Module CAE05 INTERMEDIATE ACCOUNTING 2/FA LIABILITIES

CHAPTER 8 LEASES PROBLEM DISCUSSION

Learning Objectives:

Perform the basic operations for Leases.

Learn to calculate problems related to Leases.
Applying the methods of accounting for Leases.
Perform the operations for Sales Type Lease-Lessor
Perform the operations for Direct Financing Lease-Lessor

LEASES PART 1

1. Entity A (customer) enters into a contract with Entity B (supplier) for the use of data
processing equipment. According to the contract, Entity A shall operate the
equipment only in accordance with the standard operating procedures stated in the
accompanying user’s manual. In assessing the existence of a lease, does Entity A
have the right to direct the use of the asset?
a. No, because the asset’s use is restricted.
b. Yes, because Entity A has the right to direct how and for what purpose the asset
is used.
c. Yes, because the asset’s use is predetermined and Entity B is precluded
from changing that predetermined use.
d. Maybe yes, maybe no, but exactly I don’t know.

2. 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

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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

3. 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 the lessor and the lessee use the
interest rate implicit in the lease.
d. An entity can never be both a lessor and a lessee of a same leased asset.

4. According to PFRS 16, lease liabilities are presented in the lessee’s statement of
financial position
a. Separately from the other liabilities of the lessee.
b. Together with other liabilities, with disclosure of the line items that include the
lease liabilities.
c. a or b
d. not presented in the lessee’s financial statements but only in the lessor’s financial
statements

5. According to PFRS 16, right-of-use assets are presented in the lessee’s statement
of financial position
a. Separately from the other assets of the lessee.
b. Together with other assets as if they were owned, with disclosure of the line
items that include the right-of-use assets.
c. a or b
d. not presented in the lessee’s financial statements but only in the lessor’s financial
statements

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6. On January 2, 20x9, Nori Mining Co. (lessee) entered into a 5-year lease for drilling
equipment. Nori recognized a lease liability of ₱240,000 at the commencement date.
This amount includes the ₱10,000 exercise price of a purchase option. At the end of
the lease, Nori expects to exercise the purchase option. Nori estimates that the
equipment's fair value will be ₱20,000 at the end of its 8-year life. Nori regularly uses
straight-line depreciation on similar equipment. For the year ended December 31,
20x9, what amount should Nori recognize as depreciation expense on the leased
asset?
a. 48,000 b. 46,000 c. 30,000 d. 27,500

Solution:

Cost 240,000

Residual value (fair value) (20,000)

Depreciable amount 220,000

Useful life 8

Depreciation expense 27,500

7. In the long-term liabilities section of its balance sheet at December 31, 20x9, Mene
Co. reported a lease liability of ₱75,000, net of current portion of ₱1,364. Payments
of ₱9,000 were made on both January 2, 2x10, and January 2, 2x11. Mene's
incremental borrowing rate on the date of the lease was 11% and the lessor's implicit
rate, which was known to Mene, was 10%. In its December 31, 2x10, balance sheet,
what amount should Mene report as lease liability, net of current portion?
a. 66,000 b. 73,500 c. 73,636 d. 74,250

Solution:

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First step: Place the given information on the amortization table.

Date Payments Int. expense Amortization Present value

12/31/x9

1/1/x10 9,000 75,000

This is the lease obligation as of Dec.

31, 20x9, net of current portion.

Second step: “Squeeze” for the requirement.

Date Payments Int. expense Amortization Present value

12/31/x9

1/1/x10 9,000 75,000

1/1/x11 9,000 7,500 a 1,500 73,500

a
(75,000 x 10%)

8. Oak Co. leased equipment for its entire nine-year useful life, agreeing to pay
₱50,000 at the start of the lease term on December 31, 20x8, and ₱50,000 annually
on each December 31 for the next eight years. The present value on December 31,
20x8, of the nine lease payments over the lease term, using the rate implicit in the
lease which Oak knows to be 10%, was ₱316,500. The December 31, 20x8, present
value of the lease payments using Oak's incremental borrowing rate of 12% was
₱298,500. Oak made a timely second lease payment. What amount should Oak
report as lease liability in its December 31, 20x9, balance sheet?
a. 350,000 b. 243,150 c. 228,320 d. 0

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Solution:

Date Payments Int. expense Amortization Present value

12/31/x8 316,500

12/31/x8 50,000 - 50,000 266,500

12/31/x9 50,000 26,650 23,350 243,150

9. On January 2, 20x5, Marx Co. as lessee signed a five-year noncancelable

equipment lease with annual payments of ₱200,000 beginning December 31, 20x5.
The five lease payments have a present value of ₱758,000 at January 2, 20x5,
based on interest of 10%. What amount should Marx report as interest expense for
the year ended December 31, 20x5?
a. 0 b. 48,000 c. 55,800 d. 75,800

Solution: (758,000 x 10%) = 75,800

10. On January 1, 20x1, ABC Co. enters into a 4-year lease of office equipment. The
rent in 20x1 is ₱10,000 and shall increase by 10% annually starting on January 1,
20x2. Rentals are payable at the end of each year. ABC Co. pays the lessor a lease
bonus of ₱5,000 on January 1, 20x1. ABC Co. opts to use the practical expedient
allowed under PFRS 16 for leases of low value assets. How much is the lease
expense in 20x1?
a. 10,000 b. 11,000 c. 11,603 d. 12,853

Solution:

20x1 10,000

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20x2 (10K x 110%) 11,000

20x3 (11K x 110%) 12,100

20x4 (12.1K x 110%) 13,310

Lease bonus 5,000

Total 51,410

Divide by: 4

Annual lease expense 12,853

LEASES PART 2

1. Lessor Co. entered into two contract leases. Lease #1 transfers substantially all the
risks and rewards incidental to ownership of the leased asset. Lease #2 does not
transfer substantially all the risks and rewards incidental to ownership of the leased
asset. How should Lessor Co. classify the leases? (Lease #1); (Lease #2)
a. Finance, Operating c. Finance, Finance
b. Operating, Finance d. Operating, Operating

2. 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)

3. A lessor’s unearned interest income 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)

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d. sum of (a) and (b)

4. Which of the following does not correctly relate to the accounting for leases?
a. The underlying asset in a lease contract is recognized by the lessee in its
financial statements.
b. The lessor recognizes a finance lease receivable equal to the net investment in a
finance lease.
c. A manufacturer or dealer lessor recognizes gross profit or loss on
commencement of a finance lease in accordance with its policy for outright sales.
d. The lessor recognizes lease payments receivable from an operating lease as
income in the period earned.
e. The lessor continues to recognize an asset subject to a finance lease in its
financial statements.

5. Regarding the accounting for the residual value of a leased asset, which of the
following statements is incorrect?
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.

6. Under operating leases, lessors

a. Recognize rent income using a straight line basis, unless another method
is more appropriate.
b. Recognize interest income using the effective interest method.
c. recognize different amounts of rent income each year depending on the
contractual payments
d. any of these

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7. Security deposits that are refundable

a. Are treated as unearned income by lessors under an operating lease.
b. are not discounted because they are normally of a short-term nature
c. Are treated as receivable by lessees and as payable by lessors.
d. are discounted only by lessees but not by lessors

8. If the lessor recognizes rent income (lease income), then the lease must have been
classified as
a. finance lease c. a or b
b. operating lease d. none of these

9. 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.

10. Which of the following is correct regarding the accounting for operating leases?
a. A lessor under an operating lease may classify the lease as either direct
operating lease or sales type operating lease.
b. A lessor includes a rent collected in advance as part of the cost of the leased
asset.

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c. A lessor includes initial direct costs incurred on the operating lease as part
of the cost of the leased asset to be recognized in profit or loss on the
same basis as rent income is recognized.
d. A lessor includes initial direct costs incurred on the operating lease as part of the
cost of the leased asset to be recognized in profit or loss on the same basis as
depreciation expense is recognized.

LEASES PART 3

Use the following information for the next five questions:

On January 1, 20x1, IMBROGLIO Co. leased equipment to COMPLICATION, Inc.

Information on the lease is shown below:

Cost of equipment ₱ 1,200,000

Useful life of equipment 5 years

Lease term 4 years

Annual rent payable at the start of each year 400,000

Interest rate implicit in the lease 10%

Initial direct costs amounted to ₱80,000. The lease qualifies for sales type lease
accounting.

1. How much is the gross investment in the lease on January 1, 20x1?

a. 2,000,000 b. 1,600,000 c. 1,200,000 d. 1,800,000
Solution: (400,000 x 4 years) = 1,600,000

2. How much is the net investment in the lease on January 1, 20x1?

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a. 1,200,000 b. 1,280,000 c. 1,394,740 d. 1,474,741

Solution: (400,000 x PV annuity due @10%, n=4) = 1,394,741

3. How much is the total interest income (finance income) to be recognized by

IMBROGLIO over the lease term?
a. 205,259 b. 235,260 c. 125,259 d. 525,259
Solution: (1,600,000 – 1,394,741) = 205,259

4. How much is the gross profit from the sale?

a. 114,740 b. 194,741 c. 125,259 d. 45,259
Solution: (1,394,741 – 1,200,000 = 194,741

5. How much is the net profit from the sale?

a. 125,259 b. 45,259 c. 194,740 d. 114,741
Solution: (194,741 – 80,000 initial direct costs) = 114,741

Use the following information for the next three questions:

On January 1, 20x1, YATAGHAN Financing Co. leased equipment to LONG KNIFE,

Inc. Information on the lease is shown below:

Cost of equipment ₱ 1,322,588

Useful life of equipment 5 years

Lease term 4 years

Annual rent payable at the end of each year 400,000

Interest rate implicit in the lease 10%

Residual value 80,000

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The equipment will revert back to YATAGHAN at the end of the lease term. The lease is
classified as direct financing lease.

6. Assuming the residual value is guaranteed, how much is the gross investment in the
lease on January 1, 20x1?
a. 1,600,000 b. 1,680,000 c. 1,520,000 d. 2,080,000
Solution: (400,000 x 4) + 80,000 = 1,680,000

7. Assuming the residual value is unguaranteed, how much is the net investment in the
lease?
a. 1,322,587 b. 1,267,948 c. 1,213,308 d. 1,345,981
Solution: (400,000 x PV ordinary annuity @10%, n=4) + (80,000 X PV of 1 @10%,
n=4) = (1,267,946 + 54,641) = 1,322,587

8. How much is the total interest income to be recognized by YATAGHAN over the
lease term if the residual value is unguaranteed and guaranteed, respectively?
Unguaranteed Guaranteed

a. 357,412 341,270
b. 341,270 357,412
c. 341,753 341,985
d. 357,413 357,413
Solution: (1,680,000 - 1,322,587) = 357,413

9. Wall Co. leased office premises to Fox, Inc. for a five-year term beginning January 2,
20x9. Under the terms of the operating lease, rent for the first year is ₱8,000 and
rent for years 2 through 5 is ₱12,500 per annum. However, as an inducement to
enter the lease, Wall granted Fox the first six months of the lease rent-free. In its
December 31, 20x9, income statement, what amount should Wall report as rental
income?
a. 12,000 b. 11,600 c. 10,800 d. 8,000

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Solution:

Rent for the first year (8,000 x 6/12) 4,000

Rent for the subsequent years (12,500 x 4) 50,000

Total collection on rentals 54,000

Divide by: 5

Annual rent income 10,800

10. As an inducement to enter a lease, Arts, Inc., a lessor, grants Hompson Corp., a
lessee, nine months of free rent under a five-year operating lease. The lease is
effective on July 1, 20x5, and provides for monthly rental of ₱1,000 to begin April 1,
20x6. In Art's income statement for the year ended June 30, 20x6, rent income
should be reported as
a. 10,200 b. 9,000 c. 3,000 d. 2,550

Solution:

Lease term in years 5

Multiply by: No. of months in a year 12

Lease term in months 60

Nine months free rent (9)

Total 51

Multiply by: Monthly rental 1,000

Total rental payments on the lease 51,000

Divide by: Lease term in years 5

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Annual rent income (July 1 to June 30) 10,200

SALES TYPE LEASE-LESSOR

 Tecson Company leased equipment to Trinidad Company on January 1, 2020,

for an eight-year period expiring December 31, 2026. Equal payments under the
lease are P500,000 and are due on January 1 of each year. The first payment
was made on January 1, 2020. The selling price of the equipment is P2,900,000
and the carrying amount is P2,000,000. The lease is appropriately accounted for
as a sales type lease. The present value of the lease payments at an implicit
interest rate of 12% is P2,780,000. What amount of gross profit on sale should
be reported for 2020?
a. 900,000
b. 780,000
c. 240,000
d. 333,600
Solution:

Sales revenue equal to the present value of lease payments – lower

2,780,000

Carrying amount of equipment sold 2,000,000

Gross profit on sale 780,000

PAS 17, paragraph 44, provides that the sales revenue recognized at the
commencement of the lease term by a manufacturer or dealer lessor is equal to the fair
value of the asset or the present value of the minimum lease payments, whichever is
lower.

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 Tecson Company is a car dealer. On January 1, 2019, the entity entered into a
finance lease with a customer under which the customer would pay P200,000 on
January 1 each year for 5 years, commencing in 2020. The cost of the car is
P600,000 and the cash selling price was P750,000. The entity paid legal fees of
P20,000 to a law firm in connection with the arrangement of the lease. What
amount of gross profit on sale should be recognized for 2020?
a. 150,000
b. 130,000
c. 20,000
d. 0
Solution:

Sales revenue 750,000

Cost of sales (600,000)

Legal fees – initial direct cost (20,000)

Gross profit on sale 130,000

 Tecson Company used leases as a means of marketing its products. On January

1, 2020, Tecson Company leased an equipment to Trinidad Company for
P500,000 per year for 10 years, payable on December 31 of each year. The cost
of the equipment is P2,000,000 and the fair value is P3,072,500 on January 1,
2020 using an implicit rate of 10%. The fair value of the equipment approximated
the present value of rentals. At the expiration of the lease, title to the equipment
passes to Trinidad Company. What is the interest income for 2020?
a. 200,000
b. 192,750
c. 307,250
d. 257,250
Solution: Interest income for 2020 (10% x 3,072,500) 307,250

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 Tecson Company, a dealer in machinery and equipment, leased equipment to

Trinidad Company on July 1, 2020. The lases is appropriately accounted for as a
sale by Tecson Company and as a purchase by Trinidad. The lease is for a ten-
year period equal to the useful life of the asset expiring June 30, 2029. The first
of ten equal annual payment of P250,000 was made on July 1,2020. Tecson
Company had purchased the equipment for P1,337,500 on January 1, 2020, and
established a list selling price of P1,687,500 on the equipment. The present
value on July 1, 2020 of the rent payments over the lease term discounted at
12% was P1,582,500. What amount of profit on sale and interest income should
be recorded for the year ended December 31, 2020, respectively?
a. 245,000 and 94,950
b. 245,000 and 79,950
c. 350,000 and 79,950
d. 350,000 and 94,950
Solution:

Present value of rentals – Sales revenue 1,582,500

Cost of equipment 1,337,500

Profit on sale 245,000

Present value – July 1, 2020 1,582,500

Payment on July 1, 2020, all applicable to principal (250,000)

Lease receivable – July 1, 2020 1,332,500

Interest income from July 1, 2020 to June 30, 2021

(12% x 1,332,500) 159,900

Interest income from July 1, 2020 to December 31, 2020

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(159,900 x 6/12) 79,950

 Tecson Company leased equipment to Trinidad Company on January 1, 2020.

The lease is for an
eight-year period expiring December 31, 2026. The first of eight annual payments of
P900,000 was made on January 1, 2020. The entity had purchased the equipment on
December 29, 2019 for P4,800,000. The lease is appropriately accounted for as a sales
type lease. The present value on January 1, 2020 of all rent payments over the lease
term discounted at a 10% interest rate was P5,280,000.

1. What is the gross profit on sale for 2020?

a. 1,920,000
b. 2,400,000
c. 480,000
d. 240,000
Solution:

Present value of rentals – sales revenue 5,280,000

Cost of sales 4,800,000

Gross profit on sale 480,000

2. What amount of interest revenue should be recorded in 2021?

a. 490,000
b. 480,000
c. 438,000
d. 391,800
Solution:

Present value – January 1, 2020 5,280,000

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First payment on January 1, 2020 900,000

Lease receivable – January 1, 2020 4,380,000

Second payment on January 1, 2021 900,000

Interest for 2020 (10% x 4,380,000) (438,000) 462,000

Lease receivable – January 1, 2021 3,918,000

Third payment on January 1, 2022 900,000

Interest for 2021 (10% x 3,918,000) (391,800) 508,200

Lease receivable – January 1, 2022 3,409,800

 On January 1, 2020, Tecson Company entered into a lease agreement with

Trinidad Company for a machine which was carried on the accounting records of
Tecson Company at P2,000,000. Total payments under the lease which expires
on December 31, 2028, aggregate P3,550,800 of which P2,400,000 represents
cost of the machine to Trinidad. Payments of P355,080 are due each January 1
of each year. The interest rate of 10% which was stipulated in the lease is
considered fair and adequate compensation to Tecson Company for the use of
its funds. Trinidad expects the machine to have a 10-year life, no residual value
and be depreciated on a straight-line basis. The lease is conceived as a sales
type lease. What is the total income before income tax derived by Tecson
Company from the lease for the year ended December 31, 2020?
a. 204,492
b. 604,492
c. 355,080
d. 755,080
Solution:

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Present value of rentals 2,400,000

First payment on January 1, 2020 all applicable to principal 355,080

Lease receivable – January 1, 2020 2,044,920

Interest income for 2020 (2,044,920 x 10%) 204,492

Present value of rentals – cost of Trinidad (lessee) 2,400,000

Cost of asset to Tecson Company (lessor) 2,000,000

Gross profit on sale 400,000

Interest income for 2020 204,492

Total income of Tecson Company for 2020 604,492

DIRECT FINANCING LEASE-LESSOR

 On January 1, 2020, Esteban Company, acting as a lessor, leased an equipment

for ten years at an annual rental of P1,200,000, payable by Tecson Company,
the lessee, at the beginning of each year under a direct financing lease. The
equipment had a cost of P8,400,000 with an estimated life of 12 years and no
residual value. The implicit rate is 9%. What amount of interest income should be
reported in 2020?
a. 500,000
b. 648,000
c. 756,000
d. 360,000
Solution:

Present of rentals equal to the cost of asset 8,400,000

Advance payment on January 1, 2020 1,200,000

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Lease receivable – January 1, 2020 7,200,000

Interest income for 2020 (7,200,000 x 9%) 648,000

 Esteban Company acquired a specialized packaging machine for P3,000,00 cash

and leased it
for a period of six years, after which the machine is to be returned to Tecson Company.
The unguaranteed residual value of the machine is P200,000. The lease terms are
arranged so that a return of 12% is earned by Cassandra. The PV of 1 at 12% for six
periods is .51, and the PV of an annuity in advance of 1 at 12% for six periods is 4.60.
What is the annual lease payment payable in advance required to yield the desired
return?

a. 630,000
b. 652,174
c. 608,695
d. 732,000
Solution:

Cost of asset 3,000,000

PV of unguaranteed residual value (200,000 x .51) (102,000)

Net investment to be recovered from rentals 2,898,000

Divide by PV of an annuity in advance of 1 at 12% 4.60

Annual rental payable in advance 630,000

Whether guaranteed or unguaranteed, the residual value is deducted from the

cost of the asset if the leased asset will revert to the lessor at the end of lease term.

 Esteban Company entered into a finance lease on January 1, 2020. A third party
guaranteed the residual value of the asset under the lease estimated to be

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P120,000 on January 1, 2024, the end of the lease term. Annual lease payments
are P100,000 due each December 31, beginning December 31, 2020. The last
payment is due December 31, 2023. Both the lessor and lessee used 10% as the
interest rate. The remaining useful life of the asset was six years at the
commencement of the lease.

The PV of 1 at 10% for 5 periods is .62, and the PV of an ordinary annuity of 1 at 10%
for 5 periods is 3.70. What is the lease receivable of the lessor and lease liability of the
lessee at the commencement of the lease?

Lease receivable Lease liability

a. 453,400 453,400
b. 379,000 379,000
c. 453,400 379,000
d. 379,000 453,400
Solution:

Lessor

Present value of rentals (100,000 x 3.79) 379,000

Guaranteed residual value (120,000 x .62) 74,400

Lease receivable 453,400

The lease term is from January 1, 2020 to December 31, 2023 or 5 years. Thus, the
present value factors are determined for 5 periods.

Lessee

Lease liability (100,000 x 3.79) 379,000

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The guaranteed residual value is not included in the lease liability because it is
guaranteed by a third party.

 On December 31, 2020, Esteban Company, a lessor, sold a machinery that it

had been leasing under a direct financing lease. On January 1, 2020 after
receipt of the lease payment for the year, the following account balances were
associated with the lease:
Gross lease receivable 5,850,000

Unearned interest income 1,000,000

Present value of lease receivable 4,850,000

The interest rate implicit in the lease is 10%. On December 31, 2020, Esteban
Company sold the leased machinery to the lessee for P3,250,000 cash. What is the
loss on sale of machinery that should be recognized on December 31, 2020?

a. 2,085,000
b. 1,600,000
c. 2,600,000
d. 2,015,000
Solution:

Interest income for 2020 (10% x 4,850,000) 485,000

Sale price 3,250,000

Carrying amount of lease receivable:

Lease receivable 5,850,000

Unearned interest income

(1,000,000 – 485,000) (515,000) 5,335,000

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Loss on sale of machinery (2,085,000)

Entries on December 31, 2020

1. Unearned interest income 485,000

Interest income 485,000

2. Cash 3,250,000
Unearned interest income 515,000
Loss on sale of machinery 2,085,000
Lease receivable 5,850,000

Reference:

Lecture Notes Compilation by Dean Rene Boy R. Bacay, CPA, CrFA, CMC, MBA, FRIAcc

For further discussion please refer to the link provided:

Lease Bonus- https://www.youtube.com/watch?v=4JECb3QQXug

Security Deposits- https://www.youtube.com/watch?v=ebeeLAhcrT4

Accounting for Lease- https://www.youtube.com/watch?v=yIh3RJ3Dheg

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