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LEASES (PAS 17)

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ISSUES IN ACCOUNTING FOR LEASES:


1. Objective and scope of PAS 17
2. Definition and classification of leases
3. Accounting for an operating lease
4. Accounting for a finance lease for lessee
5. Accounting for a direct financing lease for lessor
6. Accounting for a sales-type lease for lessor
7. Accounting for sale and leaseback
8. Disclosures

The implicit interest rate in the lease is the discount rate that causes the
aggregate present value of the minimum lease payments and the
unguaranteed residual value to equal the fair value of the leased asset and
the initial direct costs of the lessor. (PVofMLP + PVofRV = FV + IDC)
The lessee's incremental borrowing rate is the rate of interest that the
lessee would have to pay on a similar lease, or the rate that the lessee
would incur by borrowing funds to purchase the asset over a similar term
and similar security.

OBJECTIVE & SCOPE OF PAS 17

Other situations that could also lead to classification as a finance lease are:

The objective of PAS 17 is to prescribe, for lessees and lessors, the appropriate
accounting policies and disclosures to apply in relation to finance and operating
leases.

(5.) The lease assets are of a specialized nature such that only the lessee can use
them without major modifications being made.

PAS 17 applies to all leases except for:


1. Lease agreements for minerals, oil, natural gas, and similar regenerative
resources; and
2. Licensing agreements for films, videos, plays, manuscripts, patents,
copyrights, and similar items.
Moreover, PAS 17 does not apply as the basis of measurement for the following
leased assets:
1. Property held by lessees that is accounted for as investment property for
which the lessee uses the fair value model set out in PAS 40;
2. Investment property provided by lessors under operating leases (see PAS 40)
3. Biological assets held by lessees under finance leases (see PAS 41)
4. Biological assets provided by lessors under operating leases (see PAS 41)

(6.) If the lessee is entitled to cancel the lease, the lessor's losses associated with
the cancellation are borne by the lessee. In this case, the lease is deemed noncancellable. Furthermore, cancellable lease was deemed noncancellable when:
(a) the lease can be cancelled only upon the occurrence of some remote
contingency.
(b) the lease can be cancelled only with the permission of the lessor.
(c) the lessee, upon cancelation, enters into a new lease for the same or
equivalent asset with the same lessor.
(d) the lease can be cancelled only upon payment of an additional amount
or penalty of such magnitude that the lessee shall be discouraged from
cancelling the lease.

(7.) 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).
(8.) The lessee has the ability to continue to lease for a secondary period at a rent
that is substantially lower than market rent.

DEFINITION & CLASSIFICATION OF LEASE


A lease is an agreement whereby the lessor conveys to the lessee in return for a
payment or series of payment the right to use an asset for an agreed period of
time.
The classification of leases adopted in this standard is based on the extent to
which risks and rewards incident to ownership of a leased asset lie with the
lessor or the lessee. Risks include the possibilities of losses from idle capacity or
technological obsolescence and of variations in return due to changing economic
conditions. Rewards may be represented by the expectation of profitable
operation over the asset's economic life and of gain from appreciation in value or
realisation of a residual value. A lease is classified as a finance lease if it
transfers substantially all the risks and rewards incident to ownership even
title may not pass to the lessee. All other leases are classified as operating
leases. Whether a lease is a finance lease or an operating lease depends on the
substance of the transaction rather than its form. (substance over form)
Classification is made at the inception of the lease. 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. At this date, the amounts to be
recognized at the commencement of the lease term are determined, in case of a
finance lease. The date from which the lessee is entitled to exercise its right to
use the leased asset is the commencement of the lease term. It is the initial
recognition of the assets, liabilities, income or expenses resulting from the lease .

Situations that would normally lead to a lease being classified as a finance lease
include the following:

When a lease includes both land and building, an entity should determine the
separate classification of the lease of the land and the building based on the
classification criteria taking into account the fact that land normally has an
indefinite economic life. Under the modification, land lease with lease term of
several decades or longer may be classified as finance lease even if the title will
not pass to the lessee at the end of the lease term. It is because in such
arrangement, substantially all the risks and rewards are transferred to the lessee
and the present value of the leased asset is considered negligible. 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 FOR AN OPERATING LEASE
LESSEE

LESSOR

AT COMMENCEMENT OF THE LEASE.


Initial direct costs - often incurred by the lessor, such as commissions,
legal fees, and other direct attributable costs in negotiating and arranging
a lease, shall be presented as an addition to the carrying amount of the
leased asset in the statement of financial position and recognized as an
expense over the lease term on the basis as the lease income.

Deferred IDC
Cash
#

(1.)There is transfer of ownership by the end of the lease term.


(2.) The lessee has the bargain purchase option 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.

(3.) The lease term is for the major part of the economic life of the asset, even if
title is not transferred. PAS, unfortunately, didn't specified what percentage
represents a "major part". But, under USA GAAP, the lease term must be at least
75% of economic life of the leased asset. 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 beginning 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 enterprise.
(4.) The present value of the minimum lease payments amounts to at least
substantially all of the fair value of the leased asset at the inception of the lease.
Again, PAS 17 didn't set a percentage to define what "substantially all" is. Under
USA GAAP, present value of minimum lease payments must be at least 90% of
fair value of the leased property. In general, minimum lease payments are
payments which the lessee is required to make in connection with the lease and
consist of:
a. the total of periodic rental payments; and
b. any bargain purchase option price; or
c. any guaranteed residual value
In computing for the minimum lease payments, the discount factor to be
used is the implicit interest rate if it is practically determinable;
otherwise, the lessee's incremental borrowing rate must be used.

XX

XX

Lease bonus - paid by the lessee to the lessor in addition to the periodic
rentals are treated as prepaid rent by the lessee and unearned revenue by
the lessor and to be amortized over the lease term.

Prepaid Rent
Cash
#

XX

XX

Cash
XX
Unearned Rent Income XX
#

Refundable security deposits - shall be accounted for as an asset by the


lessee and a liability by the lessor.
Rent deposit
Cash
#

XX

XX

Cash
XX
Liability for rent deposit XX
#

AT PAYMENT/RECEIPT OF THE RENT. PAS 17 provides that the lease payment


should be recognized as an expense (for lessee) or revenue (for lessor) 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.
Rent expense
Cash
#

XX

XX

Cash
Rent income
#

XX

XX

Unequal rental payments - are not uniform periodic payment of rentals.


Such unequal rental payments much be summed and be amortized
uniformly on the straight line basis as rent expense or income over the
lease term. The lessee/lessor must, therefore, record an asset or liability
arising from the difference between the amount paid/received and the
amount recognized as lease expense or revenue.

Rent incentives - such as rent-free periods or contributions by the lessor


to the lessee's relocation costs, under SIC 15, should be recognized by the
enterprise as a reduction of the rent income or expense over the lease
term, irrespective of the incentive's nature or form, or the timing of
payments.

Leases (PAS 17) Page 1

Total Periodic Rentals

XX

Less: Rent incentives

(XX)

Total Rent income/expense over the lease term

XX

Divided by: Lease term (in months/years)

XX

Monthly/annual rent expense/income

XX

If there is reasonable certainty that the lessee will obtain ownership of the leased
asset at the end of the lease term, depreciation must be recorded by the lessee
based on the useful life of the asset. Otherwise, the leased asset must be
depreciated over the lease term or useful life, whichever is shorter. The
depreciation policy for depreciable leased assets shall be consistent with that for
depreciable assets that are owned, and the depreciation recognised shall be
calculated in accordance with IAS 16 Property, Plant and Equipment and IAS 38
Intangible Assets.

(if payment is lower than annual rent):


Rent expense XX
Cash
XX
Cash
XX
Rent receivable
XX
Rent payable XX
Rent Income
#
#

CITERIA
XX

(or if payment is greater than annual rent):


Rent expense XX
Cash
XX
Prepaid rent XX
Rent income
XX
Cash
XX
Unearned rent income XX
#
#
AT PAYMENT OF OTHER COSTS.
Leasehold improvements - installed by the lessee shall be capitalized
by the lessee as an asset and depreciated over the life of the improvement
or the lease term, whichever is shorter. Any residual value is ignored
by the lessee in computing the depreciation since the lessor becomes the
legal owner of the leasehold improvement in the end of the lease term.
Leasehold improvement XX
Cash
XX
#
Other executory costs - incurred by any party such as real property
taxes, insurance and maintenance shall be recognized immediately as
period cost in the books of who is liable for such costs in the
agreement.
(if paid by the lessee):
Expense account XX
Cash
XX
#
(if paid by the lessor):

Expense account
Cash
#

XX

XX

AT COMMENCEMENT OF THE LEASE. In this date, the lessee must initially


record the leased asset and lease liability equal to the lower of the fair value of
the leased asset and the present value of the minimum lease payments.
XX

Asset under finance lease XX


Cash
XX
#

Interest
Expense

XX

(CV x
interest
rate)

Amortization Carrying Value


of Liability

At commencement

XX

At payment

Interest expense
Lease liability
Cash

XX
XX
#

(payment interest)

(CV amortization)

XX

AT PAYMENT OF OTHER COSTS. Contingent rents paid by the lessee that is


not fixed in amount but based on factors other than passage of time such as
percentage of sales, usage, price index, and market rate of interest, are expensed
immediately as incurred.
Contingent rent expense
Cash
#

XX

XX

Any executory costs paid by the lessee must be expensed immediately as


incurred.
Expense account
Cash
#

XX

Useful Life or Lease Term, whichever is shorter

Depreciation expense
XX
Acc. Depreciation
XX
#
The accrued interest is a portion of the interest expense from the
commencement of the lease or from the last payment to the date of the next
payment.
Interest expense
XX
Interest payable
XX
#
AT ACTUAL PURCHASE OF LEASE ASSET. When a lessee actually purchased
the leased asset under a finance lease, the cost of the asset purchased is equal to
the carrying amount of the leased asset plus any cash payment and minus the
balance of the lease liability.
Carrying value of leased asset
Add: Any cash payment

XX
XX

Less: Lease liability balance

(XX)

Cost of the asset purchased

XX

Asset
XX
Lease Liability
XX
Acc. Depreciation
XX
Asset under finance lease
Cash
#

Lease liability
Cash

XX
#

XX
XX

XX

Carrying value of leased asset

XX

Less: Lease liability balance

(XX)

Loss on finance lease

AT PAYMENT OF RENTAL. In this date, the lessee must apportion its payment
of rental - first to the finance cost and the remaining as payment for the
principal lease liability. An amortization table maybe necessary.
Payments

3-8

However, if the bargain purchase option is not exercised, the excess of the lease
liability over the carrying amount of the machinery must be recognized as loss
on finance lease.

XX

Any initial direct costs paid by the lessee must be recognized by the lessee as
part of the leased asset.

Date

Useful Life

AT EXERCISE OF THE BARGAIN PURCHASE OPTION. Since the present


value of the minimum lease payment is already inclusive of the bargain purchase
option price, the lessee will only close the lease liability account.

ACCOUNTING FOR A FINANCE LEASE FOR LESSEES

Asset under finance lease


Lease liability
#

BASIS OF DEPRECIATION

1-2

XX

AT END OF THE REPORTING PERIOD. At this date, the lessee must record
the depreciation of the leased asset and any accrued interest, in case the
payment of rentals doesn't coincide with the end of the reporting period.

Lease liability
XX
Loss on finance lease
XX
Acc. Depreciation
XX
Asset under finance lease
#

XX

XX

AT THE END OF THE LEASE TERM. At end of the lease term, the lessee will
simply close all accounts related to the lease.
Lease liability
XX
Acc. Depreciation
XX
Asset under finance lease
#

XX

However, if the lessee has guaranteed the residual value of the leased asset, any
cash payment made to compensate the deficiency of the fair value shall be
accounted for as loss in finance lease. Needless to say, if the fair value (actual
residual value) of the leased asset is greater than the amount guaranteed by the
lessee, no loss or gain shall be recognized since there is no cash settlement
occurred.
Lease liability
XX
Acc. Depreciation
XX
Loss on finance lease
XX
Asset under finance lease
Cash
#

XX
XX

ACCOUNTING FOR A DIRECT-FINANCING LEASE FOR LESSORS


In the lessor's perspective, a finance lease is either a direct financing lease or a
sales-type lease. A lessor under direct financing lease is actually engaged in
financing business wherein he earns only interest income from the transaction. In
direct financing lease, the fair value of the leased asset is equal to its cost;
therefore, no dealer's profit is to be recognized. (FV = Cost)
Under sales-type lease, the dealer or manufacturer, in fact, is selling its products
in the form of lease particularly for buyers who cannot procure the product by
single outlay of cash, especially when it costs a lot to buy such asset. Thus, the
dealer-lessor doesn't only recognize interest income, but also a dealer's profit on
sale. In sales-type lease, the fair value of the leased asset does not necessarily
equal to the cost of purchasing the asset. (FV Cost)

Leases (PAS 17) Page 2

AT COMMENCEMENT OF THE LEASE. At commencement of the lease term,


conceptually, the lessor should record a finance lease receivable in the balance
sheet, at an amount equal to the net investment in the lease. However, practically,
the lease receivable is recorded equal to the gross investment of the lease.

Sales price

Conceptually, Lease Receivable = Net investment or


LR = Cost + IDC
Practically,

AT ACTUAL SALE OF LEASED ASSET. When a lessee actually purchased


the leased asset, the lessor must account for the difference between the sales
price and the carrying value of the lease receivable.

Gain (loss) on sale of leased asset

Lease Receivable = Gross investment or


LR = GR + RV (or LR = GR + BPO)

Cash
XX
Unearned interest income XX
Lease receivable
Gain on finance lease
#

Gross investment - the gross rentals for the entire lease term plus the absolute
amount of residual value, whether guaranteed or not; or the absolute value of bargain
purchase option.
Net investment - the cost of the asset plus any initial direct cost incurred by the
lessor.
Unearned interest income - the total financial revenue of the lessor which is the
difference between the gross investment and net investment.
Gross investment (GR + RV or BPO)

Asset account (@FV)


XX
Loss on finance lease
XX
Lease receivable
#

AT RECEIPT OF RENTAL PAYMENTS. Since the aggregate present value of the


minimum lease payments and the unguaranteed residual value is equal the cost or
FV of the leased asset and the initial direct costs of the lessor (PVofGR + PVofRV =
Cost + IDC), the periodic rental payment can be computed as:

Cash
XX
Asset account (@FV)
XX
Lease receivable
#

XX
(XX)

Net investment to be recovered from rentals

XX

Divided by: PV annuity factor of MLP

XX

Annual rental

XX

XX

Divided by: PV annuity factor of MLP

XX

Annual rental

XX

Asset account (@FV)


XX
Lease receivable
Gain on finance lease
#

Payments

Interest
income

Amortization

At commencement
At payment

Cash

Present Value
of Receivable
XX

XX

Lease receivable
#

(PV x
interest
rate)
XX

Unearned interest income XX


Interest income
#

(payments interest)

(PV amortization)

Rent Income
#

XX

XX

AT THE COMMENCEMENT OF THE LEASE. Like under the directfinancing type of lease, the lessor must record a finance lease receivable in
its statement of financial position in equal to the gross investment of the
lease. Because the lease is accounted for as a sales-type lease, the net
investment is only the aggregate present value of the minimum lease
payments and the unguaranteed residual value.
However, aside from the finance revenue to be recognized by the dealerlessor over the lease term in connection with the lease, he 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.
Gross investment - the gross rentals for the entire lease term plus the
absolute amount of residual value, whether guaranteed or not; or the
absolute value of bargain purchase option. (same in direct-financing)

XX

Net investment - the aggregate present value of the minimum lease


payments and the unguaranteed residual value.

XX

Unearned interest income - the total financial revenue of the lessor which
is the difference between the gross investment and net investment.
Sales - equal to the net investment or the fair value of the asset, whichever
is lower.
Cost of sales - equal to the coat of the asset sold plus initial direct cost.

AT PAYMENT OF OTHER COSTS. Any executory costs paid by the lessor must be
expensed immediately as incurred.
Expense account
Cash
#

XX
XX

XX

Contingent rents paid by the lessee that is not fixed in amount but based on factors
other than passage of time such as percentage of sales, usage, price index, and
market rate of interest, are recorded by the lessor as lease revenue.
Cash

XX

ACCOUNTING FOR A SALES-TYPE LEASE FOR LESSORS

Upon the receipt of the rental payment, the lessor will just credit its receipt
of cash to lease receivable, but need also to recognize the earned portion of
the unearned interest revenue using the scientific method of amortization.
Date

XX

Needless to say, if the fair value (actual residual value) of the leased asset is
greater than the amount guaranteed by the lessee, a gain on finance lease is
to be recognized.

(If the lessee obtains ownership at the end of lease term):


Net investment (or Cost + IDC)

XX

However, if the lessee has guaranteed the residual value of the leased
asset, the lessor will received cash payment from the lessee to compensate
the deficiency of the fair value and therefore, no more loss shall be
recognized.

(If the leased asset will revert back to the lessor):


Less: PV of the residual value

XX
(XX)

Gain (loss) on finance lease

XX
XX

Net investment (or Cost + IDC)

XX
XX

Less: carrying value of lease receivable

XX

Lease Receivable (GI)


XX
Asset under finance lease (NI)
Unearned interest income (UII)
#

XX

Fair value of leased asset

(XX)

Unearned Interest Income

(XX)

AT THE END OF THE LEASE TERM. At end of the lease term, the lessor
will simply close all accounts related to the lease, but any difference
between the carrying value of the lease receivable and the fair value of the
asset shall be accounted for as gain or loss on finance lease.

XX

Less: Net investment (Cost + IDC)

XX

Less: carrying value of lease receivable (or LR - UII)

Gross investment (GR + RV or BPO)


Less: Net investment (PVofGR + PVofRV or PVofBPO)
Unearned Interest Income

XX

XX
(XX)
XX

(If the lessee guaranteed the residual value of the leased asset:
AT END OF THE REPORTING PERIOD. In case the balance sheet date doesn't
coincide with the payment date, the lessor must accrue any interest receivable.
Interest receivable
Interest income
#

XX

Less: Cost of sale ( Cost + IDC)


Gross profit on sale

XX
(XX)
XX

XX
(If the lessee does not guaranteed the residual value:)

AT EXERCISE OF THE BARGAIN PURCHASE OPTION. When the lessee


exercised the bargain purchase option, the lessor must derecognize any lease
receivable and unearned interest income thereof.
Cash
XX
Unearned interest income XX
Lease receivable
#

Sales (Lower of NI and FV of the asset)

Sales (Lower of NI and FV of the asset) - PVofURV


Less: Cost of sale ( Cost - PVofURV + IDC)
Gross profit on sale

XX

Leases (PAS 17) Page 3

XX
(XX)
XX

Lease receivable (GI)


XX
Sales (NI)
XX
Unearned interest income XX
#
Cost of sales
Inventory
#

XX

(c) If the sale price is above fair value, the excess over fair value
should be deferred and amortized over the period of use. The
difference between the fair value at the time of the transaction and the
carrying amount should be recognized immediately in the profit or
loss.

XX

NOTE:
1. That the gross investment under direct financing and sales-type is the same;
2. That the net investment of the lease under direct-financing lease becomes
the cost of sale in sales-type lease;
3. That gross profit on sale under guaranteed residual value and unguaranteed
residual value is just the same; and
4. That in direct financing lease, the aggregate present value of the minimum
lease payments and the unguaranteed residual value is equal the cost or FV of the
leased asset and the initial direct costs of the lessor, but in sales type lease, it
doesn't necesaarily equal.
In direct financing, PVofGR + PVofRV = Cost + IDC
(Net investment)
= (Cost of sale)

DISCLOSURES:

But in sales-type lease, Net investment Cost of sale

FOR LESSEES:

AT SUBSEQUENT TRANSACTIONS. Same as direct financing lease except for


the asset under finance lease must be accounted for as an inventory.
ACCOUNTING FOR A SALE AND LEASE-BACK
A sale and lease back is an arrangement whereby one party sells a property to
another party and then immediately leases the property back from its new owner.
Thus a seller becomes the lessee and the purchaser becomes the lessor.
The important consideration in the sale and lease back transaction is the
recognition of two separate transactions, the sale and the lease back.
The accounting treatment of a sale depends upon the type of lease involved.
For a sale and leaseback transaction that results in a finance lease, any excess of
proceeds over the carrying amount is deferred gain and amortized over the lease
term and any excess of the carrying amount over the selling price shall be
included as loss immediately.

The net carrying amount of each class of asset at the end of


the reporting period.
A reconciliation between the total future minimum lease
payments at the end of the reporting period and their present
value.
The total future minimum lease payments at the end of the
reporting period and their present value 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 recognize as expense in the period.
The total future minimum sublease payments expected to be
received under non-cancellable subleases at the end of the
reporting period.
A general description of the lessee's material leasing
arrangements.
FOR LESSORS:

For a transaction that results in an operating lease, the accounting treatment for
the gain or loss depends upon the selling price and the fair value of the asset.

A reconciliation between the gross investment in the lease


and the present value of the minimum lease payments
receivable at the end of the reporting period.
The gross investment in the lease and the present value of the
minimum lease payments receivable at the end of the
reporting period 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
Unearned finance income or unearned interest income.
Unguaranteed residual value accruing to the benefit of the
lessor.
Accumulated allowance for uncollectible minimum lease
payments receivable.
Contingent rents recognized as income in the period.
A general description of the lessor's material leasing
arrangements.

(a) If the transaction is clearly carried out at fair value, the profit or loss should
be recognized immediately;

(b) If the selling price is below fair value, profit or loss should be recognized
immediately. However, if a loss is compensated for by future rentals at below
market price, the loss it should be amortized over the period of use.

Leases (PAS 17) Page 4

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