
 c. If gains or losses from the fluctuation in the fair value of the residual accrue to
the lessee.

Best example for this is in the form of rental rebate equaling most of the sales
proceeds at the end of the lease.

Some lease contracts requires that the asset be sold at the end of the lease
contract and that the proceeds from sale will be shared by the lessee and the
lessor.

Ex: Company X leased and equipment to Company Y. The lease contracts

provides that at the end of the lease term, the equipment will be sold
and the proceeds from will be shared by Company X and Y.

Sales Proceeds (FV) 100,000

Residual Value 20,000
----------
Gain 80,000

If the P80,000 goes to Company Y, the lease is finance lease, because it

can be assumed that Company Y assumes substantially all the risk of
the underlying asset, thus Company Y has bigger share in the proceeds
which almost equals the sales proceeds (P80K vs P100k). The 20k
which goes to Company X only means that Company X is only
recovering the residual value which probably guaranteed by Company
Y.

If it is other way around, then the lease is an operating lease.

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

Ex: After the expiration of the lease term, the lessee can still continue or extend
the lease for another period (secondary period), wherein the rental say,
is just P20,000 when the lessor can lease it out in the market (to
another lessee) for P100,000. So, P20k is substantially lower than the
existing market rental rate.

OPERATING LEASE – LESSOR

Example: On January 1, 2020, ABC C. purchased an equipment for P2M. The expected
useful life of the equipment is 10 years.

a. On April 1, 2020, ABC Co. leased the equipment to XYZ Co. for 3 years at a
monthly rental of P40k payable at the start of every month.

b. A security deposit of P120k is received by ABC Co which will be refunded at

the end of the lease contract.

c. In addition, ABC Co also received a lease bonus from XYZ Corp (lessee)
amounting to P150k, and
 d. ABC Company paid initial direct cost of P200k which is directly attributable to
negotiating the and arranging for the lease.

e. During the year, ABC paid a maintenance cost of P30,000

1. The lessor recognize lease payment received from operating lease as INCOME

Cash (40k x 9) 360,000

Lease Income 360,000

2. Any security deposit refundable upon the lease expiration is recognized as a liability
by the lessor.

Cash 120,000
Liability for lease deposit 120,000

3. Any lease bonus received by the lessor from the lessee is recognized as Unearned
Lease Income to be amortized over the lease term

Cash 150,000
Unearned lease income 150,000

4. Initial direct cost incurred by the lessor will be added to the carrying amount of the
underlying asset and recognized as an expense over the lease term

Deferred direct cost 200,000

Cash 200,000

5. All executory costs (eg. depreciation of leased property, property taxes, insurance
and maintenance) will be shouldered by the lessor

Repairs and maintenance 30,000

Cash 30,000

6. The underlying asset remains the asset of the lessor. Thus at the end of each year,
lessor, records depreciation

Depreciation expense 200,000

Accumulated depreciation 200,000

Note: Depreciation should start when the equipment was bought, not
when the lease commenced. Even if the equipment is idle from
Jan 1 to April 1, it is still subject for depreciation as long as it is
available for its intended use.

Unearned lease income 37,500

Lease income 37,500
(Amortized unearned lease income = P150k/3 x 9/12)

Direct cost 50,000

Deferred direct cost 50,000
(Amortization of deferred direct cost = (P200k/3 x 9/12)
 Unequal lease payments

IFRS 16 requires that lease payments under operating lease shall be recognized as
income on a straight line basis or another systematic basis.

If the lease payments are unequal, the total lease payment shall be amortized
uniformly on a straight-line basis as lease income over the lease term..

Example: Pedro Company leased its equipment to Juan Company starting January 1,
2020, with the following terms:

a) The lease term be for 3 years

b) Lease for the first year is P1,000,000 and P1,300,000 for the next 2
years.
c) As a bonus, Pedro Co. granted a free rent for the first 3 months.

Total lease will be:

2020: P1M x 9/12 – April to Dec 750,000

2021: 1,300,000
2022: 1,300,000
Total rent – 3 years 3,350,000

Average annual rent (3,350,000/3) 1,116,667

2020: Cash 750,000

Lease receivable 366,667
Lease income 1,116,667

2022: Cash 1,300,000

Lease income 1,116,667
Lease receivable 183,333

Lease income for 2020 and 2021 2,233,333

Lease collected (750k + 1.3M) 2,050,000
183,333

2023:Cash 1,300,000
Lease income 1,116,667
Lease receivable 183,333

At the end of the lease, the lease receivable is zero.

FINANCE LEASE – LESSOR

A finance lease on the part of the lessor can either be

a.Direct financing lease

b.Sales type lease
DIRECT FINANCING LEASE – the lessor is actually engaged in the financing
business.
-recognizes only interest income

Ex: Company A buys an equipment and leased it out to Company B with the
intention of generating revenue through interest payment.

Accounting treatment:

Gross investment – equals to the gross rentals for the entire lease term plus the
absolute amount of the residual value, whether guaranteed
or unguaranteed.

Net investment - equals to the cost of the underlying asset plus any initial
direct cost paid by the lessor.

Unearned interest
Income: - the difference between gross investment and net
investment

Initial direct cost - in a direct financing lease, the initial direct cost paid
by the lessor is added to the cost of the asset to get
the net investment in the lease.

Example: On January 1, 2020, Co. X leased an equipment to Co. Y, with

the following details:

Cost of the machinery 480,360

Lease term 3 years
Useful life of the machinery 3 years
Implicit interest rate 12%
The annual lease payment is at the end of each year

Steps:
1. Determine the annual lease payment by dividing the cost of the
machinery by the PV of an annuity 1

The PV of an annuity of 1 for 12% at 3 yrs is = 2.4018

480,360 divided by 2.4018 = 200,000 (annual lease)

2. Compute for the gross investment and net investment:

Gross investment (200,000 x 3) = 600,000

Net investment (PV of gross rentals) 480,360
Unearned interest income 119,460

Note: If you will notice the Net investment is actually the cost of
the equipment which is also the Present Value of the lease
payments, being:
 200,000 x 2.4018 = 480,360
3. Entries would be:

Equipment 480,360
Cash 480,360
(Purchase of equipment by Co. X)

Lease receivable 600,000

Equipment 480,360*
Unearned interest income 119,640
(Lease of the equipment to Co. Y)

*Equipment is credited because under a finance lease, the tittle to

the equipment is transferred to Co. Y (lessor) after the end of the
lease.

Cash 200,000
Lease receivable 200,000
(Collection of annual lease payment)

4. Record/recognize earned interest income at the end of the year.

But an amortization table has to be prepared first:

Date Payment Interest Principal PV

1/1/2020 480,360
12/31/2020 200,000 57,643 142,357 338,003
12/31/2021 200,000 40,560 159,440 178,563
12/31/2022 200,000 21,428 178,563* -

*difference due to rounding off

Dec 31, 2020: Unearned interest income 57,643

Interest income 57,643

Dec 31, 2021:Unearned interest income 40,560

Interest income 40,560

Same entry will be for Dec 31, 2022

So, under direct finance lease, ang objective ng lessor is ma

recover ung cost nung pina rentahan nyang equipment thru the
annual lease payment. Ung sobra nung total lease payment dun
sa cost nung equipment, un ung total interest income.

Direct financing with initial direct cost

Assuming, from the above example, Co. X (lessor) incurred an initial

direct cost of P30,000. The direct cost will be added to the Net
investment as follows:

Cost of equipment 480,360

 Initial direct cost 10,000
Net investment 490,360

The implicit rate of 12% cannot be applied anymore because of the

the additional direct cost. Thus, we have to find an interest which when
the PV factor is obtained, this will equate to the new net investment of
490,360.

This is done thru interpolation (remember your Bonds payable?). So

definitely, the implicit interest rate should be lower than 12%. Let’s
interpolate:

At 12% (2.4018 x 200,000) = 480,360 (just the cost of the eqpt)

At 11% (2.4437 x 200,000) = 488,740 (still lower than 490,360)
At 10% (2.4869 x 200,000) = 497,380 (higher than 490,360)

So, the implicit interest rate could be in between 11% and 12%

X% – 10% 490,360 – 497,380 7,020

11%- 10% 488,740 – 497,380 8,640

=0.8125

So the effective implicit interest rate would be (10+0.8125=10.8125%)

So, the PV of an annuity of 1 for 3 yrs at 10.8125% = 2.4517

which is, P200,000 x 2.4517 = 490,340 (close to 490,360)

The reduced implicit interest rate of 10.8125% will be using in

constructing the amortization table.

Direct financing – with residual value

If there is a residual value, and there is no purchase option, then the

leased asset will revert back to the lessor

Ex: On January 1, 2020, Co. X leased an equipment to Co. Y, with

the following details:

Cost of the equipment 480,360

Lease term 3 years
Useful life of the machinery 3 years
Implicit interest rate 12%
Residual value 50,000

Steps: 1. Determine the annual lease payment:

PV of an ordinary annuity of 1 at 12% for 3 yrs = 2.4018

PV of 1 at 12% for 3 yrs 0.7118
 Note: if the lease payment is at the start of the year, then
the PV to be used should be the PV of an annuity of 1 in
advance (Refer to previous exercise on how to compute
for this in the calculator).

Cost of the equipment 480,360

PV of residual value(50,000*0.7118) (35,590)
Net investment to be recovered from lease 444,770
Divided by PV of an ordinary of 1 at 12%
For 3 yrs 2.4018
Annual rental 185,182

The PV of the residual value is deducted from the cost of the

equipment because the equipment will revert back to Co. X
(lessor) after the expiration of the lease. If the ownership
will not revert back to the lessor, the residual value is
ignored.

2. Compute for the unearned interest income:

Gross lease (185,182 x 3 yrs) 555,546

Residual value 50,000
Gross investment 605,546
Net investment – cost of the equipment (480,360)
Unearned interest income 125,186

3. Create amortization table

Date Payment Interest Principal PV

1/1/2020 480,360
12/31/2020 185,182 57,643 127,539 352,821
12/31/2021 185,182 42,339 142,843 209,978
12/31/2022 185,182 25,197 159,978 50,000

4. Journal entries:

Lease receivable 605,546

Machinery 480,360
Unearned interest income 125,186

Cash 185,182
Lease receivable 185,182

Unearned interest income 57,643

Interest income 57,643

When the lease expires on Dec. 31, 2022, the equipment will

revert back to Co. X, the entry in the books of Co. X, regardless

whether the residual value is guaranteed or unguaranteed:
 Equipmet 50,000
Lease receivable 50,000

If in case, the 50,000 residual value is guaranteed and the fair

value of the equipment on Dec 31, 2022 (expiration of lease) is
P40,000, Company Y (lessee) will pay for the difference
Cash 10,000
Machinery 40,000
Lease receivable 50,000

If the residual value is unguaranteed, then, Co. X will shoulder the

difference as a loss.

Loss on finance lease 10,000

Machinery 40,000
Lease receivable 50,000

SALES TYPE LEASE - LESSOR

A manufacturer or a dealer that leases its product as a means of facilitating

the sale of product.

Ex: A company manufactures heavy equipment for construction businesses.

Instead of directly selling this to construction companies, it leases it out.

Accounting treatment:

Gross investment = Gross rentals + absolute amount of Residual Value( whether

guaranteed or unguaranteed)

Net investment = PV Gross rentals + PV Residual Value (guaranteed or

Unguaranteed)

Unearned interest income = Gross investment – Net investment

Sales = Net investment or Fair Value of the asset whichever is lower.

Cost of goods sold = Cost of the asset sold – PV of unguaranteed residual value +
Initial direct cost paid by the lessor

Gross profit = Sales – Cost of goods sold

Initial direct cost = forms part of the cost of goods sold

Example: Co. X manufactures a machinery. On Jan1, 2020, a machinery was

was leased to Company Y with the following details:

Annual rent payable at the end of each year 200,000

Lease term 3 years
Useful life of machinery 4 years
 Cost of machinery 500,000
Fair value of the machinery 510,000
Implicit rate 12%
Estimated residual value (unguaranteed) 50,000
Initial direct cost paid by Co. X 20,000

The machinery will revert back to Company X when the lease contract
expires on Dec 31, 2022

Solution:

Gross Investment:
Gross rentals (200,000 x 3) 600,000
Residual value 50,000
Total 650,000

Net Investment:
PV Gross rentals (200,000*2.4018) 480,360
PV Residual value(50,000*0.7118) 35,590
Total 515,950

Unearned interest income:

Gross investment 650,000
Net investment (515,950)
Unearned interest income 134,050

Sales:
PV of Gross rentals only 480,360*

*PV of gross rentals is used because it is lower than

the Fair value of the machinery. (rule: whichever is ower)

Cost of goods sold:

Cost of machinery 500,000
PV of residual value – unguaranteed (35,590)*
Initial direct cost 20,000
Cost of goods sold 484,410

*Ignore if RV is guaranteed

Gross profit:
Sales 510,000
Cost of goods sold (484,410)
Gross profit 25,590

Amortization Table:

Date Payment Interest Principal PV

1/1/2020 515,950
12/31/2020 200,000 61,914 138,086 377,864
 12/31/2021 200,000 45,344 154,656 223,208
12/31/2022 200,000 26,785 173,215* 50,000

*Due to rounding off

Journal entries:

01/01/2020:Lease receivable 650,000

Cost of goods sold 484,410
Sales 480,360
Inventory* 500,000

Unearned interest income 134,050

Cash 20,000

*Inventory account name is used because the business of Co.

X is to sell machinery, therefore, an inventoriable item.

12/31/2020: Cash 200,000

Lease receivable 200,000

Unearned interest income 61,914

Interest income 61,914

Upon expiration of the lease contract on Dec 31, 2022, the FV of the machinery is
P40,000. The entry on Dec 31, 2022 would be:

If RV is guaranteed: If RV is unguaranteed

Cash 10,000 Inventory 40,000

Inventory 40,000 Loss on finance lease 10,000
Lease receivable 50,000 Lease receivable 50,000

Sales type lease with purchase option

If there is a purchase option and there is a certainty that the lessee will exercise
the purchase option, then residual value will no longer relevant. The purchase
option will take the place of residual value in the computation