FINANCIAL ACCOUNTING & REPORTING

FAR.0732 Leases FAR 732-Online

LECTURE NOTES
Definition of terms
A lease is 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.

A finance lease is a lease that transfers substantially all the risks and rewards
incidental to ownership of an asset. Title may or may not eventually be transferred.

An operating lease is a lease other than a finance lease.

A non-cancellable lease is a lease that is cancellable only:

(a) upon the occurrence of some remote contingency;
(b) with the permission of the lessor;
(c) if the lessee enters into a new lease for the same or an equivalent asset with
the same lessor; or
(d) upon payment by the lessee of such an additional amount that, at inception of
the lease, continuation of the lease is reasonably certain.

The 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. As at
this date:
(a) a lease is classified as either an operating or a finance lease; and
(b) in the case of a finance lease, the amounts to be recognized at the
commencement of the lease term are determined.

The 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 the date of initial recognition of
the lease (ie the recognition of the assets, liabilities, income or expenses resulting
from the lease, as appropriate).

The lease term is the non-cancellable period for which the lessee has contracted to
lease the asset together with any further terms for which the lessee has the option
to continue to lease the asset, with or without further payment, when at the
inception of the lease it is reasonably certain that the lessee will exercise the
option.

Minimum lease payments are the payments over the lease term that the lessee is or
can be required to make, excluding contingent rent, costs for services and taxes to
be paid by and reimbursed to the lessor, together with:
(a) for a lessee, any amounts guaranteed by the lessee or by a party related to
the lessee; or
(b) for a lessor, any residual value guaranteed to the lessor by:
i. the lessee;
ii. a party related to the lessee; or
iii. a third party unrelated to the lessor that is financially capable of
discharging the obligations under the guarantee.

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However, if the lessee has an option to purchase the asset at a price that is
expected to be sufficiently lower than fair value at the date the option becomes
exercisable for it to be reasonably certain, at the inception of the lease, that the
option will be exercised, the minimum lease payments comprise the minimum
payments payable over the lease term to the expected date of exercise of this
purchase option and the payment required to exercise it.

Economic life is either:

(a) the period over which an asset is expected to be economically usable by one
or more users; or
(b) the number of production or similar units expected to be obtained from the
asset by one or more users.

Useful life is the estimated remaining period, from the commencement of the lease
term, without limitation by the lease term, over which the economic benefits
embodied in the asset are expected to be consumed by the entity.

Guaranteed residual value is:

(a) for a lessee, that part of the residual value that is guaranteed by the lessee or
by a party related to the lessee (the amount of the guarantee being the
maximum amount that could, in any event, become payable); and
(b) for a lessor, that part of the residual value that is guaranteed by the lessee or
by a third party unrelated to the lessor that is financially capable of
discharging the obligations under the guarantee.

Unguaranteed residual value is that portion of the residual value of the leased
asset, the realization of which by the lessor is not assured or is guaranteed solely
by a party related to the lessor.

Initial direct costs are incremental costs that are directly attributable to negotiating
and arranging a lease, except for such costs incurred by manufacturer or dealer
lessors.

Gross investment in the lease is the aggregate of:

(a) the minimum lease payments receivable by the lessor under a finance lease,
and
(b) any unguaranteed residual value accruing to the lessor.

Net investment in the lease is the gross investment in the lease discounted at the
interest rate implicit in the lease.

Unearned finance income is the difference between:

(a) the gross investment in the lease, and
(b) the net investment in the lease.

The interest rate implicit in the lease is the discount rate that, at the inception of
the lease, causes the aggregate present value of (a) the minimum lease payments
and (b) the unguaranteed residual value to be equal to the sum of (i) the fair value
of the leased asset and (ii) any initial direct costs of the lessor.

The lessee’s incremental borrowing rate of interest is the rate of interest the lessee
would have to pay on a similar lease or, if that is not determinable, the rate that, at

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the inception of the lease, the lessee would incur to borrow over a similar term, and
with a similar security, the funds necessary to purchase the asset.

Contingent rent is that portion of the lease payments that is not fixed in amount but
is based on the future amount of a factor that changes other than with the passage
of time (eg percentage of future sales, amount of future use, future price indices,
future market rates of interest).

Classification of Leases
A lease is classified as a finance lease if it transfers substantially all the risks and
rewards incident to ownership. All other leases are classified as operating leases.
Classification is made at the inception of the lease.

Whether a lease is a finance lease or an operating lease depends on the substance

of the transaction rather than the form. Situations that would normally lead to a
lease being classified as a finance lease include the following:
 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; and
 the lease assets are of a specialized nature such that only the lessee can use
them without major modifications being made.

Other situations that might also lead to classification as a finance lease are:
 If the lessee is entitled to cancel the lease, the lessor's losses associated with
the cancellation are borne by the lessee;
 gains or losses from fluctuations in the fair value of the residual fall to the
lessee (for example, by means of a rebate of lease payments); and
 the lessee has the ability to continue to lease for a secondary period at a rent
that is substantially lower than market rent.

Lease of land and building

In classifying a lease of land and buildings, land and buildings elements would
normally be considered separately. The minimum lease payments are allocated
between the land and buildings elements in proportion to their relative fair values.
The land element is normally classified as an operating lease unless title passes to
the lessee at the end of the lease term. The buildings element is classified as an
operating or finance lease by applying the classification criteria in PAS 17.
However, separate measurement of the land and buildings elements is not required
if the lessee's interest in both land and buildings is classified as an investment
property in accordance with PAS 40 and the fair value model is adopted.

Accounting by Lessees
The following principles should be applied in the financial statements of lessees:
 at commencement of the lease term, finance leases should be recorded as an
asset and a liability at the lower of the fair value of the asset and the present

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value of the minimum lease payments (discounted at the interest rate implicit in
the lease, if practicable, or else at the enterprise's incremental borrowing rate);
 finance lease payments should be apportioned between the finance charge and
the reduction of the outstanding liability (the finance charge to be allocated so as
to produce a constant periodic rate of interest on the remaining balance of the
liability);
 the depreciation policy for assets held under finance leases should be consistent
with that for owned assets. If there is no reasonable certainty that the lessee will
obtain ownership at the end of the lease - the asset should be depreciated over
the shorter of the lease term or the life of the asset; and
 for operating leases, the lease payments should be recognized as an expense in
the income statement over the lease term on a straight-line basis, unless
another systematic basis is more representative of the time pattern of the user's
benefit.

Incentives for the agreement of a new or renewed operating lease should be

recognized by the lessee as a reduction of the rental expense over the lease term,
irrespective of the incentive's nature or form, or the timing of payments.

Accounting by Lessors
The following principles should be applied in the financial statements of lessors:
 at commencement of the lease term, the lessor should record a finance lease in
the statement of financial position as a receivable, at an amount equal to the net
investment in the lease;
 the lessor should recognize finance income based on a pattern reflecting a
constant periodic rate of return on the lessor's net investment outstanding in
respect of the finance lease; and
 assets held for operating leases should be presented in the statement of financial
position of the lessor according to the nature of the asset. Lease income should
be recognized over the lease term on a straight-line basis, unless another
systematic basis is more representative of the time pattern in which use benefit
is derived from the leased asset is diminished.

Incentives for the agreement of a new or renewed operating lease should be

recognized by the lessor as a reduction of the rental income over the lease term,
irrespective of the incentive's nature or form, or the timing of payments.

Manufacturers or dealer lessors should include selling profit or loss in the same
period as they would for an outright sale. If artificially low rates of interest are
charged, selling profit should be restricted to that which would apply if a
commercial rate of interest were charged.

Sale and Leaseback Transactions

For a sale and leaseback transaction that results in a finance lease, any excess of
proceeds over the carrying amount is deferred and amortized over the lease term.

For a transaction that results in an operating lease:

 if the transaction is clearly carried out at fair value - the profit or loss should be
recognized immediately;
 if the sale price is below fair value - profit or loss should be recognized
immediately, except if a loss is compensated for by future rentals at below
market price, the loss should be amortized over the period of use;

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 if the sale price is above fair value - the excess over fair value should be deferred
and amortized over the period of use; and
 if the fair value at the time of the transaction is less than the carrying amount - a
loss equal to the difference should be recognized immediately.

- done -

ILLUSTRATIVE PROBLEMS

PROBLEM NO. 1 – Operating Lease (Lessor and Lessee)

Lessor Company purchased a machine on January 1, 2016, for P1,250,000 for the
express purpose of leasing it. The machine was expected to have a 9-year life from
January 1, 2016, no salvage value, and to be depreciated on a straight-line basis.
On March 1, 2016, Lessor leased the machine to Lessee Company for P300,000 a
year for a 4-year period ending February 28, 2020. The appropriate interest rate is
12% compounded annually. Lessor paid a total of P 15,000 for maintenance,
insurance, and property taxes on the machine for the year ended December 31,
2016. Lessee paid P300,000 to Lessor on March 1, 2016. Lessor retains title to the
property and plans to lease it to someone else after the 4-year lease period.

REQUIRED:
Prepare the 2016 journal entries relating to the lease on (1) Lessor Company's
books and (2) Lessee Company's books.

SOLUTION GUIDE:

LESSOR’S BOOKS
To record purchase of machine
Machinery P1,250,000 To record depreciation
Cash P1,250,000 Depreciation P125,000*
Accumulated depreciation P125,000
To record receipt of advance rental *(P1,250,000/10)
Cash P300,000
Rent income P300,000 LESSEE’S BOOKS
To record payment of advance rental
To record payment of executory costs Rent expense P300,000
Expenses P15,000 Cash P300,000
Cash P15,000
To recognize prepaid rent
To recognize unearned rent Prepaid rent P50,000
Rent income (P300T x 2/12) P50,000 Rent expense P50,000
Unearned rent inc. P50,000

PROBLEM NO. 2 – Finance Lease (Lessee, with BPO)

Nuggets Enterprises has a long-standing policy of acquiring company equipment by
leasing. Early in 2016, the company entered into a lease for a new equipment. The
lease stipulates that annual payments will be made for 5 years. The payments are
to be made in advance on December 31 of each year. At the end of the 5-year
period, Nuggets may purchase the equipment. The estimated economic life of the
equipment is 12 years. Nuggets uses the calendar year for reporting purposes and
straight-line depreciation for other equipment. In addition, the following
information about the lease is also available:
Annual lease payments (including executory costs of P5,000) P60,000
Purchase option price P25,000
Estimated fair value of equipment after 5 years P75,000
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Implicit rate 10%

Date of first lease payment Jan. 1, 2016

REQUIRED:
1. Prepare the 2016 journal entries relating to the lease on the books of Nuggets
(Round off present value factors to four decimal places.)
2. Prepare the journal entry to record the exercise of the purchase option.
3. Prepare the journal entry at the end of the lease term if the purchase option is
not exercised.

SOLUTION GUIDE: December 31, 2016

To record the second payment
REQUIREMENT NO. 1 Interest expense P18,987
January 1, 2016 Finance lease liab. P36,013
To recognize asset and liability Cash P55,000
Equipment under FL P244,868
Finance lease liab. P244,868 To record payment for executory costs
Prepaid expenses P5,000
To record initial payment Cash P5,000
Finance lease liab. P55,000
Cash P55,000 To record depreciation
Depreciation P20,406*
To record payment for executory costs Accumulated depreciation P20,406
Expenses P5,000 *(P244,868/12)
Cash P5,000

REQUIREMENT NO. 2 Amortization schedule:

Interest expense P2,268 Carrying
Finance lease liability 22,732 Date Payment Interest Principal amount
Cash P25,000 1/1/16 244,868
1/1/16 55,000 - 55,000 189,868
REQUIREMENT NO. 3 12/31/16 55,000 18,987 36,013 153,855
Interest expense P2,268 12/31/17 55,000 15,386 39,614 114,241
Finance lease liability 22,732
12/31/18 55,000 11,424 43,576 70,665
Accumulated Depr. 102,028
Loss on finance lease 117,840 12/31/19 55,000 7,067 47,933 22,732
Equipment under finance lease P244,868 12/31/20 25,000 2,268 22,732 -

PROBLEM NO. 3 – Finance Lease (Lessee, with GRV)

On January 1, 2016, Nets Company entered into a lease contract with Denver
Company for a new equipment that had a selling price of P2,120,000. The lease
contract provides that annual payments of P420,000 will be made for 6 years. Nets
made the first payment on January 1, 2016, subsequent payments are made on
January 1 of each year. Nets guarantees a residual value of P367,122 at the end of
the lease term. After considering the guaranteed residual value, the rate implicit in
the lease is determined to be 12%. Nets has an incremental borrowing rate of
15%. The economic life of the equipment is 9 years. Nets depreciates its
equipment using straight line method.
REQUIRED:
1. Prepare the 2016 and 2017 journal entries relating to the lease on the books of
Nuggets (Round off present value factors to four decimal places.)
2. Prepare the journal entry at the end of the lease term if the fair value of the
leased asset is P400,000.
3. Prepare the journal entry at the end of the lease term if the fair value of the
leased asset is P300,000.

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SOLUTION GUIDE:

REQUIREMENT NO. 1
REQUIREMENT NO. 2
January 1, 2016
To recognize asset and liability To record return of equipment to lessor
Equipment under finance lease P2,120,000 Interest payable P39,337
Finance lease liability P2,120,000 Finance lease liability 327,785
Accumulated depreciation 1,752,878
To record initial payment Equipment under finance L P2,120,000
Finance lease liability P420,000
Cash P420,000 REQUIREMENT NO. 3

December 31, 2016 To record return of equipment to lessor

To record accrual of interest Interest payable P39,337
Interest expense P204,000 Finance lease liability 327,785
Interest payable P204,000 Accumulated depreciation 1,752,878
Equipment under finance L P2,120,000
To record depreciation
Depreciation P292,146* To record payment to lessor
Accumulated depreciation P292,146 Loss on finance lease P67,122
*[(P2,120,000-P367,122)/6] Cash P67,122

January 1, 2017 Amortization schedule:

To record the second payment Carrying
Interest payable P204,000 Date Paym. Int. Principal amount
Finance lease liability 216,000 01.01.16 2,120,000
Cash P420,000 01.01.16 420,000 - 420,000 1,700,000
01.01.17 420,000 204,000 216,000 1,484,000
December 31, 2017
01.01.18 420,000 178,080 241,920 1,242,080
To record accrual of interest
01.01.19 420,000 149,050 270,950 971,130
Interest expense P178,080
Interest payable P178,080 01.01.20 420,000 116,536 303,464 667,665
01.01.21 420,000 80,120 339,880 327,785
To record depreciation 01.01.22 367,122 39,337 327,785 -
Depreciation P292,146
Accumulated depreciation P292,146

PROBLEM NO. 4 – Finance Lease (Lessor and Lessee) Lessor, Direct Financing
Lease)
Assimilator Controls Corporation is in the business of leasing equipment.
Assimilator Controls purchased a new equipment on December 31, 2016. The
equipment was delivered the same day (by prior arrangement) to Tantalum
Investment Company, a lessee. The corporation accountant revealed the: following
information relating to the lease transaction:
Cost of equipment to Assimilator Controls P550,000
Estimated useful life and lease term 8 years
Expected residual value (unguaranteed) P40,000
Assimilator Controls' implicit rate of interest 12%
Tantalum’s incremental borrowing rate 14%
Date of first lease payment Dec. 31, 2016

Additional information is as follows:

(a) At the end of the lease, the equipment will revert to Assimilator Controls.
(b) Tantalum is aware of Assimilator Controls' rate of implicit interest.
(c) The lease rental consists of equal annual payments.

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REQUIRED:
Prepare the 2016 and 2017 journal entries relating to the lease on the books of
Assimilator Controls and Tantalum Investment Company (Round off present value
factors to four decimal places.)

LESSOR’S BOOKS
To record depreciation
December 31, 2016 Depreciation P66,731
Commencement of finance lease Accumulated depreciation P66,731
Finance lease receivable P807,600
Equipment P550,000 Amortization schedule - lessor
Discount on FLR* P257,600 Carrying
*Alternatively, “Unearned Interest Income” Date Payment Interest Principal amount
12/31/16 550,000
To record initial payment 12/31/16 95,950 - 95,950 454,050
Cash P95,950 12/31/17 95,950 54,486 41,464 412,586
Finance lease receivable P95,950 12/31/18 95,950 49,510 46,440 366,146
12/31/19 95,950 43,938 52,012 314,134
12/31/20 95,950 37,696 58,254 255,880
December 31, 2017
12/31/21 95,950 30,706 65,244 190,636
To record the second payment
12/31/22 95,950 22,876 73,074 117,562
Cash P95,950
12/31/23 95,950 14,107 81,843 35,719
Finance lease receivable P95,950 12/31/24 40,000 4,281 35,719 -

To record amortization of discount on FLR *Computation of annual lease payment

Discount on FLR P54,486 Cost of equipment/
Interest income P54,486 Net investment P550,000
Less PV of URV (P40,000 x 0.4039) 16,156
LESSEE’S BOOKS NI to be recovered 533,844
/PVF (advance, 12%, 8 per.) 5.5638
December 31, 2016 Annual lease payment P95,950
To recognize asset and liability
Equipment under FL P533,844 Amortization schedule – lessee
Finance lease liability P533,844 Carrying
Date Payment Interest Principal amount
To record initial payment 12/31/16 533,844
Finance lease liability P95,950 12/31/16 95,950 - 95,950 437,894
Cash P95,950 12/31/17 95,950 52,547 43,403 394,491
12/31/18 95,950 47,339 48,611 345,880
December 31, 2017 12/31/19 95,950 41,506 54,444 291,436
To record the second payment 12/31/20 95,950 34,972 60,978 230,458
Interest expense P52,547 12/31/21 95,950 27,655 68,295 162,163
Finance lease liability 43,403 12/31/22 95,950 19,460 76,490 85,673
Cash P95,950 12/31/23 95,950 10,277 85,673 -

PROBLEM NO. 5 – Finance Lease (Lessor and Lessee, Lessor, Sales-type Lease)
Excel Inc. leases equipment to its customers under noncancelable leases. On
January 1, 2016, Excel leased equipment costing P4,000,000 to PRISM Co., for nine
years. The rental cost was P440,000 payable in advance semiannually (January 1
and July 1). The equipment had an estimated life of 15 years and sold for
P5,330,252 with an estimated unguaranteed residual value of P800,000. The
implicit interest rate is 12 percent.

REQUIRED:
Prepare the 2016 journal entries relating to the lease on the books of Excel and
PRISM (Round off present value factors to four decimal places.)

LESSOR’S BOOKS January 1, 2016

Commencement of finance lease

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Finance lease R. P8,720,000
Cost of sales 3,719,760 July 1, 2016
Sales P5,050,012 To record the second payment
Discount on FLR 3,389,748 Interest expense P276,601
Inventory 4,000,000 Finance lease liability 163,399
Cash P440,000
To record initial payment
Cash P440,000 December 31, 2016
Finance lease receivable P440,000 To record accrual of interest
Interest expense P266,797
July 1, 2016 Interest payable P266,797
To record the second payment
Cash P440,000 To record depreciation
Finance lease receivable P440,000 Depreciation P561,112
Accumulated depreciation P561,112
To record amortization of discount on FLR
Discount on FLR P293,415 Amortization schedule (partial) - lessor
Interest income P293,415 Carrying
Date Paym. Int. Princ. amount
December 31, 2016 1/1/16 5,330,252
To record amortization of discount on FLR 1/1/16 440,000 440,000 4,890,252
Discount on FLR P284,620 7/1/16 440,000 293,415 146,585 4,743,667
Interest income P284,620 1/1/17 440,000 284,620 155,380 4,588,287

LESSEE’S BOOKS
Amortization schedule (partial) - lessee
January 1, 2016 Carrying
To recognize asset and liability Date Paym. Interest Princ. amount
1/1/16 5,050,012
Equipment under finance L P5,050,012
1/1/16 440,000 440,000 4,610,012
Finance lease liability P5,050,012
7/1/16 440,000 276,601 163,399 4,446,613
1/1/17 440,000 266,797 173,203 4,273,409
To record initial payment
Finance lease liability P440,000
Cash P440,000 - end -

REVIEW QUESTONS

MULTIPLE CHOICE PROBLEMS

1. On January 1, 2016, Jessie Company signed a 5-year operating lease for office
space at P3,600,000 per year. The lease included a provision for additional rent
of 10% of annual company sales in excess of P6,000,000. Jessie’s sales for the
year ended December 31, 2016 were P10,000,000. Upon execution of the lease,
Jessie paid P500,000 as a bonus for the lease.

Jessie’s rent expense for the year ended December 31, 2016 is
a. P3,600,000 b. P4,100,000 c. P4,000,000 d. P3,700,000

2. Mindoro Company purchased a new machine on January 1, 2016 at a cost of

P2,000,000 for the purpose of leasing it. The machine is estimated to have a
useful life of ten years with a residual value of P200,000. Depreciation is
computed by Mindoro on a straight line basis. On January 2, 2016, Mindoro
entered into a lease contract with Oriental Company for a term of up to four
years until December 31, 2019. The lease fee is P1,000,000 per year and was
paid in advance by Oriental. Mindoro paid P120,000 commissions associated
with negotiating the lease and receive an additional P400,000 as lease bonus.

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Mindoro Company should report net rental income for 2016 at

a. P820,000 b. P908,000 c. P890,000 d. P800,000

3. On July 1,2014, Gee, Inc. leased a delivery truck from Marr Corp. under a three
year operating lease. Total rent for the term of the lease will be P360,000,
payable as follows:
12 months at P5,000 = P60,000
12 months at P7,500 = 90,000
12 months 1t P17,500 = 210,000

All payments were made when due. In Marr’s June 30, 2016 statement of
financial position, the accrued rent receivable should be reported as
a. P0 b. P90,000 c. P120,000 d. P210,000

4. The Junior Company leased a freehold building for 20 years with effect from 1
January 2016. The useful life of the building is 40 years. As part of the
negotiations for the lease the lessor granted Junior a rent-free period. Annual
rentals of P1.6 million are payable in advance on 1 January, commencing in
2018.

What expense should Junior recognize in profit loss in the year ended 31
December 2105?
a. P1.6 million b. Nil c. P1.52 million d. P1.44 million

5. The Chemsee Company leased a canning machine with a fair value of P165,000.
The present value of the minimum lease payments discounted at the rate implicit
in the lease is P158,400. The initial direct costs incurred in negotiating the lease,
were P1,250. The asset has a useful life of 5 years and the lease is for a period of
4 years, after which the asset can be acquired for a near zero cost, which is
substantially below the expected value of the asset at that date. The asset is
depreciated on a straight line basis.

According to PAS17 Leases, what amount should be the annual depreciation

expense?
a. P39,912 b. P31,930 c. P39,600 d. P31,680

6. On December 31, 2015, Sawyer Co. leased a machine from Bass, Inc. for its
entire economic life of five years. Equal annual payments under the lease are
P525,000 (including P25,000 annual executory costs) and are due on December
31 of each year. The first payment was made on December 31, 2015, and the
second payment was made on December 31, 2016. The interest rate implicit in
the lease is 10%. Sawyer learned that a third party guaranteed to pay Bass, Inc.
a residual value of P200,000 at the end of the lease term.
In its December 31, 2016 statement of financial position, Sawyer should report in
the non-current liability section a lease liability of
a. P1,243,445 b. P1,018,047 c. P867,790 d. P375,655

7. Bowtock has leased an item of plant under the following terms:

 Commencement of the lease – January 1, 2015
 Term of the lease – 5 years
 Annual payments in advance – P12,000

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 Cash price and fair value of the asset – P52,000

 Implicit interest rate – 8% per annum
 Depreciation policy – 20% per annum

The total lease related expenses for the fiscal year ended September 30, 2016 is
a. P13,072 b. P12,896 c. P12,272 d. P10,200

SOLUTION GUIDE:
Date Payment Interest(8%) Principal C.A.
1/1/15 52,000
1/1/15 12,000 12,000 40,000
1/1/16 12,000 3,200 8,800 31,200
1/1/17 12,000 2,496 9,504 21,696

Use the following information for the next two questions.

Camarines Company is a dealer in machinery. On January 1, 2016, a machine was
leased to another entity with the following provisions:
Annual rental payable at the end of each year P2,000,000
Lease term and useful life of machinery 5 years
Cost of machinery P5,000,000
Residual value-unguaranteed P1,000,000
Implicit interest rate 10%
PV of an ordinary annuity of 1 for 5 periods at 10% 3.79
PV of 1 for 5 periods at 10% 0.62

At the end of the lease term, the machinery will revert to Camarines. The perpetual
inventory system is used. Camarines incurred initial direct costs of P200,000 in
finalizing the lease agreement.

8. How much is the total finance income from the lease to be recognized by
Camarines over the lease term?
a. P2,800,000 b. P1,800,000 c. P2,420,000 d. P2,600,000

9. Camarines Company will recognize profit on the sale at

a. P3,000,000 b. P3,200,000 c. P5,800,000 d. P6,000,000

Use the following information for the next two questions.

Good Company, a dealer in machinery and equipment, leased equipment to Luck,
Inc., on July 1, 2016. The lease is appropriately accounted for as a sale by Good
and as a purchase by Luck. The lease is for a 10-year period (the useful life of the
asset). The first of 10 equal annual payments of P828,000 was made on July 1,
2016. Good had purchased the equipment for P5,200,000 on July 1, 2015, and
established a list selling price of P7,200,000 on the equipment. Assume that the
present value at July 1, 2016, of the rent payments over the lease term discounted
at 8% (the appropriate interest rate) was P6,000,000.

10. What is the amount of profit on the sale and the amount of interest income
that Good should record for the year ended December 31, 2016?
a. P800,000 and P240,000. c. P1,320,000 and P206,880.
b. P800,000 and P206,880. d. P1,320,000 and P240,000.

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11. Assuming that Luck, Inc. uses straight-line depreciation, what is the amount
of depreciation and interest expense that Luck should record for the year ended
December 31, 2016?
a. P300,000 and P206,880. c. P360,000 and P206,880.
b. P300,000 and P240,000. d. P360,000 and P240,000.

12. Jenny Ltd leases a machine with a fair value of P109,444 to Rose Ltd for five
years at an annual rental (in advance) of P25,000, and Rose Ltd guarantees in
full the estimated residual value of P15,000 on return of the asset. What would
be the interest rate implicit in the lease?
a. 14% b. 12% c. 10% d. 9%

13. Soundesign Company entered into a lease of special equipment to LabCorp

Company. The lease term was six years. The equipment cost Soundesign
P40,000 and Soundesign plans to earn a P4,000 dealer profit. Soundesign’s
implicit rate on the lease is 12 percent.

As a result of this agreement, Soundesign will receive year-end lease payments

of
a. P7,333 b. P8,213 c. P10,702 d. P12,090

14. An asset with a market value of P100,000 is leased on January 1, 2016. Five
annual lease payments are due each January 1 beginning January 1, 2016. The
lessee guarantees the P40,000 residual value of the asset as of the end of the
lease term on December 31, 2020. The lessor’s implicit interest rate is 8%.

What is the annual lease payment?

a. P16,877 b. P18,227 c. P23,191 d. P25,046

Use the following information for the next two questions.

Naga Company 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. Naga wishes to earn 14% interest on a 5-
year lease of equipment with a cost of P1,955,000. The present value of an annuity
due of 1 at 14% for 5 years is 3.91 Naga incurs initial direct cost of P65,000.

15. What is the total amount of interest income that Naga will earn over the life of
the lease?
a. P480,000 b. P500,000 c. P545,000 d. P273,700

16. What is the interest income to be recognized in the first year of the lease?
a. P242,400 b. P182,400 c. P273,700 d. P203,700

17. The Minor Company leased a freehold building for 20 years, the useful life of
the building, with effect from 1 January 2016. At that date the fair value of the
leasehold interest was P7.5 million of which P6.0 million was attributable to the
building. Annual rentals of P800,000 are payable in advance on 1 January.
How much should Minor recognize as an operating lease expense in the year
ended 31 December 2016?
a. Nil b. P640,000 c. P160,000 d. P800,000

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18. On December 31, 2016, Ronnel Corp. sold to Alex Co. two depreciable assets
and simultaneously leased them back. Additional information pertaining to the
sale-leasebacks follows:
Asset #1 Asset #2
Sales price P600,000 P1,000,000
Carrying amount, 12/31/16 P100,000 P550,000
Remaining useful life, 12/31/16 10 years 35 years
Lease term 8 years 3 years
Annual lease payments P100,000 P200,000

In its December 31, 2016 statement of financial position, what amount should
Ronnel report as deferred gain on these transactions?
a. P950,000 b. P500,000 c. P450,000 b. P0

19. Thunder Bay Ltd sells land that originally cost P150,000 to Victoria Ltd for
P230,000 when the land's fair value is P215,000, and then enters into a
cancellable lease agreement to use the land for two years at an annual rental of
P2,000.

In the current year, how much profit would Thunder Bay Ltd record on the sale of
the land?
a. P15,000 b. P65,000 c. P80,000 d. Nil

20. Porkee Corp. sells equipment with a carrying amount P150,000 to Chopee
Corp. for P170,000 when the equipment’s fair value is P100,000, and then enters
into a cancellable operating lease agreement to use the equipment for two years.
In the current year, how much profit would Porkee Corp. record on the sale of
the equipment?
a. P20,000 b. P50,000 c. P70,000 d. Nil

MULTIPLE CHOICE THEORY

1. 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.

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

3. Which of the following is a correct statement of one of the capitalization criteria?

a. The lease transfers ownership of the property to the lessor.
b. The lease contains a purchase option.
c. The minimum lease payments (excluding executory costs) equal or exceed
90% of the fair value of the leased property.
d. The lease term is equal to or more than 75% of the estimated economic life of
the leased property.

4. Which statement is correct?

a. PAS 17 requires companies to capitalize all long-term leases.

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b. A lease that contains a purchase option must be capitalized by the lessee.

c. A capitalized leased asset is always depreciated over the term of the lease by
the lessee.
d. Leasing equipment reduces the risk of obsolescence to the lessee, and passes
the risk of residual value to the lessor.

5. Which statement is correct?

a. The distinction between a direct-financing lease and a sales-type lease is the
presence or absence of a transfer of title.
b. Lessors classify and account for all leases that don’t qualify as sales-type
leases as operating leases.
c. Only the lessor makes the distinction of classifying leases as operating or
finance leases.
d. Lessors classify and account for all leases that do not qualify as direct-
financing or sales-type leases as operating leases.

6. The classification of a lease is normally carried out

a. At the end of the lease term.
b. After a "cooling off” period of one year.
c. At the inception of the lease.
d. When the entity deems it to be necessary.

7. The inception of the lease is

a. The date of the lease agreement
b. The date of commitment by the parties to the principal provisions of the lease
c. Earlier of a and b
d. Later of a and b

8. Which of the following are included in the definition of minimum lease payments?
I. Contingent rent
II. Costs for services and taxes to be paid by and reimbursed to the lessor
III. Required payments over the lease term
IV. Any amounts guaranteed by a party related to the lessee
a. I, II, III and IV b. II, III and IV c. I, III and IV d. III and IV

9. What impact does a bargain purchase option have on the present value of the
minimum lease payments computed by the lessee?
a. No impact as the option does not enter into the transaction until the end of
the lease term.
b. The lessee must increase the present value of the minimum lease payments
by the present value of the option price.
c. The lessee must decrease the present value of the minimum lease payments
by the present value of the option price.
d. The minimum lease payments would be increased by the present value of the
option price if, at the time of the lease agreement, it appeared certain that the
lessee would exercise the option at the end of the lease and purchase the
asset at the option price.

10. Where there is a lease of land and buildings and the title to the land is to be
transferred to the lessee at the end of the short lease, generally the lease is
treated as if
a. The land is a finance lease; the building is a finance lease.

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b. The land is a finance lease; the building is an operating lease.

c. The land is an operating lease; the building is a finance lease.
d. The land is an operating lease; the building is an operating lease.

11. The lease of land and buildings when split causes difficulty in the allocation of
the minimum lease payments. In this case the minimum lease payments should
be split
a. According to the relative fair value of the two elements.
b. By the entity based on the useful life of the two elements.
c. Using the sum of the digits method.
d. According to any fair method devised by the entity.

12. An entity classifies a lease of land and buildings as an investment property

under PAS 40. The entity has adopted the fair value model. In this case
a. Separate measurement of the lease of land and buildings is compulsory.
b. Separate measurement of the lease of land and buildings is not required.
c. The lease is treated as an operating lease.
d. The lease cannot be treated as an operating lease.

13. Which is the correct accounting treatment for a finance lease in the accounts
of a lessor?
a. Treat as a noncurrent asset equal to net investment in lease. Recognize all
finance payments in statement of comprehensive income.
b. Treat as a receivable equal to gross amount receivable on lease. Recognize
finance payments in cash and by reducing debtor.
c. Treat as a receivable equal to net investment in the lease. Recognize finance
payment by reducing debtor and taking interest to statement of
comprehensive income.
d. Treat as a receivable equal to net investment in the lease. Recognize finance
payments in cash and by reduction of debtor.

14. The profit on a finance lease transaction for lessors who are manufacturers or
dealers should
a. Not be recognized separately from finance income.
b. Be recognized in the normal way on the transaction.
c. Only be recognized at the end of the lease term.
d. Be allocated on a straight-line basis over the life of the lease.

15. Which of the following statements is true?

a. In a finance lease, the lessee, but not the lessor, should use present value
computations in recording and reporting the lease results.
b. Accounting symmetry is said to exist in accounting for leases when the lessor
and lessee record the same amounts but the accounts and the debits/credits
are reciprocal.
c. There is always "accounting symmetry" for recording and reporting leases
between the lessor and lessee.
d. A finance lease does not transfer substantially all of the risks and rewards of
ownership from the lessor to the lessee, whereas an operating lease does.

16. Which of the following statements is false?

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a. In general, equipment leased under an operating lease involves depreciation

expense for the lessor; equipment leased under a finance lease involves
depreciation expense for the lessee.
b. It is possible for neither the lessor nor lessee to depreciate the asset under
lease.
c. If a lease transfers the residual value of the leased asset to the lessee at the
end of the lease term, the lessee has permanent ownership of the leased
asset.
d. A lessee's debt equity ratio is not increased if the lease is a finance lease,
whereas, it would be if the asset were purchases outright.

17. Which of the following statements is incorrect?

a. If a lease qualifies as a finance lease for the lessor, it will also always qualify
as a finance lease for the lessee.
b. In accounting for an operating lease, the lessor will recognize depreciation on
the leased property.
c. In an operating lease, if a nonrefundable down payment is made in advance,
the lessor should initially debit Cash and credit Unearned Rent (liability).
d. In an operating lease, depreciation expense on the leased property will be
recognized by the lessor but not by the lessee.

18. In the case of sale and leaseback transactions, if the sale is at below the fair
value of the assets and the loss is compensated by future lease payments, then
the loss is
a. Recognized immediately in reserves.
b. Deferred and amortized over the useful life of the asset.
c. Deferred until the end of the lease term.
d. Recognized immediately in the profit and loss.

19. Lessors should show assets that are out on operating leases and income from
there as follows:
a. The asset should be kept off the statement of financial position and the lease
income should go to reserves.
b. The asset should be kept off the statement of financial position and the lease
income should go to the statement of comprehensive income.
c. The asset should be shown in the statement of financial position according to
its nature and the lease income should go to reserves.
d. The asset should be shown in the statement of financial position according to
its nature with the lease income going to the statement of comprehensive
income.
20. The current accounting standard PAS 17, Leases, was criticized for not
reflecting current practice. Why was there a need to look to change PAS I7?
a. The FASB wanted change.
b. To ensure comparability and bring leasing finance onto the statement of
financial position.
c. For legal reasons.
a. Because of the recent credit crisis.

 - end - 

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