Liabilities

A liability is now defined as “a present obligation of the entity to transfer an economic resource as a result of
past events.” (Revised Conceptual Framework)

Previously, liability was defined as “a present obligation of the entity arising from past events, the settlement of
which is expected to result in an outflow from the entity of resources embodying economic benefits”

Three aspects on the definition of liability

1. Obligation
2. Transfer of an economic resource
3. Present obligations as a result of past events

Obligation
An obligation is “a duty or responsibility that the entity has no practical ability to avoid”.
An obligation is either:
1. Legal obligation
2. Constructive Obligation

Transfer of an economic resource-(potential to transfer)

An obligation to transfer an economic resource may be an obligation to:
1. pay cash, deliver goods, or render services;
2. exchange assets with another  party on unfavorable terms;
3. transfer assets if a specified uncertain future events occurred; or
4. issue a financial instrument that obliges the entity to transfer an economic resort.

Present obligations as a result of past events

The obligation must be a present obligation that exists as a result of past events. A present obligation exists as a
result of past events if:
1. the entity has already obtained benefits or taken an action; and
2. As a consequence, the entity will or may have to transfer an economic resource that it would not otherwise
have had to transfer.

Identification of Present Obligation

✧ Intention to acquire goods in the future

✧ An entity operates a nuclear power plant. In the current year, a new law was enacted penalizing the
improper disposal of toxic waste. No similar law existed in prior years.

✧ An entity enters into an irrevocable commitment with another to acquire goods in the future, on credit.

✧ Although not stated in the sales contract, an entity has a publicly-known policy of providing free repair
services for the goods it sells. The entity has consistently honored this implied policy in the past.

✧ An entity obtained a loan from a bank. Repayment of the loan is due in 10-years’ time.

✧ An entity has caused environmental damages. Although  no law exists penalizing such, the entity believes it
has an obligation to rectify the damages. However, the identity of the party to whom the obligation is owed
cannot be specifically identified.

✧ An entity employed Mr. Juan.

Recognition of liabilities
An item is recognized as a liability when: (OLD)
1. It meets the definition of a liability;
2. It is probable that an outflow of resources embodying economic benefits will result from its settlement;
and 
3. The settlement amount can be measured reliably. 

An item is recognized as a liability when: (NEW)

1. It meets the definition of a liability;
2. Recognizing it would provide useful information, i.e., relevant and faithfully presented information
Financial liabilities
A financial liability is any liability that is a contractual obligation :
1. to deliver cash or another financial asset to another entity; or
2. to exchange financial assets or financial liabilities with another entity under conditions that are potentially
unfavorable to the entity; or
3. a contract that will or may be settled in the entity’s own equity instrument and is not classified as the
entity’s own equity instrument.
*variable # of equity instruments in exchange for fixed amount of cash or another FA
*fixed # of equity instruments in exchange for variable amount of cash or another FA

Examples of financial liabilities

● Payables such as accounts, notes, loans, bonds payable and accrued expenses that are payable in cash.
● Finance lease obligations.
● Liabilities held for trading such as obligations to deliver financial assets borrowed by a “short seller” (i.e.
an entity that sells financial assets it has borrowed and does not yet own).
● Preference shares issued with mandatory redemption. 
● Security deposits received that are to be returned to tenants at the end of lease term.
● Obligations to deliver a variable number of own shares worth a fixed amount of cash. 

The following are not financial liabilities

● Unearned revenues and warranty obligations that are to be settled by future delivery of goods or services,
rather than cash.
● Taxes, SSS premiums, Philhealth and other payables arising from statutory requirements and not from
contracts. 
● Commodity contracts that either cannot be settled in cash or which are expected to be settled by commodity
exchange (e.g., coffee beans, gold bullion, oil, and the like). If a commodity contract is expected to be cash
settled, it will be included as financial liability on the part of the cash payor.
● Constructive obligations. These obligations do not arise from contracts.

Measurement of financial liabilities

Initial measurement – fair value minus transaction costs, except financial liabilities at FVPL whose transaction
costs are expensed immediately.

Subsequent measurement – amortized cost  (except financial liabilities that are classified as held for trading and
those that are designated; these are subsequently measured at fair value) 

Measurement of Non-financial liabilities

Non-financial liabilities are initially measured at the best estimate of the amounts needed to settle those
obligations or the measurement basis required by other applicable standard.
Examples:
Obligations arising from statutory requirements (e.g., income tax payable)
Unearned or deferred revenues
Warranty obligations
Commodity contracts that either cannot be settled in cash or which are expected to be settled by commodity
exchange

Redeemable preference share vs Callable preference shares

Redeemable preference shares are preferred stocks which the holder has the right to redeem at a set date.
Callable preference shares are preferred stocks which the issuer has the right to call at a set date.

Current liabilities
Current liabilities are liabilities that are:
● Expected to be settled in the entity’s normal operating cycle;
● Held primarily for trading;
● Due to be settled within 12 months after the end of the reporting period; or
● The entity does not have the right at the end of the reporting period to defer settlement of the liability for at
least twelve months after the reporting period.

All other liabilities are classified as non-current.

Trade and non-trade payables
Trade payables are obligations arising from purchases of inventory that are to be sold in the ordinary course of
business. Other payables are classified as non-trade.
Trade payables are classified as current liabilities when they are expected to be settled within the normal
operating cycle or one year, whichever is longer. 
On the other hand, non-trade payables are classified as current liabilities only when they are expected to be
settled within one year.

Remember the following: 

General rule: A currently maturing obligation is presented as current even if the obligation is refinanced on a
long-term basis after the balance sheet date. 
Exceptions: The obligation is non-current if: 
● the entity has the right, as of the balance sheet date, to roll over the obligation on a long-term basis under an
existing loan facility; or 
● the rollover on a long-term basis is completed on or before the balance sheet date. 

General rule: An obligation that is payable on demand is presented as current. 

Exception: The obligation is non-current if the lender agreed on or before the balance sheet date not to collect
within the next 12 months (grace period)

Common Issues on Current Liabilities

Unearned Income
● Unearned Revenue
● Deferred Revenue
● Unearned Subscription
● Gift certificates(PFRS 15)
breakage (proportionate and remote method)
● Liability for deposits received

Sold GC worth 100,000. 10% of will never be redeemed.

Cash 100,000
GCL 100,000

GCL 60,000
REVENUE 60,000

GCL 6,667
REVENUE 6,667

Accrued Expenses
● Salaries
● Utilities

Dividends payable
Under IFRIC 17, the liability to pay a dividend is recognized when the dividend is appropriately authorized and
is no longer at the discretion of the entity, which is: 
1. the date when the declaration of the dividend (e.g., by management or the board of directors) is approved
by the relevant authority (e.g., the shareholders) if the jurisdiction requires such approval, or
2. the date when the dividend is declared (e.g., by management or the board of directors) if the jurisdiction
does not require further approval.

Liabilities for remittable collections

APPLICATION

1. On December 31, 2021, the bookkeeper of Grand Company provided the following information:

Accounts payable, including deposits and advances

from customers of P500,000 P 2,500,000
Notes payable, including note payable to bank due
on December 31, 2023 for P1,000,000 3,000,000
Share dividends payable 800,000
Credit balance in customers' accounts 400,000
Serial bonds, payable in semiannual installments
of P1,000,000 X 2 10,000,000
Accrued interest on bonds payable 300,000
Contested BIR tax assessment 600,000
Unearned rent income 100,000

In the December 31, 2021 statement of financial position, how much current liabilities should be reported?
a) P6,800,000 c) P7,900,000
b) P7,300,000 d) P8,700,000

2. An analysis of Cool Company's liabilities disclosed the following:

Accounts payable, after deducting debit balances in

suppliers' accounts amounting to P22,500 (accounts
payable included non-trade liabilities of P32,500) P105,000 + 22,500
Accrued expenses 15,000
Credit balances of customers' accounts 13,500
Stock dividends payable 70,000
Claims for increase in wages and allowances by
employees of the company, covered in a pending lawsuit 125,000
Estimated liabilities for premiums 60,000

How much should be presented as total current liabilities in the statement of financial position?
a) P 6,000 c) P183,500
b) P168,500 d) P216,000

3. The balance in Coward Company's accounts payable account at December 31, 2021 was P1,170,000 before
any year-end adjustments relating to the following:

● Goods were in transit from a vendor to Coward on December 31, 2021. The invoice cost was P65,000
and the goods were shipped FOB shipping point on December 29, 2021. The goods were received on
January 2, 2022.
● Goods shipped FOB shipping point on December 20, 2021 from a vendor to Coward, were lost in
transit. The invoice cost was P32,500. On January 5, 2022, Coward filed a P32,5000 claim against the
common carrier.
● Goods shipped FOB destination on December 21, 2021, from a vendor to Coward, were received on
January 6, 2022. The invoice cost was P19,500.

What amount should Coward report as accounts payable on its December 31, 2021 statement of financial
position?

a) P1,202,500 c) P1,235,000
b) P1,222,000 d) P1,267,500
4. The balance in Stem Corporation's accounts payable account at December 31, 2021 was P1,350,000 before
any necessary year-end adjustments relating to the following:

● Goods were in transit to Stem from a vendor on December 31, 2021. The invoice cost was P75,000. The
goods were shipped FOB shipping point on December 29, 2021 and were received on January 2, 2022.
● Goods shipped FOB destination on December 21, 2021, from a vendor to Stem, were received on
January 6, 2022. The invoice cost was P37,500.
● On December 27, 2021, Stem wrote and recorded checks totaling P60,000 which were mailed on
January 10, 2022.

In Stem's December 31, 2021 statement of financial position, how much should be the accounts payable?

a) P1,410,000 c) P1,462,500
b) P1,425,000 d) P1,485,000

5. Echo Company sells office equipment contracts agreeing to service equipment for a two-year period. Cash
receipts from contracts are credited to unearned service contract revenue and service contract costs are charged
to service contract expense as incurred. Revenue from service contract is recognized as earned over the lives of
the contracts.

Additional information for the year ended December 31, 2021 is as follows:

Unearned service contract revenue, January 1, 2021 P600,000

Cash receipts from service contracts sold 980,000
Service contract revenue recognized 860,000
Service contract expense 520,000

What amount should Echo report as unearned service contract revenue at December 31, 2021?
a) P460,000 c) P490,000
b) P480,000 d) P720,000

6. Offset Co. sells gift certificates as part of its sales promotion. During the year, Offset Co. sells gift certificates
worth ₱500,000, of which ₱360,000 were redeemed. Based on Offset Co.’s past experience, 10% of gift certificates
sold are never redeemed. Under PFRS 15, what amounts of (1) total revenue and (2) liability should be reported in
Offset Co.’s 2021 financial statements?
a. 400,000; 100,000 c. 410,000; 90,000
b. 360,000; 90,000 d. 360,000; 100,000

7. DULL Co. has a 10%, ₱2,000,000 loan payable as of December 31, 2021 which will be maturing on July 1, 2022.
Interest on the loan is due every July 1 and December 31 and all the interests that have accrued in 2021 were paid
on these scheduled dates. On February 1, 2022, DULL Co. entered into a refinancing agreement with a bank to
refinance the loan on a long-term basis. Both parties are financially capable of honoring the agreement's provisions.
The contract on the ₱2,000,000 loan payable does not state any refinancing or roll over option. DULL’s 2021
financial statements were authorized for issue on March 15, 2022. In DULL’s 2021 financial statements, how
much is presented as current liability in relation to the loan payable?
a. 2,100,000 b. 2,000,000 c. 100,000 d. 0

8. Eliot Corporation’s liabilities at December 31, 2008 were as follows:

Accounts payable and accrued interest 2,000,000
5-year 10% Notes payable – due December 31, 2011 5,000,000
Part of the loan agreement is for Elliot to appropriate a fixed amount out of its accumulated profits and losses annually until the
amount of appropriation has equaled the face amount of the obligation. Non-compliance will render the note as payable on
demand by the lender. As of December 31, 2008, Elliot Corporation has not yet complied with the loan agreement. What
amount of current liabilities should Elliot Corporation report in its December 31, 2008 statement of financial position?
a. 2,000,000 b. 5,000,000 c. 7,000,000 d. 0

9. FLUNK Co. requires advance payments for custom-built guitar effects, gadgets, and racks. The records of FLUNK
show the following:
● Unearned revenue, January 1, 2021 ₱ 2,000,000
● Advances received during 2021 20,000,000
● Advances applied to orders shipped in 2021 16,000,000
● Advances pertaining to orders cancelled in 2021 600,000

How much is presented as current liability assuming the advance payments received are non-refundable?
a. 4,500,000 b. 5,400,000 c. 6,000,000 d. 6,600,000

10. WAIVE Co. maintains escrow accounts and pays real estate taxes for its customers. Escrow funds are kept in
interest-bearing accounts. Interest, less a 10% service fee, is credited to the mortgagee’s account and used to reduce
future escrow payments. Information on escrow accounts are shown below:
Escrow accounts liability, January 1, 2021 400,000
Escrow payments received during 2021 3,000,000
Real estate taxes paid during 2021 1,000,000
Interest on escrow funds during 2021 200,000

How much is the current liability for the escrow accounts on December 31, 2021?
a. 2,580,000 b. 2,600,000 c. 2,400,000 d. 2,420,000

Provisions, Contingent Liabilities and Contingent Assets

Provisions
A provision is a liability of uncertain timing or amount. 
Provisions differ from other liabilities because of the uncertainty about the timing or amount of expenditure
required in settlement. Unlike for other liabilities, provisions must be estimated. Although, some other liabilities
are also estimated, their uncertainty is generally much less than for provisions. 
Other liabilities, such as accruals, are reported as part of “Trade and other payables” whereas provisions are
reported separately.

Provision vs. Contingent liability

Provision Contingent liability

Present obligation Possible obligation

Probable and measured reliably Present obligation but not probable or Present obligation but
not measured reliably

Recognized (accrued in the statement of Not recognized (not accrued in the statement of financial
financial position) position)

Recognition of provisions
A provision is recognized when all of the following conditions are met:
1. The entity has a present obligation (legal or constructive) as a result of a past event;
2. It is probable that an outflow of resources embodying economic benefits will be required to settle the
obligation; and
3. A reliable estimate can be made of the amount of the obligation.

Present obligation is probable Present obligation is possible Present obligation is remote

Recognize or accrue a provision if Disclose only a contingent liability. Do nothing.

outflow of economic benefits is both
probable and reliably estimable.
Do not recognize or accrue a liability.

Provide appropriate disclosures

Measurement
Nature of the outflow Measurement basis
1. General rule Best estimate

2. Involves large population of items Expected value (Probability Weighted Average)

3. Each expected outcome in a range is as likely as any other Mid-point

Provisions for one-off events (restructuring, environmental clean-up, settlement of a lawsuit) are measured at
the most likely amount.
Provisions for large populations of events (warranties, customer refunds) are measured at a probability-
weighted expected value.
PWA
500,000 50% 250,000
300,000 20% 60,000
200,000 25% 50,000
100,000 5% 5,000 365,000

Present value
Where the effect of the time value of money is material, the amount of a provision shall be the present value of
the expenditures expected to be required to settle the obligation.
Expected disposal of assets
Gains from the expected disposal of assets shall not be taken into account in measuring a provision. Gains shall
be recognized only when the assets are actually disposed of.

Reimbursements
Where some or all of the expenditure required in settling a provision is expected to be reimbursed by another
party, the reimbursement is recognized only when it is virtually certain that reimbursement will be received if
the entity settles the obligation. 
The reimbursement shall be treated as a separate asset.
In the statement of profit or loss and other comprehensive income, the expense relating to a provision may be
presented net of the amount recognized for a reimbursement.

Changes in provisions
Provisions shall be reviewed at the end of each reporting period and adjusted to reflect the current best
estimate. 
If it is no longer probable that an outflow of resources embodying economic benefits will be required to settle
the obligation, the provision shall be reversed.

Product warranties and guarantees

If a customer has the option to purchase a warranty separately (for example, because the warranty is priced or
negotiated separately), the warranty is accounted for in accordance with PFRS 15 Revenue from Contracts with
Customers.
If a customer does not have the option to purchase a warranty separately, the warranty is accounted for in
accordance with PAS 37 Provisions, Contingent Liabilities and Contingent Assets unless the promised warranty
provides the customer with a service in addition to the assurance that the product complies with agreed-upon
specifications.

Liability for premiums

A customer option to acquire additional goods or services for free or at a discount is accounted for under PFRS
15 if the option provides the customer a material right that the customer would not receive without entering
into that contract. 
A customer option that does not provide the customer with a material right is not accounted for under PFRS 15;
and therefore, accounted for in accordance with PAS 37.

Guarantee for indebtedness of others

A provision for the guarantee for indebtedness of others is recognized when it becomes probable that the entity
will be held liable for the guarantee, such as when the original debtor defaults on the loan.

Contingent assets
Contingent asset is probable Contingent asset is Contingent asset is
possible remote

Disclose only a contingent Do nothing. Do nothing.

asset.

Do not recognize or accrue.

When to recognize a provision?

✧ Restructuring by sale of an operation

✧ Restructuring by closure or reorganization

✧ Warranty

✧ Land contamination

✧ Customer refunds

✧ Offshore oil rig must be removed and sea bed restored

✧
✧ Obligations arising from the production of oil

✧ Abandoned leasehold, four years to run, no re-letting possible

✧ CPA firm must staff training for recent changes in tax law

✧ Major overhaul or repairs

✧ Onerous (loss-making) contract

✧ Future operating losses

Restructuring
A restructuring is:
● sale or termination of a line of business
● closure of business locations
● changes in management structure
● fundamental reorganization.

Restructuring provisions should be recognized as follows:

Sale of operation: recognize a provision only after a binding sale agreement
Closure or reorganization: recognize a provision only after a detailed formal plan is adopted and has started
being implemented, or announced to those affected. A board decision of itself is insufficient.
Future operating losses: provisions are not recognized for future operating losses, even in a restructuring
Restructuring provision on acquisition: recognize a provision only if there is an obligation at acquisition date

Restructuring provisions should include only direct expenditures necessarily entailed by the restructuring, not
costs that are associated with the ongoing activities of the entity.

Disclosures
● Reconciliation for each class of provision:
opening balance
additions
used (amounts charged against the provision)
unused amounts reversed
unwinding of the discount, or changes in discount rate
closing balance
● A prior year reconciliation is not required.
● For each class of provision, a brief description of:
nature
timing
uncertainties
assumptions
reimbursement, if any.

1. On April 30, 2022, an explosion occurred at TWIST Co.’s plant causing extensive property damage to area buildings.
TWIST’s management and counsel concluded that it is likely that claims will be asserted and that it is probable that
TWIST will be held responsible for damages. TWIST’s management believed that ₱5,000,000 would be a reasonable
estimate of its liability. TWIST’s ₱20,000,000 comprehensive public liability policy has a ₱1,000,000 deductible
 clause. TWIST’s financial statements were authorized for issue on March 30, 2022. How should the event above be
reported in TWIST’s December 31, 2021 financial statements?
a. accrue a provision of ₱1M.
b. disclose only ₱1M.
c. accrue and disclose ₱1M.
d. neither accrue nor disclose.

2. In 2021, JUBILEE Co. recognized a provision for a probable loss on a pending lawsuit amounting to ₱2,000,000. In
2022, the lawsuit remains unsettled and JUBILEE determined that the provision on the pending law suit must be
increased by ₱800,000. In 2023, JUBILEE won the lawsuit. Nothing was paid on the settlement. The effect of the
settlement on the 2023 profit is: increase (decrease)
a. 2,800,000 c. 2,000,000
b. (2,800,000) d. 0

3. On January 1, 2021, DECRY Co. signed a three year, non-cancelable purchase contract, which allows DECRY Co. to
purchase up to 60,000 units of a microchip annually from BELITTLE Co. at ₱100 per unit and guarantees a minimum
annual purchase of 15,000 units. At year-end, it was found out that the goods are obsolete. DECRY had 10,000 units of
this inventory at December 31, 2021, and believes these parts can be sold as scrap for ₱20 per unit. How much is the
loss on purchase commitment?
a. 2,400,000 c. 3,200,000
b. 800,000 d. 9,600,000

4. FUNNY Co. provides 3-year warranty for the products it sells. FUNNY estimates that warranty costs ₱400 per unit sold.
As of January 1, 2021, the liability for warranty has a balance of ₱800,000 for units sold in 2020. During the year
FUNNY sold 5,000 units and actual warranty costs incurred were ₱1,240,000. How much is the warranty expense to be
recognized in 2021?
a. 2,000,000 c. 3,240,000
b. 1,240,000 d. 4,240,000

BEG. 800,000
WARRANTY EXPENSE 2,000,000 5,000 * P400
ACTUAL WARRANTY COST (1,240,000)
END. 1,560,000

5. CANDID Co. launched a sales promotion in 2021. For every five bottles returned to CANDID, customers will receive a
T-shirt. The unit cost of T-shirt is ₱400. CANDID estimates that 80% of sales will be redeemed. Additional
information is as follows:
Units
Sales in 2021 500,000
Sales in 2022 900,000
T-shirts distributed in 2021 60,000
T-shirts distributed in 2022 147,600

PREMIUM EXP 2021 32,000,000

2022 57,600,000
89,600,000

AÇTUAL COST OF 2021 24,000,000

PREMIUM DISTRIBUTED 2022 59,040,00
83,040,000

How much is the liability for premiums as of December 31, 2022?

a. 6,650,000 c. 6,870,000
b. 7,860,000 d. 6,560,000

Leases
PFRS 16 specifies how an PFRS reporter will recognize, measure, present and disclose leases. The standard
provides a single lessee accounting model, requiring lessees to recognize assets and liabilities for all leases
unless the lease term is 12 months or less or the underlying asset has a low value. Lessors continue to classify
leases as operating or finance, with PFRS 16’s approach to lessor accounting substantially unchanged from its
predecessor, PAS 17.

Identifying a lease
“A contract is, or contains, a lease if the contract conveys the right to control the use of an identified asset for a
period of time in exchange for consideration.” (PFRS 16.9)

Right to Control 
An entity has the right to control the use of an identified asset if it has both of the following throughout the
period of use:
1. the right to obtain substantially all of the economic benefits from use of the identified asset; and
2. the right to direct the use of the identified asset.

Identified asset
An asset can be identified by being explicitly stated in the contract or by being implicitly specified at the time
the asset is made available for use by the customer.
A portion of an asset can be identified if it is physically distinct.

Substantive substitution rights

A customer does not have the right to use an identified asset if the supplier has the substantive right to substitute
the asset throughout the period of use.

A supplier’s right to substitute an asset is substantive if both of the following conditions exist:
1. the supplier has the practical ability to substitute alternative assets throughout the period of use; and
2. the supplier would benefit economically from the exercise of its right to substitute the asset.

Right to direct the use

The customer has the right to direct how and for what purpose the asset is used throughout the period of use

Identifying whether a contract is, or contains, a lease

Accounting for leases by Lessee

GENERAL RECOGNITION
Lessee recognizes both:
      1. Lease liability; and
      2. Right-of-use asset

RECOGNITION EXEMPTION 
(for “short-term” and ‘low value’ leases)
Lessee recognizes lease payments as expense over the lease term using straight line basis, or another more
appropriate basis.

GENERAL RECOGNITION

Discount rate
Discount rate is the interest rate implicit in the lease; if not determinable, then the lessee’s incremental
borrowing rate.

Separating components of a contract

An entity accounts for each lease component of a contract separately from the non-lease components of the
contract.

A lessee allocates the consideration in the contract to each lease component on the basis of the relative stand-
alone price of the lease component and the aggregate stand-alone price of the non-lease components.
Payments for activities or costs that do not transfer goods or services to the lessee are not a separate component
of the contract. The payments for these items are included in the total consideration that is allocated to the
separately identified components of the contract.

Initial direct costs

A lessee capitalizes initial direct costs as follows:
 General recognition Recognition exemption

Treat as part of the cost of the right-of-use Treat as prepaid rent and recognize as expense under the
asset and include in depreciation. straight line basis (or another more appropriate basis).

Lease payments made to lessor at or before commencement date

General recognition Recognition exemption
Advance rent arises when rentals are payable at the beginning treated as prepaid rent and recognized
of each period. as expense under the straight line basis
(or another more appropriate basis).
Excluded from the initial measurement of lease
liability but included in the initial measurement
of right-of-use asset.
Lease bonus is an amount, in addition to periodic rentals, paid same accounting as advance rent
by a lessee to the lessor in order to induce above.
granting of leasehold rights to the lessee. Lease
bonus is the opposite of ‘lease incentive.’

same accounting as advance rent above.

Classification of lease by the lessor

1. Finance lease - a lease that transfers substantially all the risks and rewards incidental to ownership of
an asset. Title may or may not eventually be transferred.
2. Operating lease - a lease other than a finance lease
Indicators of a finance lease
● the lease transfers ownership of the asset to the lessee by the end of the lease term
● the lessee has the option to purchase the asset at a price which is expected to be sufficiently lower than fair
value at the date the option becomes exercisable that, at the inception of the lease, it is reasonably certain
that the option will be exercised

● the lease term is for the major part of the economic life of the asset, even if title is not transferred at the
inception of the lease,
● the present value of the minimum lease payments amounts to at least substantially all of the fair value of the
leased asset
● the leased assets are of a specialized nature such that only the lessee can use them without major
modifications being made

Accounting for Finance Leases by Lessors

Initial recognition
Lessors recognize assets from a finance lease as receivable measured at an amount equal to the net investment
in the lease.

INCEPTION DATE VS COMMENCEMENT DATE

LEASE RECEIVABLE GI
ASSET NI
UNEARNED INTEREST INCOME GI-NI

Discount rate
The discount rate to be used in calculating the present value of the lease payments is the interest rate implicit
in the lease. 

Interest rate implicit in the lease – the rate of interest that causes the present value of (a) the lease payments and
(b) the unguaranteed residual value to equal the sum of (i) the fair value of the underlying asset and (ii) any
initial direct costs of the lessor.
Initial direct costs
Initial direct costs are capitalized except direct costs incurred by a manufacturer or dealer lessor under a sales
type lease, which are expensed immediately.
The interest rate implicit in the lease is defined in such a way that the initial direct costs are included
automatically in the net investment in the lease; there is no need to add them separately.

Classification of finance lease as to the lessor

As to the lessor, finance leases may be classified as either:
     a. Direct financing lease, or
     b. Sales type lease

Accounting for operating lease

The accounting for operating leases is straight-forward. The lessor recognizes the lease payments as rent
income on a straight line basis over the lease term, unless another systematic basis is more representative of
the time pattern of user’s benefit. 

Lease bonus
Lease bonus is an amount, in addition to periodic rentals, paid by a lessee to the lessor in order to induce
granting of leasehold rights to the lessee. 

The lessor accounts for the lease bonus as unearned rent to be amortized to rent income over the lease term.
1. Omega made the following journal entry at the end of the first lease year:
Rent expense 1,500 (Dr.)
Cash 1,500 (Cr.)
Omega must have a(n) (applied):
a. general recognition c. finance lease.
b. operating lease. d. recognition exemption.

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

3. Which of the following situations would prima facie lead to a lease being classified as an operating lease?
a. Transfer of ownership to the lessee at the end of the lease term. -F
b. Option to purchase at a value below the fair value of the asset. -F
c. The lease term is for a major part of the asset’s life. -F
d. The present value of the minimum lease payments is 50% of the fair value of the asset. -O

4. The basic accounting issue for lessors is:

a. computing depreciation on the leased asset.
b. revenue recognition during the lease term.
c. determination of the cost of the leased asset.
d. expense recognition during the lease term.

5. The classification of a lease as either an operating or finance lease is based on

a. The length of the lease.
b. The transfer of the risks and rewards of ownership.
c. The minimum lease payments being at least 50% of the fair value.
d. The economic life of the asset.
e.
6. Which of the following would lead to finance lease classification?
a. The lease term is 7 years while the remaining economic life of the leased asset is 10 years.
b. The present value of future minimum lease payments is P80,000 while the fair value of the leased asset
as of inception of the lease is P100,000.
c. The lease contains a purchase option which is equal to the fair value of the leased asset.
d. Ownership over the leased asset will be transferred to the lessee upon lease expiration

7. Lessees under general recognition recognize

a. interest expense c. interest expense and depreciation expense
b. rent expense d. rent expense and interest expense

8. A lessor under finance lease recognizes all of the following, except

a. Gross investment c. Unearned interest income
b. Net investment d. Depreciation on leased asset

9. If the lease provides for the transfer of ownership over the leased asset or a bargain purchase option
a. the lessor shall depreciate the leased asset over its useful life
b. the lessee shall depreciate the leased asset over the shorter of the asset’s useful life and the remaining
lease term
c. the lessee shall depreciate the leased asset over its useful life
d. both the lessee and the lessor shall depreciate the leased asset

10. Net investment in the lease is equal to the

a. Gross investment in the lease plus unearned finance income
b. Present value of gross investment
c. The present value of the minimum lease payment
d. The present value of minimum lease payments less the present value of any unguaranteed residual value

11. Which of the following statements is incorrect regarding the accounting for the residual value of a leased
asset?
a. A lessee accounts for a residual value only if it is guaranteed.
b. A lessor accounts for a residual value only if it is guaranteed.
 c. A lessor accounts for a residual value whether guaranteed or not.
d. Both lessee and lessor will account for a residual value only if the leased asset reverts back to the lessor

12. Customer X enters into a five-year contract with Supplier Y for the use of a rolling stock specifically
designed for Customer X. The rolling stock is designed to transport materials used in Customer X’s
production process and is not suitable for use by other customers. The rolling stock is not explicitly
specified in the contract, but Supplier Y owns only one rolling stock that is suitable for Customer X’s use. If
the rolling stock does not operate properly, the contract requires Supplier Y to repair or replace the rolling
stock. Supplier Y does not have a substantive substitution right. Is the rolling stock an identified asset?
a. Yes, because the rolling stock is implicitly specified in the contract.
b. Yes, because the contract extends beyond 12 months.
c. No, because the rolling stock is not explicitly specified in the contract.
d. No, because I don’t know what a rolling stock is.

13. A lessor’s gross investment in a finance lease is computed as

a. lease payments plus unguaranteed residual value.
b. present value of (a).
c. difference between (a) and (b).
d. sum of (a) and (b).

14. Which of the following statements is false regarding the accounting for leases?
a. The lessor may not use the straight line basis for recognizing lease income under an operating lease if
another systematic basis is more representative of the pattern in which benefit from the use of the
underlying asset is diminished.
b. The amount of lease income recognized each year under an operating lease is typically constant even
though the contractual payments increase every year by a certain amount specified in the contract.
c. It is possible that the lessor does not depreciate the leased asset even if the lease is classified as an
operating lease.
d. Under an operating lease, the lessor capitalizes initial direct costs. These costs will increase the
lease income each year.

15. Customer X enters into a five-year contract with Supplier Y for the right to transport oil from Country A to
Country B through Supplier Y’s pipeline. The contract provides that Customer X will have the right to use
60% of the pipeline’s capacity throughout the term of the arrangement. Is the portion of the pipeline
specified in the contract qualifies as an identified asset for purposes of lease accounting?
a. Yes, because it is physically distinct.
b. Yes, because it represents substantially all of the capacity of the entire pipeline.
c. No, because it is not physically distinct and it does not represent substantially all of the capacity of
the entire pipeline.
d. No, but I don’t know why.

16. Which of the following statements is correct regarding the accounting for leases?
a. The lessor depreciates the leased asset under a finance lease.
b. The lessee depreciates the leased asset under a “short-term” or a “low-valued asset” lease.
c. When discounting lease payments both the lessor and the lessee use the interest rate implicit in the
lease, unless the lessee cannot determine this rate.
d. An entity can never be both a lessor and a lessee of a same leased asset.

17. Which of the following is not one of the criteria when determining whether a contract is or contains a
lease?
a. Identified asset
b. Identified liability
c. Right to obtain substantially all of the economic benefits from use of an identified asset throughout the
period of use
d. Right to direct the use of the identified asset throughout the period of use.

18. On January 1, 2021, Lebron enters into a 3-year lease of equipment for an annual rent of P100,000 payable
at the end of each year. The equipment has a remaining useful life of 10 years. The interest rate implicit in
 the lease is 10% while the lessee’s incremental borrowing rate is 12%. Lebron uses the straight-line method
of depreciation. The relevant present value factors are as follows:
- PV of an ordinary annuity of P1 @10%, n=3………… 2.48685
- PV of an ordinary annuity of P1 @12%, n=3………… 2.40183

How much is the lease liability to be recognized by Lebron on initial recognition?

a. 240,183 c. 252,314
b. 248,685 d. 0

19. Assume the lease in problem #18 above qualifies for accounting under the recognition exemption under
PFRS 16. Which of the following statements is correct?
a. Lebron recognizes annual depreciation of P80,061 on the right-of-use asset.
b. Lebron recognizes a lease liability of P252,314 at the lease commencement date.
c. Lebron recognizes a lease liability of P200,000 at the lease commencement date.
d. Lebron recognizes lease expense of P100,000 in the first year of the lease.

20. On January 2, 2021, Ashley Company entered into a ten-year non-cancellable lease requiring year-end
payments of P100,000. Ashley's incremental borrowing rate is 12% while the lessor's implicit interest rate,
known to Ashe, is 10%. Ownership of the property remains with the lessor at expiration of the lease. The
leased property has an estimated economic life of 12 years. What amount should Ashley recognize for this
leased property on January 2, 2021?
a. 1,000,000 c. 565,000
b. 614,500 d. 0

21. Oak Co. leased equipment for its entire nine-year useful life, agreeing to pay P50,000 at the start of the lease
term on December 31, 2028, and P50,000 annually on each December 31 for the next eight years. The
present value on December 31, 2028, of the nine lease payments over the lease term, using the rate implicit
in the lease which Oak knows to be 10%, was P316,500. The December 31, 2028, present value of the lease
payments using Oak's incremental borrowing rate of 12% was P298,500. Oak made a timely second lease
payment. What amount should Oak report as lease liability in its December 31, 2029, balance sheet?
a. 350,000 c. 228,320
b. 243,150 d. 0

22. On December 30, 2021, Haber Co. leased a new machine from Gregg Corp. The following data relate to the
lease transaction at the inception of the lease:
Lease term 10 years
Annual rental payable at the end of each lease year P100,000
Useful life of machine 12 years
Implicit interest rate 10%

The lease has no renewal option, and the possession of the machine reverts to Gregg when the lease terminates.
At the inception of the lease, Haber should record a lease liability of (rounded-off)
a. 0 c. 630,000
b. 615,000 d. 676,000

23. On January 1, 2021, Babson, Inc., leased two automobiles for executive use. The lease requires Babson to
make five annual payments of P13,000 beginning January 1, 2021. Babson expects to pay P10,000 on the
residual value guarantee. The interest rate implicit in the lease is 9%. Babson's recorded lease liability on
initial recognition is
a. 48,620 c. 35,620
b. 44,070 d. 31,070

24. On January 1, 2021, Row Co. leased a machine from Boat, Inc. Information on the lease is as follows:
 Annual rent payable at the beginning of each
year P200,000
Lease term 10 years
Useful life of machine 12 years
Implicit interest rate 10%

The lease contract provides Row Co. an option to purchase the machine at the end of the lease term for
P100,000. The option price approximates the machine’s expected fair value at the end of the lease. Row Co. is
reasonably certain to exercise the option. What amount of interest expense should Row Co. recognize on the
lease in 2021?
a. 139,036 b. 135,181 c. 119,036 d. 115,181

25. January 1, 2021, Lock Co. enters into a 4-year lease of office equipment. The rent in 2021 is P10,000 and
this will increase by 10% annually starting on January 1, 2022. Lock Co. pays the lessor a lease bonus of
P5,000 on January 1, 2021. Lock Co. opts to use the practical expedient allowed under PFRS 16 for leases
of low value assets. How much is the lease expense in 2021?
a. 10,000 c. 11,603
b. 11,000 d. 12,853

26. On January 1, 2021, Day Corp. entered into a 10-year lease agreement with Ward, Inc. for a piece of
industrial equipment. Annual lease payments of P10,000 are payable at the end of each year. Day knows
that the lessor expects a 10% return on the lease. Day has a 12% incremental borrowing rate. The equipment
is expected to have an estimated useful life of 10 years. In addition, a third party, unrelated to Day, has
guaranteed to pay Ward a residual value of P5,000 at the end of the lease. In Day's January 1, 2021 balance
sheet, the principal amount of the lease obligation was
a. 63,374 c. 58,112
b. 61,446 d. 56,502

Use the following information for the next two questions:

On January 1, 2021, VACILLATE Financing Co. leased equipment to HESITATE, Inc. Information on the
lease is shown below.
Cost of equipment P1,394,740
Useful life of equipment 5 years
Lease term 4 years
Annual rent payable at the start of each year P400,000
Interest rate implicit in the lease 10%

27. How much is the total interest income (finance income) to be recognized by VACILLATE over the lease
term?
a. 400,000 c. 205,260
b. 605,260 d. 365,260

28. How much is the carrying amount of the net investment in the lease as of December 31, 2021?
a. 694,215 c. 735,260
b. 1,094,215 d. 1,165,260

29. On January 1, 2021, OFFICIOUS Financing Co. leased equipment to MEDDLESOME, Inc. under direct
financing lease. Information on the lease is shown below:
Cost of equipment P1,200,000
Useful life of equipment 5 years
Lease term 4 years
Annual rent payable at the end of each year P440,000
Non-lease component included in annual rent P36,196
Initial direct costs 80,000
Implicit rate of interest in the lease 10%

The non-lease component pertains to payment for supplies and other consumables relating to the operation of
the equipment. The stand-alone selling prices are: P36,196 for the supplies and P403,804 for the rent.
On January 1, 2023, due to cash flow problems, OFFICIOUS agreed to sell the equipment to MEDDLESOME,
Inc. for P600,000. How much is the gain (loss) on the sale?
a. (100,816) c. 20,816
b. 100,816 d. 0

30. On January 1, 2021, UPPITY Co. leased a piece of equipment to ARROGANT, Inc. Information on the
lease is shown below.
Cost of equipment P1,200,000
Useful life of equipment 5 years
Lease term 4 years
Annual rent payable at the end of each year ?

UPPITY Co. incurred direct costs of P80,000 in negotiating the lease. If UPPITY Co. desires a fair rate of
return of 10%, what amount of annual rental should it charge ARROGANT, Inc.?
a. 440,000 c. 340,000
b. 403,803 d. 200,000