Welcome class!

Our lesson for today is Lease Accounting, particularly on the part or point of view of the
Lessee. This lesson is an introductory to your 6 chapters Lease Accounting. In this lesson, we will tackle
what is a Lease based on our new standard, there are 2 types of lease accounting treatment on the part
of the lessee, we will distinguish the two - the Finance Lease and Operating Lease model, and we will
analyze how to compute the Right of Use Asset account of the Lessee and measure the Lease Liability.

We will use my power point presentation to discuss the concepts, combined with some practice
questions. And at the end of our discussion, we will solve practice problems using Microsoft Excel. See
you on our synchronous session.

Welcome to our synchronous session. How are you today class? I hope you are all well and fine. So, for
today’s session, we will discuss the Lease Accounting of the Lessee, Lessee Accounting on the IFRS 16
standard.

But before I discuss the topic, I have a simple question here. It is just to test if any of you have any
background knowledge of the topic. Maybe some of you already heard of the standard or knew how to
account for it, or maybe some of you made an advance reading for the topic. You may now answer our
poll question for today. Let’s see the result. Majority of you answered you do not have any background
knowledge of the topic. That’s great because we will discuss the basic concepts of the topic up to the
complex, so you may be able to answer any type of questions on your assessments.

Let us now move to our Learning Objectives. First, after this session, you may be able to define what is
Lease based on our new accounting standard. Determine how to account for the lease accounting of the
Lessee, we have two, Finance Lease model as well as the Operating Lease model. I will also teach you
how to compute the Right of Use Asset of the lessee as well as measure the Lease Liability. Let’s first
define what is Lease.

Lease, based on our new standard, is a contract or part of a contract that conveys the right of use of the
underlying asset for a period of time in exchange for consideration. Let us use some illustrations.

Mr. A here, is a magician, and he wants to find a perfect place for him to perform his stunts. Instead of
building his own stadium, he decided to just rent a building. Because by renting, Mr. A can now start
performing his stunts instead of building his own. Mr. A only has a limited budget since he is only
starting his career. He wants a lease that has a ₱50,00 monthly rent. Luckily, Mr. Landlord happens to
own several buildings with a monthly rate of ₱50,000 per month. Mr. A and Mr. Landlord entered into a
Contract of Lease. In a contract of lease there 2 parties, the lessee, and the lessor. In our example, Mr. A
is the lessee, and Mr. Landlord is the Lessor. In a contract of lease, the lessor will give the lessee the
Right to Use the asset in our case is the building of Mr. Landlord for, let’s say 5 years. So, in exchange for
the Right to Use of the building of the Landlord, Mr. A will pay Mr. Landlord the lease payments agreed.
If we will go back to the definition of the standard.

The right to use the underlying asset is the building of the Mr. Landlord, for a period of time which is 5
years based on the contract and in exchange for a consideration which is ₱50,000 per month. Now, the
question is, “Is the right to use the underlying asset” enough to be considered a lease? The standard also
provides that to be a lease, a contract must convey not just the right to use but also the right to control
the use of an identified asset. So, what does that mean?
A contract conveys the right to control the use of an asset if throughout the period of use, the lessee has
the right to:

a. Obtain substantially all the economic benefit from the use of the identified asset. The lessee can
obtain substantially all the economic benefits from the use of the asset by having exclusive use
of the asset throughout the period of use. In our example, Mr. A, the magician must have the
control on the building throughout the period of use, either directly or indirectly in many ways,
such as using, holding, or subleasing the asset.
b. And direct use of the identified asset. A lessee has the right to direct use of the asset when he
has the right to direct how and for what purpose the asset is used throughout the period of use.
In our example, Mr. A can decide solely on its own on how he will use the building without any
consent from Mr. Landlord, the lessor.

Now that you know what Lease is based on the standard, let us now move to our next objective, which is
to determine the finance lease model of the lessee and the optional application of the operating lease.

So, at the commencement date, in our illustrative example, it is the date the contract of lease between
Mr. A and Mr. Landlord was executed, a lessee, which is Mr. A in this case, shall recognize a right of use
asset and a lease liability. This simply means that a Mr. A is required to initially recognize a Right of Use
Asset account for the right to use the building over the lease term and a lease liability for the obligation
to make the ₱50,000 monthly payments. Take note that all leases shall be accounted for by the lessee as
a finance lease under the new lease standard. We will talk a lot about finance lease later, but for now,
just remember that finance lease is the required option of the lessee in accounting for his leases. The
other model is the Operating Lease. A lessee has the option to account his lease accounting and not
recognized a right of use asset and a lease liability in two optional exemptions: first, when it is stated in
their contract that it is a short-term lease, or it is a low value lease. A lease is a short-term lease if the
lease term is only 12 months or less. But if the lease contains a purchase option, meaning, the lessee
has the right to purchase the asset during or at the end of the lease contract, it is not considered a
short-term lease. How much is a low value asset? Unfortunately, the standard does not provide for a
quantitative threshold for a low value asset, and it is only a matter of professional judgment on the part
of the lessee to assess the value of an underlying asset based on the value of the asset when it is new
regardless of the age of the asset being leased. Typically, low value underlying assets include personal
computers, officer furniture and equipment. In our illustrative example, the building that was leased by
Mr. Landlord would not qualify as low value lease because a new building would typically not be of low
value. Under the operating lease model, the periodic rental is simply recognized as rent expense on the
part of the lessee. So, in our illustrative example, if the asset is a low value and the lease is a short-term
lease, Mr. A will debit a Rent Expense account for the ₱50,000 monthly payment of the lease. Under the
Finance Lease model, Mr. A will debit a Right of Use asset account and will credit a Lease Liability
account. Let us first discuss the components of the Right of Use Asset account.

A right of use asset is defined as an asset that represents the right of the lessee to use an underlying
asset over the term in a finance lease. In our example, the Right of Use Asset is the right of Mr. A, the
magician, to use the building of Mr. Landlord. Mr. A shall measure the right of use asset at cost at the
commencement date of the lease. Basically, it means that all the necessary costs to bring the asset to its
intended use shall be capitalized. Here are the necessary costs that form part of the right of use asset.
To compute for the Cost of Right of Use Asset, first, we need to determine the PV of lease payments.
Remember that the lessee will recognize a right of use asset and a lease liability. This PV of lease
payments basically means the initial measurement of the lease liability which we will talk about a bit
later. Next is the initial direct cost. These are incremental costs of obtaining a lease that would not have
been incurred if the lease had not been obtained. So, if Mr. A hired an agent to find him a lease, he will
then pay the agent a commission. The agent’s commission will be considered as initial direct cost in
obtaining the lease because without the help of the agent, Mr. A would not have been obtained the
lease. Another example of initial direct cost are finder’s fees and broker’s fees. If there are leasehold
improvements, they are not part of the initial direct cost, because leasehold improvements are
separately accounted as PPE of the lessee and they are depreciated over their useful life, or over the
lease term if it is shorter than the useful life. Estimate of cost of dismantling, removing, and restoring
the underlying asset for which the lessee has a present obligation. Of course, at the start of the lease,
the building will still be empty and Mr. A will need to renovate the building and make it into a stadium
so that he can perform his stunts. He will either build a stage for him to perform, a table and chairs for
his audience. But after the lease contract, before he will give the building back to Mr. Landlord, Mr. A
will need to restore it back by dismantling all the improvements that he has done to the building. These
estimated costs of dismantling, removing, and restoring the building, take note, as long as Mr. A has a
present obligation and it is written in the contract that he will need to restore it back to its normal use,
will form part of the cost of right of use asset. Any lease payments made by the lessee to the lessor at or
before the commencement date, such as lease bonus will be added as cost, and any payments made by
the lessor to lessee, such as lease incentives received by the lessee will be deducted to compute for the
total cost of the right of use asset. Let us have some practice questions over here.

You may use the zoom chat box to answer our practice questions. The first question is, under IFRS, the
lessee is required to recognize: a.) a right of use asset and a lease liability, b) only right of use asset, c)
only lease liability, or d) neither of the two. That is correct, a lessee is required to recognized both right
of use asset which we already discuss a while ago and a lease liability which we will discuss next. But
before that, lets have another one question. The question is “the cost of right of use asset comprises all,
except: a) the present value of lease payments or the initial measurement of lease liability, b) lease
payments made to lessor on or before commencement date, c) initial direct cost incurred by the lessee,
and d) estimated cost of dismantling the asset for which the lessee has no present obligation. I see a lot
of letter D, you are right, the correct answer is D. As discussed, a while ago, any estimated cost of
dismantling shall be part of the cost if the lessee a present obligation. Letter D says the lessee has no
present obligation. Let us go back again on the other choices, letter B here says lease payments made to
lessor on or before the commencement date, this is a Lease bonus which form part of the right of use
asset, letter C is initial direct cost which also form part of the cost of the right of use asset. Let us now
talk about Lease Liability. Remember as discussed, a while ago, a lessee shall recognize at the
commencement date of the lease, a right of use asset and a lease liability. The present value of lease
payments is basically the initial measurement of lease liability, so I’ll click here.

Remember on our illustrative example, Mr. A will pay ₱50,000 monthly lease payments. These lease
payments shall be discounted using the interest rate implicit in the lease. If the interest rate cannot be
readily determined, the incremental borrowing rate of the lessee is used. The incremental borrowing
rate is the rate of interest that Mr. A would have to pay to borrow funds necessary to obtain a similar
asset. What is the difference between two? Implicit interest rate is the required or target rate of return
of the lessor. Basically, the lessor knows the rate, while the incremental borrowing rate is the bank rate
whenever the lessee will borrow funds to the bank in order to obtain the lease. As stated, these lease
payments are discounted, therefore we will use present value factors. In accounting for leases, we will
use 3 different types of present value factor. If Mr. A said to Mr. Landlord that he will assure him that
when he will return the building back to Mr. Landlord, the value of which is still let’s say ₱75,000. This
₱75,000 is what we called the residual value guaranteed by Mr. A. Since this residual value is a value at
some point in the future, Mr. A will then need to compute for its present value today. To do this, he will
then need to know what the present value factor is of 1. The formula for the PV of 1 is (1+r) -n. Follow
these steps to compute for the PV of 1. Step 1, enter on your calculator 1 plus the rate and then press
equals. Step 2, press the division sign twice. The last step depends on the number of lease term. If the
lease term is 5 years, you will press equal sign 5 times.

In our previous example, Mr. A is required to pay ₱50,000 monthly let us say he will pay this amount at
the end of every month. Since this is a recurring payment or a repeating payment, The next PV factor is
the PV factor of ordinary annuity and the formula for this is shown on your screen. If your basic
calculator has a ‘GT’ sign, which means Grand Total, the steps 1, 2 and 3 are just the same as the PV of 1
computation, but this time, you will press the GT sign to sum all your PV of 1 computation.

If Mr. A is required to pay the ₱50,000 monthly lease payments at the beginning of every month, Mr. A
will use the PV factor of the PV of annuity due. Steps 1 and 2 are the same as the previous procedures,
but this time, you will need to deduct a year on your number of least terms. For example, if the least
term is 5 years, you will only press equal sign 4 times, and then press the GT then add the additional 1.
That is how you will solve PV factors on every different scenario. The question now is “what will form
part of these least payments”?

The lease payments of the lessee to the lessor comprise the following payments for the right to use the
underlying asset during the lease term: First is the Fixed lease payments. These are payments made by
the lessee to the lessor. In our example, this is the ₱50,000 monthly payment of Mr. A to Mr. Landlord.

Variable lease payments are payments made by lssee to lessor that vary. For instance, in our example,
suppose on the second year, Mr. A will pay ₱25,000 more than the ₱50,000 monthly payments. This is
now called a variable payment.

The lessee has the option to purchase the underlying asset upon the lease expiration by paying a certain
amount of money, this is called a purchase option and it must be reasonably certain to exercise by the
lessee to form part of the lease payments. If Mr. A has the right to exercise the purchase option and if
he did exercise it, the building will now be transferred to him at the end of the lease contract and the
owner will now be him instead of the lessor.

A residual value may either be guaranteed or unguaranteed. Residual value guarantee is the guarantee
made to the lessor by an unrelated party to the lessor. The lessee may be the unrelated party. If the
residual value is not assured or it is guaranteed by the party related to the lessor, it is unguaranteed
residual value. Take note that only guaranteed residual value is included in the computation of the PV of
lease payments. If the residual value is guaranteed, the lessee will return the underlying asset back to
the lessor at the end of the lease term because the lessee is guaranteeing the lessor that the asset will
have a residual value at the end of the lease contract.
And lastly, termination penalties if the lease term reflects the exercise of a termination option. These
are the components of the lease liability. Let’s have some practice exercises to refresh your knowledge
on the topic.

Which of the following statements concerning residual value guarantee is appropriate for the lessee?

a. The asset and related liability should be increased by the absolute amount of the residual value.

b. The asset and related liability should be decreased by the absolute amount of the residual value.

c. The asset and related liability should be decreased by the present value of the residual value

d. The asset and related liability should be increased by the present value of the residual value

The correct answer is letter D. As discussed, a while ago, a residual value that is guaranteed is a
component of lease payments and are discounted using appropriate rate, therefore, PV is needed for
the residual value. This increases the lease liability and the cost of the right of use asset since the PV of
lease payments are part of the cost of right of use asset. Last practice question.

In computing depreciation of a right of use asset under a lease, the lessee should deduct

a. The residual value guarantee and depreciate over the lease term.

b. The residual value guarantee and depreciate over the useful life of asset.

c. An unguaranteed residual value and depreciate over the lease term.

d. An unguaranteed residual value and depreciate over the useful life of the asset.

As discussed earlier, when the residual value is guaranteed, the lessee is guaranteeing the lessor that
the asset after it has been used by the lessee, it has a residual value. Therefore, the asset will be
reverted back to the lessor at the end of the lease contract. Since the asset will revert back to the lessor,
the lessee in this case will depreciate the asset only over the lease term and not the useful life of the
asset. Let’s talk a bit more about depreciation and some additional consideration in accounting for
leases.

Here we have 4 additional information we need to consider when solving problems. First, let us talk
about Depreciation.

As discussed, a while ago, initially, the right of use asset is measured using the cost model. Therefore,
we are depreciating it over the useful life of the asset or over the lease term. You will only depreciate it
over its useful life in 2 instances: First, if there is a transfer of ownership from the lessor to lessee,
second, if there is a reasonable purchase option that is certain to exercise by the lessee. As you noted, in
these 2 instances, whenever these 2 occurs, the ownership or title to the asset will be transferred to the
lessee, and therefore, the useful life of it is use in depreciating the asset.

If there is no transfer of ownership or there is no reasonably certain to exercise the purchase option,
that is the time the lessee will use the Lease term to depreciate its asset. Just a recap, if there is a
transfer of title or a reasonable purchase option, the useful life of the asset is used in depreciating it, if
there is no transfer of title or no reasonable purchase option, the lease term is used in depreciating it.
And if there is a residual value guaranteed, the lease term will also be used in depreciating it because
the asset will revert back to the lesser.

The next one I want to discuss with you is the presentation of the Right of Use Asset and the Lease
Liability in the Balance Sheet. They are presented as a separate line item just like the other balance
sheet account. As you can see, any accumulated depreciation is deducted to the Right of use asset to get
the carrying amount. While the lease liability is presented as Current Liability for the current portion,
and non-current liability for the non-current portion.

The last section I want to discuss with you is what we called the Executory costs. These are ownership
expenses such as maintenance, taxes, and insurance that is paid by the lessee on the underlying asset.
These are expenses immediately. When the problem says that the lessee is paying taxes on the asset
yearly, then you will record tax expense yearly as well. Now that you know the basic concepts of Lease
accounting as well as how to account for the right of use asset and lease liability of the lessee under the
finance lease, why don’t we answer some practice problems to further understand the accounting for
leases on the point of view of the lessee.

Now that you know the basic concepts of Lease accounting, why don’t you try answering our practice
problems. In this lesson, we define what is Lease based on our new accounting standard. We also
determine how to account for the lease accounting of the Lessee, the Finance Lease model as well as
the Operating Lease model. We also learn how to compute the Right of Use Asset of the lessee as well as
measure the Lease Liability.