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Definition
A lease is define as a contract or part of a contract that conveys the right to use the underlying
asset for a period of time in exchange for consideration.
IFRS 16, paragraph 22, provides that at the commencement date, a lessee shall recognize a
right of use asset and a lease liability.
Lessee is required to initially recognize a right of use asset for the right to use the underlying
asset over the lease term and a lease liability for the obligation to make payments.
At Commence date
Right of Use Asset xxx
Lease liability xxx
(lease payment x PV)
IFRS 16, paragraph 5, provides that a lessee is permitted to make an accounting policy
election to apply the operating lease accounting not recognize an asset and lease liability in two
exceptional exemptions.
a. short-term lease
b. low value lease
ILLUSTRATION 1
On January 1, 2018, an entity leased a machinery for 4 years which is the same as the useful
life of the machinery at annual rental or fixed payment of P200,000 payable at the end of each
year.
The lease provides for a transfer of ownership of the underlying asset to the lessee at the end of
the lease term.
The present value of annual payment of P200,000 for 4 years using 12% implicit interest rate is
computed as follows:
Present Value = Php200,000 x PV of an ordinary annuity of 1 for
Years at 12%
= Php200,000 x 3.0373
= Php607,460
Date Payment Interest-12% Principal Carrying Value
01/01/2018 607,460
12/31/2018 Php 200,000 Php 72,895 127,105 480,355
12/31/2019 200,000 57,643 142,357 337,998
12/31/2020 200,000 40,560 159,440 178,558
12/31/2021 200,000 21,427 178,573
21,442 178,558 0
Lessee has the option to purchase the asset upon the lease expiration. Also, lessee is
reasonably certain to exercise the purchase at the commencement date of the lease. Hence,
the asset is depreciated over the useful life because there is a purchase option that is
reasonably certain to be exercised.
Camil Company leased a machine on January 1, 2019 with the following pertinent information:
Fixed rental payment at the end of each year Php 2,000,000
Lease term 10 years
Useful life of machine 12 years
Incremental borrowing rate 14%
Implicit interest rate 12%
Present value of an ordinary annuity of 1 for 10 periods at
14% 5.216
12% 5.650
Present value of 1 for 10 periods at
14% 0.270
12% 0.322
Camil Company has the option to purchase the machine upon the lease expiration on January
1, 2029 by paying Php1,000,000.
Camil Company is reasonably certain to exercise the purchase option at the commencement
date of the lease.
The estimated residual value of the machine at the end of the 12-year life if Php1,200,000.
Journal Entries:
January 1, 2019 Right of Use Asset 11,622,000
Lease liability 11,622,000
ILLUSTRATION 3
Assuming Camil Company did not exercise purchase option, what is the entry on January 1,
2029?
As long as there is a residual value guarantee, there is no more purchase option because the
equipment will revert to the lessor upon expiration of the lease.
The residual value guarantee will not be paid by the lessee to the lessor because the underlying
asset is simply transferred by the lessee to the lessor to satisfy the liability for the residual value
guarantee.
The remaining carrying amount of the asset should be equal to the residual value
guarantee.
FMV of the underlying asset < Residual Value Guarantee : Loss on finance lease
FMV of the underlying asset > Residual Value Guarantee; No additional entry is
necessary because there is no cash settlement
The initial direct cost and lease incentive received are included in the measurement of the cost
of right of use asset but excluded in the measurement of lease liability.
The initial direct cost is added and the lease incentive received is deducted in computing the
cost of right of use asset.
Pau Company leased an equipment on January 1, 2019 with the following information:
Annual fixed payment in advance at the
beginning of each lease year Php 2,000,000
Initial direct cost paid on January 1, 2019 500,000
Lease incentive received 300,000
Residual value guarantee 600,000
Lease term 5 years
Useful life of equipment 6 years
Implicit interest rate 8%
Present value of an annuity of a in advance
At 8% for 5 years 4.3121
Present value of 1 at 8% for 5 periods 0.6806
The equipment is returned by the lessee to the lessor upon the lease expiration on January 1,
2022.
On such date, the fair value of the asset is P800,000 which is higher than the guaranteed
residual value of P600,000.
ILLUSTRATION 5
Assuming on January 1, 2024, the fair value of the Asset is P450,000, What is the entry on
January 1, 2024 to record the return of the equipment to the lessor?
The present value of the residual value is not included in the lease liability because it is
unguaranteed.
Depreciation period is either the lease term period or the life of the asset whichever is shorter.
Mari Company leased a warehouse on January 1, 2019 with the following information:
Annual rental payable at the end of each year Php 1,200,000
Unguaranteed residual value 400,000
Payment to lessor to obtain a long-term lease 448,000
Cost of restoring the asset as required by contract 800,000
Annual executory cost paid 100,000
Lease term 6 years
Useful life of equipment 8 years
Implicit interest rate 10%
Present value of an ordinary annuity of 1 at 10%
for 6 periods 4.36
Present value of 1 at 10% for 6 periods 0.56
The lease provides for neither a transfer of title to the lessee nor a purchase option.
Thus, the equipment will revert to the lessor upon the expiration of lease on January 1, 2025.
Computation
EXERCISES
A. Pau Company leased a machine on January 1, 2019 with the following information
provisions:
Annual lease payment in advance at the
beginning of each year, starting January, 2019 P 2,000,000
Lease term 10 years
Useful life of machine 15 years
Implicit interest rate in the lease 12%
PV of an ordinary annuity of 1 at 12% for 10 periods 5.650
PV of an annuity of 1 in advance at 12% for 10 periods 6.328
PV of 1 at 12% for 10 periods 0.322
The entity has an option to purchase the machine on January 1, 2029 by paying P400,000.
At the commencement date , it is reasonably certain that the purchase option will be exercised.
Required: Prepare journal entries on the books of Pau Company for 2019 to 2021.
B. On January 1, 2019, Camil Company entered into a lease with Pau Company for a new
equipment.
The lease stipulates that annual payments of P2,000,000 will be made for five years starting
December 31, 2019.
Camil Company guaranteed a residual value of P948,120 at the end of the 5-year period. The
equipment will revert to the lessor at the lease expiration.
The implicit interest rate for the lease is 16% after considering the guaranteed residual value.
The economic life of the equipment is 10 years. The present value factors at 16% for five
periods are:
Present value of 1 0.4761
Present value of an ordinary annuity of 1 3.2743
Required:
1. Prepare a schedule of the annual payments showing reduction of liability every year.
2. Prepare journal entries on the books of Camil Company fro 2019 and 2020.
3. Prepare journal entry on December 31, 2023, end of lease term, to record the return of the
equipment to the lessor. Assume the fair value of the equipment is equal to the guaranteed
residual value.
4. Prepare journal entry on December 31, 2023 to record the return of the equipment to the
lessor assuming the fair value of the equipment is only P600,000.
5. Prepare journal entry on December 31, 2023 to record the return of the equipment to the
lessor assuming the fair value of the equipment is P1,000,000.
On January 1, 2019, Mari Company entered into a lease agreement for an equipment.
The lease stipulates an annual rental payment of P1,200,000 to be paid every December 31
starting December 31, 2019.
The lease contains neither a transfer of title to the lessee nor a purchase option.
The equipment has residual value of P600,000 at the end of the 5-year lease period but is
unguaranteed by the lessee. The economic life of the equipment is 8 years.
The implicit interest rate is 12% after considering the unguaranteed residual value.
Required:
1. Prepare journal entries on the books of Mari Company for 2019 and 2020.
2. Prepare journal entry on December 31, 2023 to record the return of the equipment to the
lessor as required by the contract. The fair value of the equipment is P400,000.