IAS 17- Operating Lease and Finance Lease

DEFINITION OF LEASE:
Unde IAS 17, 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. It is
classified into:
(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; and
(b) Operating lease is a lease other than a finance lease.

IAS 17 applies to agreement that right to use an assets even though substantial services by
the lessor may be called for in connection with the operation or maintenance of such asset.

Exemptions / Items not covered by IAS 17 :

(a) lease agreements for exploration or use of minerals, petroleum, natural gas and non-renewable
resources like; and
(b) licensing agreements for items such as movies, video recordings, plays, manuscripts, patents and
copyrights.

IAS 17 does not apply as to Measurement Basis for:

1. Property held by lessees that is accounted for as investment property (PAS 40);
2. Investment property provided by lessors under operating leases (PAS 40);
3. Biological assets held by lessees under finance leases (PAS 41); and
4. Biological assets provided by lessors under operating leases (PAS 41).

NOTE:

This standard applies to agreements by which yield the right of use of assets, even in cases
where the landlord would be obliged to provide services of some importance in connection with the
operation or maintenance of such goods.
On the other hand, this rule does not apply to agreements that have the nature of service
contracts, where a party fails to yield to the other the right to use some type of asset.

DIFFERENCE BETWEEN INCEPTION & COMMENCEMENT OF THE LEASE TERM:

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. The beginning of the lease term is the date from which the
lessee has the option of using the leased asset. Is the date of initial recognition of the lease (ie,
the recognition of assets, liabilities, income or expenses arising from the lease, as appropriate).
The lease term is the non-cancelable 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.

DIFFERENCE BETWEEN ECONOMIC & USEFUL LIFE:

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 time period that extends from the beginning of the lease term, but
not limited by it, over which the entity expects to consume the economic benefits embodied in
the leased asset.
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.

DIFFERENCE BETWEEN GUARANTEED & UNGUARANTEED RESIDUAL VALUE:

Guaranteed residual value is:

(a) for a lessee( tenant), 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 (landlord) , 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.

OTHER RELATED TERMINOLOGIES:

Minimum lease payments are the payments over the lease term that the lessee is or can be
required to make, ecluding contingent rent, costs for services and taxes to be paid by and
reimbursed to the lessor, together with:

a. amounts guaranteed by the lessee or any third party related to the lessee

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.

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.

Fair value is the amount for which an asset could be exchanged, or a liability settled, between
knowledgeable, willing parties in an arm’s length transaction.

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 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 (e.g. percentage of
future sales, amount of future use, future price indices, future market rates of interest).

CLASSIFICATION OF LEASES:

The classification of leases adopted in this Standard is based on the degree to which the risks and
benefits, arising from the ownership of assets, affecting the landlord or the tenant.

Risks include the possibilities of losses from idle capacity or technological obsolescence and of
variations in return because of changing economic conditions.

Rewards can be represented by the expectation of an economic operation along the economic life of
assets, as well as a gain on revaluation or a realization of the residual value..

1. FINANCE LEASE – transfers substantially all the risks and rewards incidental to ownership.

Under IAS 17, any of the situation mention on the following items would lead to a clear cut
evidence of classifying the lease as FINANCE LEASE. DETERMINATIVE criteria for classifying
the lease as FINANCE LEASE are as follows;

(a) the lease transfers ownership of the asset to the lessee by the end of the lease term;
(b) the lessee has the option to purchase the asset at a price that is expected to be sufficiently
lower than the 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;
(c) the lease term is for the major part of the economic life of the asset even if title is not
transferred; ( US GAAP : Atleast 75% of the economic life of the asset)

(d) 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
(US GAAP asks for atleast 90 % of the fair value of the leased asset)
(e) the leased assets are of such a specialized nature that only the lessee can use them without
major modifications.

Suggestively, the following could also lead to classification of lease as Finance Lease;
(a) if the lessee can cancel the lease, the lessor’s losses associated with the cancellation are
borne by the lessee;

(b) gains or losses from the fluctuation in the fair value of the residual accrue to the lessee (for
example, in the form of a rent rebate equaling most of the sales proceeds at the end of the
lease); and

(c) the lessee has the ability to continue the lease for a secondary period at a rent that is
substantially lower than market rent.
 A non-cancelable lease is a lease that is cancelable only:
(a) upon the occurrence of some remote contingency;C
(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.

FINANCE LEASE

Recognition in the Financial Statements of Lessee – lessees shall recognize finance leases as
assets and liabilities in their balance sheets at amounts equal to the fair value of the leased
property or, if lower, the present value of the minimum lease payments, each determined at the
inception of the lease. The discount rate to be used in calculating the present value of the
minimum lease payments is the interest rate implicit in the lease, if this is practicable to determine;
if not, the lessee’s incremental borrowing rate shall be used.

Any initial direct costs of the lessee, such as negotiating and securing leasing arrangements,
are added to the amount recognized as an asset. The costs identified as directly attributable
to activities performed by the lessee for a finance lease are added to the amount recognized as an
asset.

Minimum lease payments shall be apportioned between the finance charge and the reduction of
the outstanding liability. The finance charge shall be allocated to each period during the lease term
so as to produce a constant periodic rate of interest on the remaining balance of the liability.
Contingent rents shall be charged as expenses in the periods in which they are incurred.

A finance lease gives rise to depreciation expense for depreciable assets as well as finance
expense for each accounting period. The depreciation policy for depreciable leased assets shall
be consistent with that for depreciable assets that are owned. If there is no reasonable certainty
that the lessee will obtain ownership by the end of the lease term, the asset shall be fully
depreciated over the shorter of the lease term and its useful life. If there is reasonable certainty
that the lessee will obtain ownership by the end of the lease term, the period of expected use is
the useful life of the asset.

Recognition in the Financial Statements of Lessor – lessors shall recognize assets held under
a finance lease in their balance sheets and present them as a receivable at an amount equal to
the net investment in the lease. Initial direct costs are often incurred by lessors and include
amounts such as commissions, legal fees and internal costs that are incremental and directly
attributable to negotiating and arranging a lease. For finance leases other than those involving
manufacturer or dealer lessors, initial direct costs are included in the initial measurement of the
finance lease receivable and reduce the amount of income recognized over the lease term.

Lease payments relating to the period, excluding costs for services, are applied against the gross
investment in the lease to reduce both the principal and the unearned finance income.

Manufacturer or dealer lessors shall recognize selling profit or loss in the period, in accordance
with the policy followed by the entity for outright sales. Costs incurred by manufacturer or dealer
lessors in connection with negotiating and arranging a lease shall be recognized as an expense
when the selling profit is recognized.

Manufacturers or dealers often offer to customers the choice of either buying or leasing an asset.
A finance lease of an asset by a manufacturer or dealer lessor gives rise to two types of income:
(i.a) profit or loss equivalent to the profit or loss resulting from an outright sale of the
asset being leased, at normal selling prices, reflecting any applicable volume or trade
discounts; and
(i.b) finance income over the lease term.

The sales revenue recognized at the commencement of the lease term by a manufacturer or
dealer lessor is the fair value of the asset, or, if lower, the present value of the minimum lease
 payments accruing to the lessor, computed at a market rate of interest. The cost of sale
recognized at the commencement of the lease term is the cost, or carrying amount if different, of
the leased property less the present value of the unguaranteed residual value. The difference
between the sales revenue and the cost of sale is the selling profit, which is recognized in
accordance with the entity’s policy for outright sales.

Costs incurred by a manufacturer or dealer lessor in connection with negotiating and arranging a
finance lease are recognized as an expense at the commencement of the lease term because
they are mainly related to earning the manufacturer’s or dealer’s selling profit.

2. OPERATING LEASE – does not transfer substantially all the risks and rewards incidental to
ownership.

Recognition in the Financial Statements of Lessor – Lease payments under an operating

lease shall be recognized as an expense on a straight-line basis over the lease term unless
another systematic basis is more representative of the time pattern of the user’s benefit.

For operating leases, lease payments (excluding costs for services such as insurance and
maintenance) are recognized as an expense on a straight-line basis unless another systematic
basis is representative of the time pattern of the user’s benefit, even if the payments are not on
that basis.

Recognition in the Financial Statements of Lessee – Lessors shall present assets subject to
operating leases in their balance sheets according to the nature of the asset.

Lease income from operating leases shall be recognized in income on a straight-line basis over
the lease term, unless another systematic basis is more representative of the time pattern in which
use benefit derived from the leased asset is diminished.

Costs, including depreciation, incurred in earning the lease income are recognized as an expense.
Lease income (excluding receipts for services provided such as insurance and maintenance) is
recognized on a straight-line basis over the lease term even if the receipts are not on such a basis,
unless another systematic basis is more representative of the time pattern in which use benefit
derived from the leased asset is diminished.

Initial direct costs incurred by lessors in negotiating and arranging an operating lease shall be added
to the carrying amount of the leased asset and recognized as an expense over the lease term on the
same basis as the lease income.

The depreciation policy for depreciable leased assets shall be consistent with the lessor’s normal
depreciation policy.

A manufacturer or dealer lessor does not recognize any selling profit on entering into an operating
lease because it is not the equivalent of a sale.

ACCOUNTING FOR LAND AND BUILDING LEASE:

Land and building are treated separately by applying the classification criteria. However, for lease of
land and buildings in which the amount that would initially be recognized for the land element is
immaterial, the land and buildings may be treated as a single unit for the purpose of lease
classification. In such a case, the economic life of the building is regarded as the economic life of the
entire leased asset. In another case, separate measurement of land and building is not required
when the lessee’s interest in both land and building is treated as investment property.

ACCOUNTING FOR SALE AND LEASEBACK:

Definition – A sale and leaseback transaction involves the sale of an asset and the leasing back of
the same asset. The lease payment and the sale price are usually interdependent because they are
negotiated as a package. The accounting treatment of a sale and leaseback transaction depends
upon the type of lease involved.
If a sale and leaseback transaction results in a finance lease, any excess of sales proceeds over
the carrying amount shall not be immediately recognized as income by a seller-lessee. Instead, it
shall be deferred and amortized over the lease term.
If the leaseback is a finance lease, the transaction is a means whereby the lessor provides
finance to the lessee, with the asset as security. For this reason it is not appropriate to regard an
excess of sales proceeds over the carrying amount as income. Such excess is deferred and
amortized over the lease term.

If a sale and leaseback transaction results in an operating lease, and it is clear that the
transaction is established at fair value, any profit or loss shall be recognized immediately.
If the sale price is below fair value, any profit or loss shall be recognized immediately except
that, if the loss is compensated for by future lease payments at below market price, it shall be
deferred and amortized in proportion to the lease payments over the period for which the asset is
expected to be used.
If the sale price is above fair value, the excess over fair value shall be deferred and
amortized over the period for which the asset is expected to be used.
If the leaseback is an operating lease, and the lease payments and the sale price are at fair
value, there has in effect been a normal sale transaction and any profit or loss is recognized
immediately.
For operating leases, if the fair value at the time of a sale and leaseback transaction is less
than the carrying amount of the asset, a loss equal to the amount of the difference between the
carrying amount and fair value shall be recognized immediately.
For finance leases, no such adjustment is necessary unless there has been an impairment in
value, in which case the carrying amount is reduced to recoverable amount.

Illustrative Examples of Sale and Leaseback Transactions that result in Operating Leases

Sales price Carrying amount Carrying amount Carrying amount

at fair value equal to fair value less than fair value above fair value

Profit No profit Recognize profit Not applicable

immediately
Loss No loss Not applicable Recognize loss
immediately
Sales price
below fair value

Profit No profit Recognize profit No profit (note 1)

immediately
Loss not compen- Recognize loss Recognize loss (note 1)
sated for by future immediately immediately
lease payments at
below market price

Loss compensated Defer and amortize Defer and amortize (note 1)

for by future lease loss loss
payments at below
market price

Sales price
above fair value

Profit Defer and amortize Defer and amortize Defer and amortize
profit excess profit (note 3) profit (note 2)
Loss No loss No loss (note 1)

Note 1 These parts of the table represent circumstances dealt with for operating leases, if the fair
value at the time of a sale and leaseback transaction is less than the carrying amount of the
asset. It is required that the carrying amount of an asset to be written down to fair value
where it is subject to a sale and leaseback.
Note 2 Profit is the difference between fair value and sales price because the carrying amount would
have been written down to fair value in accordance with note 1 above.
Note 3 The excess profit (excess of sales price over fair value) is deferred and amortized over the
period for which the asset is expected to be used. Any excess of fair value over carrying
amount is recognized immediately.

PROFORMA JOURNAL ENTRIES:

OPERATING LEASE

LESSOR LESSEE

a. Acquisition of property:
Property xx None.
Cash xx
b. Payment of initial direct costs (costs of negotiating and arranging the lease such as
commissions, legal fees and internal costs):
Property xx None.
Cash xx
c. Receipt of security deposit:
Cash xx Rent deposit (asset)xx
Rent deposit (liability) xx Cash xx
d. Receipt of rentals:
Cash xx Rent expense xx
Rent income xx Cash xx
e. Receipt of lease bonus:
Cash xx Prepaid rent xx
Un. rent income xx Cash xx
f. Payment of repairs and maintenance and other executory costs such as insurance and taxes):
Repairs & maint. xx Repairs & maint. xx Cash
xx Cash xx
g. Construction of leasehold improvements by lessee:
None. Leasehold impr. xx
Cash xx
Year-end adjustments:

h. Depreciation of leased property:

Dep’n. expense xx None.
Acc. dep’n. xx
i. Depreciation of leasehold improvements (over lease term or life of leasehold improvements –
whichever is shorter):
None. Dep’n. – LI xx
AD – LI xx
j. Amortization of lease bonus (over the lease term):
Un. rent income xx Rent expense xx
Rent income xx Prepaid rent xx
k. Amortization of initial direct costs (over the lease term):
Amort. expense xx None.
Property xx
For unequal lease payments under operating lease, total cash payments for the lease term
shall be amortized uniformly on the straight line basis as rent expense or rent income.

Cash xx Rent expense xx

Rent receivable xx Cash xx
Rent income xx Rent payable xx

FINANCE OR CAPITAL LEASE

LESSOR LESSEE

a. Payment of initial direct costs (costs of negotiating and arranging the lease such as
commissions, legal fees and internal costs):
Direct financing lease
Property xx None.
Cash xx
Sales-type lease
Expenses xx None.
Cash xx

b. Acquisition of property:
Lease receivable (gross)* xx Property xx
Property (net)/Sales** xx Lease liability* *** xx
Unearned int. income*** xx

Cost of sales xx
Inventory xx

* Gross investment in lease under a finance lease is aggregate minimum lease payments plus
any residual value, whether guaranteed or unguaranteed.

** Sales (the shorter between FV and PV of min. lease payments) xx

Less: Cost or carrying amount of property xx
Manufacturer’s or dealer’s profit xx

*** Gross investment (lease receivable) xx

Less: Net investment in the lease –
√ Sales type lease (PV of minimum lease payments plus
any guaranteed or unguaranteed residual value)
Direct financing type lease (cost or carrying amount) xx
Unearned interest income xx

√ Guaranteed residual value scenario, PV of guaranteed residual value is included in

sales because the lessor knows that the entire asset has been sold.

Unguaranteed residual value scenario, PV of unguaranteed residual value is not

included in sales but deducted in cost of sales since the leased asset is not sold because
the lessor will be receiving it back at end of lease term. Thus, gross profit is computed
as:
Sales (excluding PV of unguaranteed res. value) xx
Less: Cost of sales (excluding PV of unguar. res. value) xx
Initial direct costs xx
Gross profit xx

**** FV at inception of lease or PV of minimum lease payments, whichever is lower.

PV of minimum lease payments is equal to:
a. rental payments
 b. bargain purchase option (sufficiently lower than FV at exercise date)
c. guaranteed residual value

c. Receipt of rentals:
Cash xx Interest expense xx
Lease receivable xx Lease liability xx
Cash xx
Unearned int. income xx
Interest income xx

Schedule of amortization (effective interest method)

Date Payment Interest Principal Carrying value

(CV x Rate) (Paid-Int.) (CV-Principal)
xx xx xx xx xx
xx xx xx xx xx
xx xx xx xx xx

d. Receipt of contingent rents:

Cash xx Rent expense xx
Rent income xx Cash xx

e. Payment of repairs and maintenance and other executory costs such as insurance and
taxes):
Repairs & maint. xx Repairs & maint. xx Cash
xx Cash xx

f. Bargain Purchase Option:

If exercised
Cash xx Lease liability xx
Lease receivable xx Cash xx
If not exercised
Unearned int. income xx Lease liability xx
Property (net) xx Loss on fin. lease xx
Lease receivable xx Property (net) xx
Gain on finance xx

g. Return of property to lessor if there is no transfer of title nor bargain purchase option:
Unearned int. income xx Lease liability xx
Property (net) xx Property (net) xx
Lease receivable xx

If fair value of leased asset is lower than guaranteed residual value

Cash xx Loss on fin. lease xx
Property xx Cash xx
Lease receivable xx
If fair value of leased asset is lower than unguaranteed residual value
Loss on finance xx
Property xx None.
Lease receivable xx
 h. Return of property to lessor whether or not there is a guaranteed or unguaranteed
residual value under sales-type lease:
Inventory xx Lease liability xx
Lease receivable xx Property (net) xx

If fair value of leased asset is lower than guaranteed residual value

Cash xx Lease liability xx
Inventory xx Property xx
Lease receivable xx Cash xx
If fair value of leased asset is lower than unguaranteed residual value
Loss on finance xx
Inventory xx None.
Lease receivable xx
Year-end adjustments:
a. Depreciation of leased property:
None. Dep’n. expense* xx
Acc. dep’n. xx
* If there is transfer of title and bargain purchase option, useful life of leased property is used.
Otherwise, the shorter between the lease term and useful life of leased property is used.

SALE & LEASEBACK

OPERATING LEASE -
SELLER -LESSEE PURCHASER-LESSOR

a. Sale/ Purchase:
Cash xx Property xx
Acc. Depn. xx Cash xx
Property xx
 Gain on sale & leaseback xx
b. Periodic Rentals:
Rent expense xx Cash xx
Cash xx Rental income xx
c. Depreciation:
None. Depreciation xx
Accum. Deprn. xx

FINANCE LEASE -
SELLER -LESSEE PURCHASER-LESSOR

a. Sale/ Purchase:
Cash xx Property xx
Acc. Depn. xx Cash xx
Property xx
Deferred gain on S & L xx
b. Leaseback:
Property xx Lease receivable xx
Lease liability xx Property xx
Unearned int. inc. xx
c. Periodic Rentals & Interest:
Interest expense xx Cash xx
Lease liability xx Lease receivable xx
Cash xx Unearned int. inc. xx
Interest income xx
d. Depreciation:
Depreciation xx None.
Accum. Deprn. xx
e. Amortization of deferred gain:
Deferred gain on S & L xx None.
Gain on sale & leaseback xx

MULTIPLE CHOICE:

1. Rent received in advance by the lessor for an operating lease should be recognized as
revenue:
(a) when received (c) in the period specified by the lease
(b) at the lease inception (d) at the lease expiration C

2. When should a lessor recognize as income a nonrefundable lease bonus paid by a lessee on
signing an operating lease?
(a) when received (c) over the life of the lease
(b) at the lease inception (d) at the lease expiration C

3. As an inducement to enter a lease, Graf Company, granted Zep Company, a lessee, 12

months of free rent under a 5-year operating lease. The lease was effective on January 1, 2007
and provides for monthly rental payments to begin on January 1, 2008. Zep made the first rental
payment on December 30, 2007. In its 2007 income statement, Graf should report rental revenue
in an amount equal to:
(a) zero
(b) cash received during 2007
(c) 1/4 of the total cash to be received over the life of the lease
(d) 1/5 of the total cash to be received over the life of the lease D

4. Lease A does not contain bargain purchase option, but the lease term is equal to 90% of the
estimated economic life of the leased property. Lease B does not transfer ownership of the
property to the lessee by the end of the lease term, but the lease term is equal to 75% of the
estimated economic life of the leased property. How should the lessee classify these leases?
Lease A Lease B Lease A Lease B
(a) operating capital (c) capital capital
(b) operating operating (d) capital operating C

5. During January 2007, Vail Company made long-term improvements to a recently leased
building. The leased agreement provides for neither a transfer of title to Vail nor a bargain
purchase option. The present value f the minimum lease payments equals 85% of the building’s
market value, and the lease term equals 70% of the building’s economic life. Should assets be
recognized for the building and the lease improvements?
Leasehold Leasehold
Building improvement Building improvements
(a) Yes No (c) No No
(b) Yes Yes (d) No Yes D

6. What is the cost basis of an asset acquired by a lease which is in substance an installment
purchase?
(a) the net realizable value of the asset determined at the date of the lease agreement plus
the sum of the future minimum lease payments under the lease
(b) the sum of the future minimum lease payments under the lease
(c) the present value of the amount of the future minimum lease payments under the lease
discounted at an appropriate rate
(d) the present value of the market price of the asset discounted at an appropriate rate as
an amount to be received at the end of the lease C

7. When measuring the discounted amount of future rentals to be capitalized as part of the
purchase, identifiable payments to cover taxes, insurance and maintenance should be:
(a) included with future rentals to be capitalized
(b) excluded from future rentals to be capitalized
(c) capitalized but at a different discount rate and for a relevant period that tends to be
different from the future rental payments
(d) capitalized but at different discount rate and recorded in a different account from future
rental B

8. For a finance lease, the amount recorded initially by the lessee as a liability should:
(a) exceed the present value at the beginning of the lease term of minimum lease
payments during the lease term
(b) exceed the total of the minimum lease payments during the lease term
(c) not exceed the fair value of the leased property at the inception of the lease
(d) equal the total of the minimum lease payments during the lease term C

9. A 6-year finance lease entered into on December 31, 2008 specified equal minimum annual
lease payments due on December 31 of each year. The first minimum annual lease payment paid
on December 31, 2008 consist of which of the following?
Interest Lease Interest Lease
expense liability expense liability
(a) Yes No (c) No No
(b) Yes Yes (d) No Yes D
10. A 6-year finance lease entered into on December 31 of the current year specified equal
minimum annual lease payments due on December 31 of each year, the first payment being made
on December 31 of the current year. The portion of the third minimum payment applicable to
which of the following increased over the corresponding second minimum payment?
I. Interest expense
II. Reduction of liability
(a) I only (b) II only (c) both I and II (d) neither I nor II B

11. A 6-year finance lease expiring on December 31 specifies equal minimum annual lease
payments. Part of this payment represents interest and part represents a reduction in the lease
liability. The portion of the minimum payment in the fifth year applicable to the reduction of the net
lease liability should be:
(a) less than in the 4th year (c) the same as in the 6th year
(b) more than in the 4th year (d) more than in the 6th year B

12. The excess of the fair value of leased property at the inception of the lease over its cost or
carrying amount should be classified by the lessor as:
(a) unearned income from a sales-type lease
(b) unearned income from a direct financing lease
(c) manufacturer’s or dealer’s profit from a sales-type lease
(d) manufacturer’s or dealer’s profit from a direct financing lease C

13. Lease payments under an operating lease shall be recognized as an expense in the income
statement on:
(a) straight line basis over the lease term unless another systematic basis is representative
of the time pattern of the user’s benefit
(b) diminishing balance basis
(c) sum of units basis
(d) cash basis A

14. The situations which would normally lease to a lease being classified as a finance lease
include all of the following, except:
(a) The lease transfers ownership of the asset to the lessee by the end of the lease term.
(b) The lessee has the option to purchase the asset at a price which is expected to be sufficiently
higher than the fair value at the date the option becomes exercisable.
(c) The lease term is for the major part of the economic life of the asset even if the title is not
transferred.
(d) 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. B

15. Indicators of situations which individually or in combination could also lead to a lease being
classified as finance lease include all of the following, except:
(a) The leased asset is of a specialized nature such that only the lessee can use it without major
modification.
(b) If the lessee cancels the lease, the lessor’s losses associated with the cancellation are borne
by the lessee.
(c) Gains or losses from the fluctuation in the fair value of the residual fall to the lessee.
(d) The lessee has the ability to continue the lease for a secondary period at a rent which is
substantially the same as the market rent. D
16. At the commencement of the lease term, the lessee shall recognize a finance lease as asset
and liability at an amount equal to the:
(a) fair value of the leased asset
(b) present value of the minimum lease payments
(c) fair value of the leased asset or present value of the minimum lease payments, whichever is
lower
(d) fair value of the leased asset or present value of the minimum lease payments, whichever is
higher C

17. Initial direct costs incurred by the lessee in connection with specific leasing activities as in
negotiating and securing leasing arrangements and directly attributable to activities performed by
the lessee under a finance lease are:
(a) included as part of the amount recognized as an asset under the lease
(b) expensed immediately
(c) deferred and amortized over the lease term
(d) included in the minimum lease payments at present value A

18. If there is reasonable certainty that the lessee will obtain ownership by the end of the lease
term, the depreciation of the leased asset is based on the:
(a) useful life of the asset
(b) lease term
(c) useful life of the asset or lease term, whichever is shorter
(d) useful life of the asset or lease term, whichever is longer A

19. Gross investment in the lease is the:

(a) aggregate of the minimum lease payments under a finance lease of the lessor and any
unguaranteed residual value accruing to the lessor
(b) the minimum lease payments under a finance lease of the lessor
(c) present value of minimum lease payments under a finance lease of the lessor and any
unguaranteed residual value
(d) present value of the minimum lease payments under a finance lease of the lessor A

20. Initial direct costs incurred by the lessor under a sales type lease are:
(a) recognized as expense immediately
(b) deferred and amortized over the lease term
(c) either recognized as expense immediately or deferred and amortized over the lease term
(d) disregarded A

21. If the sale and leaseback transaction results in an operating lease where the sales price and
rental are established at fair value, any gain from the sale and leaseback should:
(a) not be recognized
(b) be recognized in income immediately
(c) be deferred and amortized over the lease term
(d) be deferred and amortized over the useful life of the asset B

22. Generally accepted accounting principles require that certain lease contracts be accounted for
as finance lease. The theoretical basis for this treatment is that a lease of this type:
(a) effectively conveys all of the benefits and risks incident to the ownership of the property
(b) is an example of form over substance
(c) provides the use of the leased asset to the lessee for a limited period of time
(d) must be recorded in accordance with the concept of cause and effect A

23. An entity leased a tractor and a truck. The tractor lease does not contain bargain purchase
option but the lease term is equal to 90% of the tractor’s estimated economic life. The truck lease
does not transfer ownership of the truck to the entity by the end of the lease term but the lease
term is equal to 75% of the truck’s estimated economic life. How should the entity classify these
leases?
(a) Both leases should be classified as finance leases.
(b) An operating lease for the tractor lease and as a finance lease for the truck lease.
(c) Both the tractor and the truck leases should be classified as operating leases.
(d) The tractor lease should be classified as a finance lease and the truck lease as an operating
lease. A
24. In a lease that is recorded as a sales type lease by the lessor, unearned interest:
(a) does not arise
(b) should be recognized in full as income at the lease’s inception
(c) should be amortized over the period of the lease using the straight line method
(d) should be amortized over the period of the lease using the interest method D

25. Leases may be accounted for by the operating method. Under this method,
(a) the periodic payments of rental are recognized as expense on the part of the lessee,
and as income on the part of the lessor
(b) the periodic depreciation of the leased property are provided and the periodic rentals
are treated as payments of the liability and interests thereon
(c) the lease is a method of financing and as a consequence of which the lessee is able to
acquire the property leased
(d) the lessor conceives the lease as a source of a receivable and a revenue as it involves
the sales of property A

26. Jack Company submits quarterly and yearly accounting reports for consolidation to its parent
company in the US. Based on a review of the company’s production department, Jack needs
another packing machine to be able to hasten delivery of orders by customers. On December 31,
2007, Jack agreed to lease a packing equipment for its entire 9-year useful life from Mark
Company. The lease contract provides for lease payments of P1,400,000 from the start of the
lease term, and annually thereafter every December 31 for the next 8 years. The 9 lease
payments over the lease term have a present value on December 31, 2007, at a rate implicit in the
lease known by Jack as 10%, of P8,862,000. The December 31, 2007 present value of the lease
payments at Jack Company’s incremental borrowing rate of 12% was P8,358,000. A timely
second lease payment was made by Jack Company. The capital lease liability that Jack Company
should report to its parent company in its December 31, 2008 financial statements shall be:
(a) P0 (b) P6,392,960 (c) P9,800,000 (d) P6,808,200 D

Date Paid 10% interest Principal Present value

12/31/2007 P8,862,000
12/31/2007 P1,400,000 - P1,400,000 7,462,000
12/31/2008 1,400,000 P746,200 653,800 6,808,200

27. On December 31, 2008, Day Company leased a new machine from Parr with the following
pertinent information:
Lease term 6 years
Annual rental payable at beginning of each lease year P50,000
Useful life of the machine 8 years
Day’s increment borrowing rate 15%
Implicit interest rate in lease (known by Day) 12%
Present value of an annuity of P1 in advance for 6
periods at:
12% 4.61 15% 4.35
The lease is renewable, and the machine reverts to Parr at the termination of the lease. The cost
of the machine on Parr’s accounting records is P375,500. At the inception of the lease, Day
should record a lease liability of:
(a) P375,500 (b) P230,500 (c) P217,500 (d) P 0 B

PV of rentals (50,000 x 4.61) P2,305,000

28. As an inducement to enter a lease, Arts, Inc. a lessor, grants Hompson Corporation, a lessee,
nine months of free rent under a five year operating lease. The lease is effective on July 1, 2007
and provides for monthly rental of P10,000 to begin April 1, 2008.
In Hompson’s income statement for the year ended June 30, 2008, rent expense should be
reported as:
(a) P102,000 (b) P90,000 (c) P30,000 (d) P25,500 A

Total rent expense (100,000 x 51) P510,000

Average annual rent expense, July 1, 2008
to June 30, 2009 (5,100,000/ 5) P102,000

29. White Company leased office premises to Fight, Inc. for a five-year term beginning January 2,
2007. Under the terms of the operating lease, rent for the first year is P800,000 and rent for years
2 through 5 is P1,250,000 per annum. However, as an inducement to enter the lease, White
granted Fight the first six months of the lease rent-free. In its December 31, 2007 income
statement, what amount should White report as rental income?
(a) P1,200,000 (b) P1,160,000 (c) P1,080,000 (d) P800,000 C

First year (800,000 x 6/12) P 400,000

Second year 1,250,000
Third year 1,250,000
Fourth year 1,250,000
Fifth year 1,250,000
Total rental revenue P5,400,000
Average annual rental revenue (5,400,000/5) P1,080,000

30. Abe Company, lessor, leases its equipment under an operating lease. The lease term is 5
years and the lease payments are made in advance on January 1 of each year as shown in the
following schedule:
January 1, 2005 1,000,000
January 1, 2006 1,000,000
January 1, 2007 1,400,000
January 1, 2008 1,700,000
January 1, 2009 1,900,000
On December 31, 2006, Abe Company should recognize rent receivable at:
(a) P1,400,000 (b) P800,000 (c) P400,000 (d) P 0 B

Average rent (7M/ 5) P1,400,000

Rent income for 2005 and 2006 (1.4M x 2) P2,800,000
Rent received for 2005 and 2006 (1M + 1M) 2,000,000
Rent receivable – 12/31/2006 P4,800,000

31. Cone Company purchased a new machine for P4,800,000 on January 1, 2006 and leased it to
East the same day. The machine has an estimated 12-year life, and will be depreciated P400,000
per year. The lease if for a three-year period expiring January 1, 2009, at an annual rental of
P850,000. Additionally, East paid P300,000 to Cone as a lease bonus to obtain the three-year
lease. For 2006, Cone incurred insurance expense of P80,000 for the leased machine. What is
Cone’s 2006 operating profit on this leased asset?
(a) P670,000 (b) P550,000 (c) P470,000 (d) P370,000 C

Annual rental P850,000

Amortization of lease bonus (300,000/ 3) 100,000
Total P950,000
Depreciation P400,000
Insurance 80,000 (480,000)
Operating profit P470,000
32. Might Company purchased a tractor on January 1, 2007 at a cost of P1,600,000 for the
purpose of leasing it. The tractor is estimated to have a useful life of 5 years with scrap of
P100,000. Depreciation is on a straight line basis. On April 1, 2007, Might entered into a lease
contract for the lease of the tractor for a term of two years up to March 31, 2009. The lease fee is
P50,000 monthly and the lessee paid P600,000, the lease for one year. Might paid P120,000
commission associated with negotiating the lease, P15,000 minor repairs, and P10,000
transportation of the tractor to the lessee during 2007. Might Company should report net rent
revenue for the year 2007 at:
(a) P160,000 (b) P235,000 (c) P80,000 (d) P85,000 C

Rental from April 1 to December 31, 2007

(50,000 x 9) P450,000
Depreciation (1,600,000 – 100,000/5) (300,000)
Commission (120,000/ 2 x 9/12) ( 45,000)
Repairs ( 15,000)
Transportation ( 10,000)
Net rent revenue P 80,000

33. On January 2, 2007, North Mining Company (lessee) entered into a 5-year lease for drilling
equipment. North accounted for the acquisition as a capital lease for P2,400,000, which includes
a P100,000 bargain purchase option. At the end of the lease, North expects to exercise the
bargain purchase option. North estimates that the equipment’s fair value will be P200,000 at the
end of its 8-year life. North regularly uses straight line depreciation on similar equipment. For the
year ended December 31, 2007, what amount should North recognize as depreciation expense on
the leased asset?
(a) P480,000 (b) P460,000 (c) P300,000 (d) P275,000 D

Depreciation (2,400,000 – 200,000 / 8) P275,000

34. In the long-term liabilities section of its balance sheet at December 31, 2006, Mix Company
reported a capital lease obligation of P750,000, net of current portion of P13,636. Payments of
P90,000 were made on both January 2, 2007 and January 2, 2008. Mix’s incremental borrowing
rate on the date of lease was 11% and the lessor’s implicit rate, which was known to Mine, was
10%. In its December 31, 2007 balance sheet, what amount should Mix report as capital lease
obligation, net of current portion?
(a) P660,000 (b) P735,000 (c) P763,636 (d) P742,500 B

Total lease liability, Dec. 31, 2006

(750,000 + 13,636) P763,636
Payment on January 2, 2007 P90,000
Interest for 2007 (10% x 763,636) (76,364) ( 13,636)
Lease liability, December 31, 2007 P750,000
Payment on January 2, 2008 P90,000
Interest for 2008 (10% x 750,000) (75,000) ( 15,000)
Lease liability, December 31, 2008 P735,000
Current portion (represented by principal
payment on January 2, 2008) P 15,000
Long-term portion (remainder) 735,000
Total lease liability, December 31, 2007 P750,000

35. East Company leased a new machine from North Company on January 1, 2006, under a lease
with the following information:
Annual rental payable at beginning of each lease year P400,000
Initial direct cost paid by the lessee 200,000
Lease term 10 years
 Useful life of machine 12 years
Implicit interest rate 14%
PV of an annuity of 1 in advance for 10 periods at 14% 5.95
PV of 1 for 10 periods at 14% 0.27
East has the option to purchase the machine on January 1, 2016, by paying P500,000, which
approximates the expected fair value of the machine on the option exercise date. On January 1,
2006, East should record a capitalized leased asset at:
(a) P2,580,000 (b) P2,380,000 (c) P2,515,000 (d) P2,715,000 A

PV of rentals (400,000 x 5.95) P2,380,000

Initial direct cost 200,000
Total cost of leased asset P2,580,000

36. The following information pertains to a sale and leaseback pf equipment by Mega Company on
December 31, 2008:
Sales price P 400,000
Carrying amount 300,000
Monthly lease payment 3,250
Present value of lease payments 36,900
Estimated remaining life 25 years
Lease term 1 year
Implicit rate 12 %
What amount of deferred gain on the sale should Mega report at December 31, 2008?
(a) 0 (b) P36,900 (c) P63,100 (d) P100,000 A

37. On December 31, 2008, Bain Corporation sold a machine to Ryan and simultaneously leased
it back for one year. Pertinent information at this date follows:
Sales price P360,000
Carrying amount 330,000
Present value of reasonable lease rentals
(P3,000 for 12 months @ 12 %) 34,100
Estimated remaining useful life 12 years
In Bain’s 2008 income statement, the revenue from the sale of this machine should be reported at
(a) P 34,100 (b) P30,000 (c) P 4,100 (d) 0 B

Sales price P 360,000

Carrying amount 330,000
Gain on sale and leaseback P 30,000

Items 38 to 40:
Van Company is a dealer in machinery. On January 1, 2006, a machinery was leased to another
enterprise with the following provisions:
Annual rental payable at the end of each year P3,000,000
Lease term and useful life of machinery 5 years
Cost of machinery P8,000,000
Residual value – unguaranteed P1,000,000
Implicit interest rate 12%
At the end of the lease term on December 31, 2010, the machinery will revert to Van. The
perpetual inventory system is used. Van incurred initial direct costs of P300,000 in finalizing the
lease agreement.

38. What is the total financial revenue from the lease that will be reported by Van?
(a) P4,630,000 (b) P4,200,000 (c) P5,200,000 (d) P3,630,000 A
 Gross rentals (3,000,000 x 5) P15,000,000
Residual value – unguaranteed 1,000,000
Total P16,000,000
Present value:
Rentals (3,000,000 x 3.60) P10,800,000
Residual value (1,000,000 x .57) 570,000 (11,370,000)
Total unearned financial revenue P 4,630,000

39. Van Company should report profit on the sale in 2006 at:
(a) P7,700,000 (b) P3,070,000 (c) P2,500,000 (d) P3,370,000 B

Guaranteed Unguaranteed
Sales P11,370,000 P10,800,000
Cost of sales ( 8,000,000) ( 7,430,000)
Direct costs ( 300,000) ( 300,000)
Profit on sale P 3,070,000 P 3,070,000

40. What is the earned financial revenue or interest income for 2006?
(a) P1,364,400 (b) P1,296,000 (c) P1,800,000 (d) P926,000 A

Interest income for 2006 (11.37M x 12%) P1,364,400