NEW BRIGHTON SCHOOL OF THE PHILIPPINES, Inx`C.

Module No. 9
Subject: Intermediate Accounting 2 Date of Submission: ____________
Name of Student: __________________________________________________
Course and Year: __________________________________________________
Semester and School Year: __________________________________________

FINANCE LEASE CLASSIFICATION

On the part of the lessor, a finance lease is either:

a. Direct financing
b. Sales type lease

The main distinction between the two is the presence or absence of manufacturer or dealer profit or loss. A direct
financing lease recognizes only interest income. A sales type lease recognizes interest income and gross profit on sale.

Direct financing lease

The lessor in a direct financing lease is actually engaged in the financing business. Thus, a direct financing lease is an
arrangement between a financing entity and a lessee. The income of the lessor is only in the form of interest income.

No dealer profit is recognized because the fair value and the cost of the asset are equal.

Accounting consideration

a. Gross investment – this is equal to the gross rentals for the entire lease term plus the absolute amount of the
residual value, whether guaranteed or unguaranteed.
b. Net investment in the lease – This is equal to the cost of the asset plus any initial direct cost paid by the lessor.
c. Unearned interest income – This is the difference between the gross investment and net investment in the lease.
d. Initial direct cost – in a direct financing lease, the initial direct cost paid by the lessor is added to the cost of the
asset to get the net investment in the lease.

The initial direct cost would effectively spread the initial direct cost over the lease term and reduce the amount of
interest income.

Illustration – Direct financing lease

On January 1, 2020, Lessor Company leased a machinery to another entity with the following details:

Cost of machinery 1,518,650

Annual rental payable at the end of each year 500,000
Lease term 4 years
Useful life of machinery 4 years
Implicit interest rate 12%
Present value of annuity of 1 for 4 years at 12% 3.0373

The initial problem is the determination of the annual rental which will give the lessor a fair rate of return on the net
investment in the lease.

The procedure is to divide the “net investment in the lease to be recorded from rental” by present value factor of an
annuity of 1 for a number of periods using a desired rate of return to get annual rental.

Computation

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By the present value factor, The annual rate is computed by dividing the amount of P1,5,18,650 by the present value
factor, 3.0373, of an annuity of 1 for 4 years at 12%, or P500,000.

Gross rentals or lease receivable (500,000 x 4 years) 2,000,000

Present value of gross rentals (equal to the net investment in the lease of
Cost of the machinery) 1,518,650
Unearned interest income 481,350

Lease liability 2,000,000

Machinery 1,518,650
Unearned interest income 481,350

The annual collection of the rental is recorded as follows:

Cash 500,000
Lease receivable 500,000

Table of amortization

The unearned interest income of P481,350 is recognized over the lease term following the effective interest method.

Date Payment Interest Principal Present value

Jan. 1, 2020 1,518,650
Dec. 31, 2020 500,000 182,238 317,762 1,200,888
Dec. 31, 2021 500,000 144,107 355,893 844,995
Dec. 31, 2022 500,000 101,399 398,601 446,394
Dec. 31, 2023 500,000 53,606 446,394 -

Payment represents the annual rental.

Interest is equal to the preceding present value times the interest rate. Thus, for 2020, P1,518,650 times 12% equals
P317,762.

Principal is the portion of the rental payment after deducting the interest. Thus, for 2020, P500,000 minus P182,238
equals P317,762.

Present value is the balance of the present value after deducting the principal payment.

Thus, on December 31,2020, P1,518,650 minus P317,762 equals P1,200,888.

Recognition of interest income

The effective interest method is used in recognizing interest income. IFRS 16, paragraph 75, states that the lessor shall
recognize finance income over the lease term based on a pattern reflecting a constant periodic rate of return on the
lessor’s net investment in the lease.

2020
Dec. 31 Unearned interest income 182,238
Interest income 182,238

2021
Dec. 31 Unearned interest income 144,107
Interest income 144,107

Direct financing lease – with initial direct cost

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On January 1. 2020, Lessor Company leased a machinery to another entity with the following details:

Cost of machinery 1,518,650

Annual rental payable at the end of each year 500,000
Lease term 4 years
Useful life of machinery 4 years
Implicit interest rate 12%
Present value of annuity of 1 for 4 years at 12% 3.0373

On January 1, 2020, Lessor Company paid initial direct cost of P66,300.

The initial direct cost is added to the cost of the machinery to determine the net investment in the lease.

Cost of machinery 1,518,650

Initial direct cost 66,300
Net investment in the lease 1,584,950

The conclusion of initial direct cost in the net investment in lease will have the effect of spreading the initial direct cost
over the lease term and reduced the interest income from the finance lease.

Gross rentals 2,000,000

Net investment in the lease 1,584,950
Unearned interest income 415,050

Consequently, the initial direct cost would decrease implicit interest rate in the lease.

The problem therefore is the determination of the reduced implicit interest rate.

The original implicit interest rate of 12% cannot be applied anymore because of the added initial direct cost.

Computation of new implicit rate

The new implicit rate is computed by trial and error or through the interpolation process.

The new interest rate is definitely lower than 12% and it could be 11%, 10% or 9%.

The procedure is determine the present value of gross rentals that would equate the net investment in the lease of
P1,584,950 using a particular rate.

Using 11% the present value of an ordinary of 1 at 11% for 4 periods is 3.1024.

Thus, the present value of gross rentals is equal to P500,000 multiplied by 3.1024 or P 1,551,200.

This amount is not the same as the net investment in the lease. The new interest rate is not 11%.

Using 10%, the present value of an ordinary annuity of 1 at 10% for 4 periods is 3.1699.

Thus, the present value of gross rentals is equal to P500,000 multiplied by 3.1699 or P1,584,950.

Coincidentally, this amount is the same as the net investment in the lease.

In conclusion, the new interest rate is 10%.

Accordingly, the reduce interest rate of 10% is used in determining the annual interest income.

Journal entries

Machinery (initial direct cost) 66,300

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 Cash 66,300

Lease receivable 2,000,000

Machinery 1,584,950
Unearned interest income 415,050

The annual collection of the rental is recorded as:

Cash 500,000
Lease receivable 500,000

The unearned interest income of P415,050 is recognized as income over the lease term following the effective interest
method of amortization.

Table of amortization

Date Payment Interest Principal Present Value

Jan. 1, 2020 1,584,950
Dec. 31, 2020 500,000 158,495 341,505 1,243,445
Dec. 31, 2021 500,000 124,344 375,656 867,789
Dec. 31, 2022 500,000 86,779 413,221 454,568
Dec. 31, 2023 500,000 45,432 454,568 -

Payment represent the annual rental.

Interest is equal to the preceding present value times the interest rate.

Thus, for 2020, P1,584,950 times 10% equals P158,495.

Principal is the portion of the rental payment after deducting the interest.

Thus, for 2020, P500,000 minus P518,495 equals P341,505.

Present value is the balance of the preceding value after deducting the principal payment.

Thus, on December 31,2020 P1,584,950 minus P341,505 equals P1,243,445.

Journal entries

The recognition of interest income for the first two years is recorded as:

2020

December 31 Unearned interest income 158,495

Interest income 158,495

2021

December 31 Unearned interest income 124,334

Interest income 124,334

If a statement of financial position is prepared by the lessor on December 31, 2020, the lease receivable of P1,500,000
would be reported as partly current and partly noncurrent.

Current portion
Lease receivable 500,000
Unearned interest income (124,344)
Carrying amount 375,656

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Noncurrent portion
Lease receivable 1,000,000
Unearned interest income (132,211)
Carrying amount 867,789

IFRS 16, paragraph 67, states that lessor shall recognize assets held under a finance lease as a receivable at an amount
equal to the net investment in the lease.

Note that the unearned interest income which is realizable within one year from December 31, 2020 is deducted from
the current lease receivable.

The remaining portion is deducted from the concurrent lease receivable.

Unearned interest income 415,050

Realized in 2020 (see table) 158,495
Balance, December 31, 2020 256,555
Realizable in 2021 124,344
Realizable beyond 2021 132,211

Direct financing lease – with residual value

On January 1, 2020, Lessor Company leased a machinery to another entity with the following details:

Cost of machinery 3,194,410

Residual value 500,000
Useful life and lease term 4 years
Implicit interest rate 10%

The machinery will revert to the lessor at the end of the lease term because there is neither a transfer of title nor a
purchase option.

The problem is the determination of the annual rental. The annual rental is payable at the end of each year with the first
payment on December 31, 2020. The relevant present value factors are:

PV of at 10% for 4 periods .683

PV of an ordinary annuity of at 10% for 4 periods 3.1699

Cost of machinery 3,194,410

Present value of residual value (500,000 x .683) ( 341,500)

Net investment to be recovered from rental 2,852,910

Divide by PV of an ordinary annuity of at 1 at 10% for 4 periods 3.1699
Annual rental 900,000

Note that the present value of the residual is deducted from the cost of the asset if the machinery will revert to the
lessor at the end of the lease term.

Otherwise, if the machinery will not revert to the lessor at the end of the lease term, the residual value is completely
ignored.

Gross rental (900,000 x 4) 3,600,000

Residual value (whether guaranteed or unguaranteed) 500,000
Gross investment 4,100,000

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Cost of machinery- net investment (3,194,410)
Unearned interest income 905,590

Table of amortization

Date Payment Interest Principal Present Value

1/1/2020 3,194,410
12/31/2020 900,000 319,441 580,559 2,613,851
12/31/2021 900,000 261,385 638,615 1,975,236
12/31/2022 900,000 197,524 702,476 1,272,760
12/31/2023 900,000 127,240 772,760 500,000

Interest is equal to the preceding present value times the interest rate. Thus, for 2020, P3,194,410 times 10% equals
P319,441.

Principal is the portion of the rental asset after deducting interest.

Thus, for 2020, P900,000 minus P319,441 equals P580,559.

Present value equals the balance of the present value minus the principal payment.

Thus, on December 31, 2020, P3,194,410 minus P580,559 equals P2,613,851.

Journal entries for 2020

1. To record the direct financing lease:

Lease receivable 4,100,000

Machinery 3,194,410
Unearned interest income 905,590

2. To record the collection of annual rental:

Cash 900,000
Lease receivable 900,000

3. To record interest income:

Unearned interest income 319,441

Interest income 319,441

When the lease expires on December 31, 2023, the machinery will revert to the lessor.

Whether “guaranteed” or “unguaranteed”, the entry on the book of the lessor will be the same.

Machinery 500,000
Lease receivable 500,000

Accounting problem

The accounting problem is when the fair value of the machinery is P400,000 which is Lower than the residual value of
P500,000.

Under the guaranteed scenario, the lessee will pay the difference. The journal entry of the lessor is:

Cash 100,000
Machinery 400,000

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 Lease Receivable 500,000

Direct financing lease – with residual value

On January 1, 2020, Lessor Company leased a machinery to another entity with the following details:

Cost of machinery 3,700,100

Residual value guarantee 400,000
Useful life and lease term 4 years
Implicit interest rate 10%

The annual rental is payable in advance on January 1 of each year starting January 1, 2020.

Since the residual value is guaranteed, the machinery will revert to the lessor at the end of the lease term.

The relevant present value factors are:

Present value of 1 at 10% for 4 periods 0.6830
Present value of an annuity of 1 in advance at 10% for 4 periods 3.4869

Computation of annual rental

Cost of machinery 3,760,100

Present value of residual value(400,000 x .683) (273,200)
Net investment to be recovered from rental 3,486,900
Divide by PV of annuity of 1 in advance at 10% for 4 periods 3.4869
Annual rental 1,000,000

Note that the rental is payable in advance at the beginning of each year. Thus, the “annuity of 1 in advance factor” is
used in the computation.

Gross rentals (1,000,000 x 4 years ) 4,000,000

Residual value – guaranteed 400,000
Gross investment 4,400,000
Net investment – cost of machinery 3,760,100
Unearned interest income 639,900

Date Payment Interest Principal Present Value

1/1/2020 3,760,100
1/1/2020 1,000,000 - 1,000,000 2,760,100
1/1/2021 1,000,000 276,010 723,990 2,036,110
1/1/2022 1,000,000 203,611 796,389 1,239,721
1/1/2023 1,000,000 123,972 876,028 363,693
1/1/2024 400,000 36,307 363,693 -

Interest is equal to the preceding present value times the interest rate. The first rental payment on January 1, 2020
pertains to principal only.

Thus, on January 1, 2021, the interest is equal to P2,760,100 times 10% or P276,010. This interest income pertains to
2020.

Principal is the portion of rental payment minus the interest. Thus on January 1, 2021, P1,000,000 minus P276,010
equals P723,990.

Present value is the balance of the present value minus the principal payment.

Thus, on January 1, 2021 P2,760,100 minus P723,990 equals 2,036,110.

Journal entries

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2020
Jan. 1 Lease receivable 4,400,000
Machinery 3,760,100
Unearned interest income 639,900

1 Cash 1,000,000
Lease receivable 1,000,000

Dec. 31 Unearned interest income 276,010

Interest income 276,010

2021
Jan. 1 Cash 1,000,000
Lease receivable 1,000,000

Dec. 31 Unearned interest income 203,611

Interest income 203,611

2022
Jan. 1 Cash 1,000,000
Lease receivable 1,000,000

Dec. 31 Unearned interest income 123,972

Interest income 123,972

2023
Jan. 1 Cash 1,000,000
Lease receivable 1,000,000

Dec. 31 Unearned interest income 36,307

Interest income 36,307

2024
Jan. 1 On this date, deferred value of the machinery is P300,000 only. Since
the guaranteed residual value is P400,000, the lessee will pay for the
differences of P100,000.

Cash 100,000
Machinery 300,000
Lease receivable 400,000

Direct financing lease – transfer of title to lessee

On January 1, 2020, Lessor Company leased a machinery to another entity with the following details:

Cost of machinery 3,449,600

Residual value 500,000
Useful life and lease term 5 years
Implicit interest rate 8%

The annual rental payable in advance on January 1 of each year starting January 1, 2020. The lease provides for a
transfer of title to the lessee at the end of the lease term.

The present value of an annuity of 1 in advance at 8% for 5 periods is 4.312.

Cost of machinery to be recovered from rental 3,449,600

Divide by PV of annuity of 1 in advance at 8% for 5 periods 4,312

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Annual rental 800,000

Note well that if the machinery will not revert to the lessor at the of the lease term because the lease provide for a
transfer of title to the lessee, the residual value is completely ignored in the computation of the annual rental and the
unearned interest income.

Note also that the rental is payable in advance.

Thus, the annuity of 1 in advance or annuity due factor is used in the computation.

Gross rental (800,000 x 5 years) 4,000,000

Net investment – cost of machinery 3,449,600
Unearned interest income 550,400

Table of amortization

Date Payment Interest Principal Present Value

1/1/2020 3,449,600
1/1/2020 800,000 - 800,000 2,649,600
1/1/2021 800,000 211,968 588,032 2,061,568
1/1/2022 800,000 164,925 635,075 1,426,493
1/1/2023 800,000 114,119 685,881 740,612
1/1/2024 800,000 59,388 740,612 -

Interest is equal to the preceding present value times the interest rate. The first rental payment on January 1,2020
pertains to principal only. Thus, on January 1, 2021 the interest is equal to P2,649,600 times 8% or P211,968. This
interest income pertains to 2020/
Principal is the portion of the rental payment minus the interest. Thus, on January 1, 2021, P800,000 minus P211,968
equals P588,032.

Present value is the balance of the present value minus the principal payment. Thus, January 2021, P2,649,600 minus
P588,032 equals P2,061,568.

2020
Jan. 1 Lease receivable 4,000,000
Machinery 3,449,600
Unearned interest income 550,400

1 Cash 800,000
Lease receivable 800,000

Dec. 31 Unearned interest income 211,968

Interest income 211,968

2021
Jan. 1 Cash 800,000
Lease receivable 800,000

Dec. 31 Unearned interest income 164,925

Interest income 164,925

References

Valix, C. & Valix, C.A. (2018). Practical Accounting 1 vol 2. GIC Enterprises and Co., Inc. Manila, Philippines

Valix, C. & Valix, C.A. (2013). Theory of Accounts 2013 edition. GIC Enterprises and Co., Inc. Manila, Philippines

Module for Intermediate Accounting 2, Jonard S. Baloyo, CPA Page 9

Valix, C. Valix, C.A. (2019). Financial Accounting and Reporting vol 2. GIC Enterprises and Co., Inc. Manila,
Philippines

Robles, N. & Empleo P. (2016). The Intermediate Accounting Series Vol 2. Millenium Books, Inc., Mandaluyong City

Uberita, C. (2012). Practical Accounting 1 2013 Edition. GIC Enterprises and Co, Inc. Manila, Philippines

Testbanks and CPA Examination Reviewers

Module for Intermediate Accounting 2, Jonard S. Baloyo, CPA Page 10