Buena, David D.

Chapter 7 Cabali, Gabriel M.

Calica, Jan Brian G.
LEASE (PART 1) Cases, Crissel Rose G.
Presented by: Castorico, Dave C.
Barrun, Vincent O. Cerillo, John Nimrod G.
Belano, Mark D. Cao, Gerome Mikko L
Chapter 7
Leases (part 1)
Learning Objectives:
1. Identify the lease.
2. Account for lease by a lessee using (a) the general recognition and (b) the
recognition exemption.
 Lease
Lease is "a contract, or a part of a contract, that conveys the right to use in
asset (the underlying asset) for a period of time in exchange for
consideration." The following are the parties to a lease contract:
a. Lessee - the "entity that obtain the right to use an underlying asset for a
period of time in exchange for consideration."
b. Lessor - the "entity that provides the right to use an underlying asset for a
period of time in exchange for consideration."
Identifying a lease
"A contract is, or contains, a lease if a contract conveys the right to control the
use of identified asset for a period of time in exchange for consideration. 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.
a. The right to obtain substantially all of economic benefits from the use of
identified asset; and
b. The right to direct the use of the identified asset.
Identified Asset
An identified asset is essential in the definition of a lease. An asset can be identified
by being explicity stated in the contract or by being implicity specified at the time
the asset is made available for use by the customer.
ILLUSTRATION;

Customers X enters into a five year contract with Supplier Y for the use of a towing
truck. The specification of the truck (i.e Brand, engine, capacity, dimensions, etc) is
stated in the contract.

Case 1: The towing truck is readily available at the inception of the

contract. Analysis: The towing truck is an identified asset. It is identified
by being explicity specified by the contract.
Case 2: The towing truck is not yet available at the inception if the contract.
However, Supplier Y commits to have the towing truck specified in the contract
available for use by Customers X at the commencement of the lease.
Analysis: The towing truck is an identified asset. It is identified by being implicity
specified at the time the asset is made available for use by the customer.
Portion of Asset
A portion of asset is an identified asset if it is physical distinct (e.g. a floor of a
building). If not physical distinct, the portion is not an unidentified asset,
unless it represents substantially all of the capacity of the asset thereby
providing the right to obtain substantially all of the economic benefits from
the asset.
ILLUSTRATION:
Customer X enters a 10 year contract with Supplier Y for the right to use for
three fibres within a larger cable(consisting of 15 fibres) connecting
Country A and Country B.
Case 1: Physically distinct
The contract specifically identifies the 3 fibres within the 15 fibres
comprising the cable. The 3 fibres shall be used exclusively to transmit
Customer's data during the duration of the contract.

Analysis: The three fibres are identified asset because they are physically
distinct and explicity identified in the contract.
Case 2: Not physically distinct
The contract is not specifically identify the 3 fibres within the 15 fibres
comprising the cable. Instead, The contract requires Supplier Y to make
available to Customer X the equivalent capacity of 3 fibres all throughout the
duration of the contract, which could be any 3 of the 15 fibres. Supplier Y
decide which of 15 fibres will be used in transmitting Customer's X data.
Analysis: The three fibres are not identified asset because they are not
physical distinct. Moreover, the equivalent capacity of 3 fibres does not
represent substantially all of the capacity of the larger cable, which
consist of 15 cables.

Substantive Substitution rights

An asset is not identified asset if the supplier has the substantive right to
substitute it throughout the period of use.
A supplier right to substitute an asset is substantive if both of the
following exist:
a. The supplier has the practical ability to substitute alternative asset
throughout the period of use(For example, the customer cannot prevent the
supplier from substituting the asset and alternative asset are readily available
to the supplier or could be sourced by the supplier within a reasonable period
of time; and

b. The supplier would benefit economically from the exercise from its
right to substitute the asset (i.e, the economic benefit associated with
substituting the asset are expected to exceed the cost associated
substituting the asset).

A supplier's right to substitute an asset is not substantive if it

cannot be exercised throughout the period of use, such as when
subtitution is made:

a. Only on a particularly date or upon the occurence of a specified

events; or b. Only during repairs, maintenance or upgrading.
 A supplier's substituion right is presumed not substantive if it
is not readily determinable substantive.
Right to obtain economic benefit from use
A customer control the use of an identified asset if it has the right to obtain
substantially all of the economic benefits from the asset throughout the period
of use (For example, for having exclusive use of the asset throughout that
period).
Economic benefit include potential inflows from the asset's output,
which can be obtain directly or indirectly from using, holding or sub-leasing the
asset. When assesing the right to obtain substantially all of the economic
benefits from the use of an asset, an entity considers only the economic
benefits within the defined scope of its the right to use asset. For example, if a
contact limit the use of a motor vehicle within the specific territory or up to
specific mileage, the entity considers only in economic benefits from the asset
within that territory, or up to specified mileage, and not beyond.
A stipulation in a contract requiring to custome to pay additional
consideration based on a portion of a cash flows derived from use of an asset
(i.e, percentage of sales derived) does not prevent the customer from having
the right to obtain substantially all of the economic benefits from use of the
asset.
Right to direct the use
A customer has the right to direct the use of an identified asset throughout the
period of use if;
a. The customer has the right to direct how and for what purpose the asset
is use throughout the period of use; or
b. The asset's use predetermined and the supplier is precluded from
changing that predetermined use.

The following decision-making right may signify the existence

of the right to change how and for what purpose the asset used:

a. Right to change the type of output that is produced by the asset (For
example, to decide whether the use a shipping container to transport goods
or for storage, or decide to mix upon of product sold in a retail price);
b. Right to change when the output is produced (For example, to decide
when a machinery or a power plant will be used);
c. Right to change where the output is produced (For example, to decide
upon the destination of a truck or a ship, or to decide where an item
equiment is used); and d. Right to change whether the output is produced,
and the qunatity of that output (For example, to decide whether to produce
energy from the power plant and how much energy to produce from that
power plant).
Although essential for the efficient use of an asset, rights to
operate or maintain the asset do not necessarily grant the right to direct
how and for what purpose the asset is used. However, rights to operate an
asset may grant the customer the right to direct the use of the asset if the
relevant decision about how and what purpose the asset is used are
predetermined.

Protective rights
Protective rights include contractual restrictions designed to protect the
supplier's interest in the asset or its personnel, or to ensure the compliance
with laws or regulation.
.
For example, a contract may specify the maximum amount of use
of an asset or limit where or when the customer can use the asset, require a
customer to inform the supplier of changes on how an asset will be used.

Protective right typically define the scope of the customer's right

of use but do not, in isolation, prevent the customer from having the right
to direct the use of an asset.
Illustration 1: Identifying the lease
Customer X, engage in quarrying comstructions aggregate, enters into a
10-year contract with Supplier Z for the use of 20 dump truck of a
particular type. The contract specifies the following;

• Supplier Z remain remain the owner of the specified trucks and shall
provide drivers for their operation and technicians for repairs and
maintenance. • The truck are to be used for hauling excess materials from
 Customer's X mining site to any dumping site that customers X will specify.
Customer X can also use the truck to deliver construction aggregates to
customers. However customer X is prohibited from using the trucks to
transport toxic waste.
• Customer X operates 24/7 and 365 days a year. Thus, supplier Z is
to make all specified truck available at all times during the duration of the
contract. • The trucks are to be kept in customer X premises. If not in use, a
truck become idle. Supplier Z cannot retrieve any of the truck other than
for reason for default.
• If a truck needs to be serviced or repaired, Supplier Z is required to
provide a substitute truck of the same type.
Analysis:
The contract contains a lease because Customer X has the right to control
the use of an identified asset for a period of time. Thisis
evidenced by the following
a. The trucks are identified assets (explicitly specified in the contract) and
Customer X has the right to obtain substantially all of the economic
benefits from their use throughout the period of use (Customer X has
exclusive use of the trucks).

• Substitution rights: Supplier Z's substitution rights are not substantive

because substitution is made only during repairs and maintenance rather
than throughout the period of use.
• Customer X has the right to direct the use of the trucks because Customer X
makes relevant decisions on how and for what purpose the trucks are to be
used. Although Supplier Z control the drivers and the technicians this is
necessary only for the efficient use of the trucks and does not give Supplier Z
the right to direct how and for what purpose the trucks are used.

• Protective rights: The contractual restriction on the cargo that can be

transported by the trucks (toxic wastes) is a protective right of Supplier Z and
does not prevent Customer X from having the right to direct the use of the
trucks.
Illustration 2: ldentifying a lease
Customer X a seller of "siomai, enters into a contract with Supplier Y to use a
space in Supplier Y's mall to sell its goods. The contract states the amount of
space and that the space may be locate at any one of several areas within
the mall. Supplier Y has the right to change the location of the spare
allocated to Customer X at any time during the period of use. Changing the
space entails minimal cost to Supplier Y because Customer X uses a both
that its owns and can be moved easily. There are many areas in the mall
that are available and would meet the specification for the space in the
contract.

Analysis:
The contract does not contain a lease because there is no identified asset.
Customer X controls its booth but the contract is for space in the mall ,and this
space can change at the discretion or Supplier Y.
Supplier Y's substitution right is substantive because:
a. Supplier Y has the practical ability to substitute alternative spaces
throughout the period of use (i.e., Customer X cannot prevent Supplier Y from
substituting another space and an alternative space is readily available and
meets the specifications in the contract); and
b. Supplier Y would benefit economically from the exercise of its right to
substitute the space (i.e, substitution allows Supplier Y to make the most
effective use of mall space to meet changing circumstances and it entails minimal
cost as Customer X's booth can be moved easily).
Lease term
Lease term is "the non-cancellable period of a lease, together with
both; a. Periods covered by an option to extend the lease if the lessee is
reasonably certain to exercise that option; and
b. Periods covered by an option to terminate the lease if the lessee is
reasonbly certain not to exercise that option."

Non-cancellable period is the period in which the contract is enforceable. A

lease is no longer enforceable when each of the lessor and the lessee can
terminate the lease without permission from the other and subject only to
an insignificant penalty.
> If only the lessee has right to terminate the lease, the lessee considers
this right when determining the lease term (i.e, whether exercise is
reasonably certain or not).

> If only the lessor has the right to terminate a lease, the non-cancellable
period of the lease includes the period covered by the option to terminate
the lease.
In assessing whether a lessee is reasonably certain to exercise an option to
extend a lease, or not to exercise an option to terminate a lease, an entity
considers all relevant facts and circumtances that create an economic
incentive for the lessee to exercise the option to extend the lease, or not
to exercise the option to terminate the lease.
For example:
> The lessee may be reasonably certain to exercise an option to extend
the elase if:
• Lease payments on the extended period are expected to be below
market rate. • The lessee made significant leasehold improvement with
useful life longer than the original lease term.
> The lessee may be reasonably certain not to exercise an option to
terminate the lease if:
• The cost of terminating the lease(e.g., relocation costs) are
significant. • The leased asset is important to the lessee's operations
(e.g., because it is specialized in nature or because of its location and
would be difficult to find a replacement asset if the lease is
 terminated).
The shorter the non-cancellable period is the more likely that a lesser will
exercise its right to extend ( or not to exercise its right to terminate ) the
lease because the shorter the non-cancellable period is, the more likely
that the costs associated with obtaining a replacement asset would be
higher. The lease term begins at the commencement date and includes
any rent-free periods provided by the lessor to the lessee.
Illustration: Assessment of lease term - Option to extend
Extend X enters into a 3-year non-cancellable lease for an office space.
Upon expiration, Entity X has the option to extend the lease for another 3
years. Entity X determines the following at the commencement of the
lease.
• Entity X intends to make significant leasehold improvement with expected
useful life of 6 years.
• The lease payment on the extended period are equal to the lease
payments on the extended period are equal to the lease payments on the
original term of the lease, and therefore are expected to be below market
rate during the extended period, after consideration of the effects of
inflation.
• The office to Entity X. Entity X expects that an alternative office space in a
similar location would not be readily available at the end of the 3-year term
of the lease.
Analysis:
The lease term is 6 years, including the extension, it is reasonably certain
that Entity X will exercise the option to extend the lease. Each of the
additional information evidences an economic incentive for Customer X
exercise the option to extend the lease.
Accounting for lease by Lessee

Recognition
A lessee recognizes a lease and a right-of-use asset at the commencement date.

Initial measurement of Lease liability

The lease liability is initially measured at the present value of the lease
payments that are not yet paid as at the commencement date.

Lease payments include the following:

a. Fixed payments, including in-substance fixed payments, less any lease
incentives receivable;
b. Variable lease payments that depend on an index or a rate, initially
measured using the index or rate as at the commencement date;
c. Amounts expected to be payable by the lessee under residual value
guarantees; d. The exercise price of a purchase option if the lessee is
reasonably certain to exercise that option; and
e. Payments of penalties for terminating the lease, if the lease term
reflects the lessee exercising an option to terminate the lease.
Lease payments do not include:
i. Payment for non-lease elements (except when the entity elects to
apply the 'practical expedient')
ii. Payment in optional extension periods, unless the extension is
'reasonably certain'
iii. Future changes in variable payments that depend on an index or rate iv.
Variable payments linked to the lease's future sales or usage of the
underlying asset.

Discount rate
The lease payments are discounted using the interest rate implicit in the
lease. If that rate is not readily determinable, the lessee's incremental
borrowing rate is used.
The lessee's incremental borrowing rate is "the rate of interest
that a lessee would have to pay to borrow over a similar term, and with
similar value to the right-to-use asset in a similar economic environment."
Initial measurement of Right of use asset
The right-of-use asset is initially measured at cost. The cost
comprises the following:
a. The amount of the initial measurement of the lease liability;
b. Any lease payments made at or before the commencement date, less
any lease incentives received;
c. Any initial direct costs incurred by the lessee; and
d. The present value of any decommissioning and restoration costs for
which the entity has incurred an obligation, unless those costs are
incurred to produce inventories.

Subsequent measurement of Lease liability

The lease liability is subsequently measured similar to an amortized cost
financial liability (but remeasured to reflect any reassessment or lease
modifications). Accordingly:
• Interest on the lease liability is computed using the effective interest
method and recognized in profit or loss, unless in each period reflects a
constant periodic rate of interest on the remaining balance of the lease
liability.
• Lease payments are apportioned between the interest and a reduction
to the lease liability.
Subsequent measurement of the Right-of-use asset
The right-of-use asset is subsequently measured similar to a purchased asset.
Accordingly, the asset is subsequently measured under the cost model, except
when: a. It relates to a class of PPE that is measured under the revaluation
model, in which case, the asset may be measured under the revaluation
model.
b. It meets the definition of an investment property and the entity uses the fair
value model, in which case, the asset is measured under the fair value model.
Cost model
Under the cost model, the right-of-use asset is measured at cost:
a. Less any accumulated depreciation and any accumulated impairment
losses; and b. Adjusted for any remeasurement of the lease liability.
Depreciation
The lessee depreciates the underlying asset over its useful life if:
a. The contract provides for the transfer of ownership to the lessee by the end
of the lease term; or
b. There is a reasonable certainty that the lessee will exercise a purchase option.
In any other case, the lessee depreciates the underlying asset over the shorter of
the asset's useful life and the lease term. Depreciation starts from the
commencement date of the lease.
Illustration General recognition
On january 1, 20x1, Entity X 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 each year. The equipment has a
remaining useful life of 10 years. The interest rate implicit in the lease is
10%, while the lesser's incremental borrowing rate is 12%, Entity X uses
the straight-line method of depreciation.

> Initial measurement of Lease liability and Right-of-use asset

Fixed payments. 100,000 Multiply by: PV of an ordinary annuity of
P1 @10%, n=3 2.48685 Present value of lease payments 248,685
The entity to record the lease is as follows;
Jam 1. Right-of-use asset 248,685
20x1. Lease liability. 248,685
> Subsequent measurement - Lease liability
The lease liability is subsequently measured at amortized cost.

Amortized table:
Date Payments Interest Amortization Present value

1/1/x1 248,685

12/31/x1 100,000 24,869 75,131 173,554

12/31/x2 100,000 17,355 82,645 90,909
12/31/x3 100,000 9,091 90,909 0

> Subsequent measurement - Right-of-use asset

The right-of-use asset is subsequently measured under the cost model.
Because the lease contract neither provides for the transfer of ownership
to the lease nor a 'reasonably certain' purchase option, the asset will be
depreciated over the shorter of its useful life (10 yrs) and the lease term
(3years).
 The annual depreciation, using the straight line method, is computed as follow:

Cost. 248,685 Divide by: Lease term (shorter). 3 Annual depreciation.

82,895 The entrie on December 31,20x1 are as follows:
Dec. 31 Interest 24,869 100,000
20x1 expense Lease 75,132
liability
Cash
To record the
lease payment
and to recognize
interest expense
Dec. 31 Depreciation 82,895 82,895
20x1 expense
Right-of-use
asset
To record the
depreciation
expense

The entries in 20x2 and 20x3 continue in the same pattern.

Under PAS 17 (superseded), the lease described in the illustration above
would most likely be classified as an operating lease. In this case, the total
expense over the lease term is P300,000 (at an annual rent expense of
P100,000). Under PFRS 16, the total expense over the lease term (interest &
depreciation) is also P300,000 but this is "front-loaded" - meaning the
expense is higher in the early years. This results from recognizing interest at a
constant rate of return on the outstanding liability.

PFRS 16 (current standard) PAS 17 (old)

Year Interest Depreciation Total Rent expense

20x1 24,869 82,895 107,764 100,000

20x2 17,355 82,895 100,250 100,000

20x3 9,091 82,895 91,986 100,000

Total expense 300,000 300,000

Recognition exemptions
A lessee may elect not to apply the recognition requirements described
earlier (i.e, the recognition of a lease liability and a right-of-use asset) for:
a. Short-term leases; and
b. Leases for ehich the underlying asset is to low value.
 Short-term lease
A short-term lease is "a lease that, at the commencement date, has a
lease term of 12 months or less. A lease that contains a purchase option is
not a short-term lease."
The election for short-term leases is made based on the class
(i.e, grouping of asset with similar nature and use) of underlying asset
to ehich the right of use relates.
Journal Entry 20x1

Jan. 1
NO ENTRY

Dec. 31 Rent expense 10,000 4,000

20x1 (L.E.) Cash 6,000
Rent payable(S)

Dec. 31 Rent 10,000 12,000

20x2 expense(L.E.) 2,000
Rent payable(S)
Cash
Dec. 31 Rent 10,000 14,000
20x3 expense(L.E.) 4,000
 Rent payable(S)
Cash

Amortization table:
Date Payment Interest Amotization Present value
1/1/x1 340,183

1/1/x1 100,000 100,000 240,183

1/1/x2 100,000 28,822 71,178 169,005

1/1/x3 100,000 20,281 79,719 89,286
1/1/x4 100,000 10,714 89,286 0

20x1 Journal Entries

Jan. 1 20x1 liability Cash 240,193
Right of use asset Lease 340,193 100,000

Dec. 31 Dep. Expense 85,046 85,046

20x1 Right of use
asset
 Dec. 31 Interest 20,281 20,281
20x1 expense
Lease
liability

Residual fair value

It is the estimated amount that an entity would currently obtain from
disposal of an assets.
- A lessee accounts for the residual value of an underlying asset in the
measurement of the lessee liability only if the residual value is
guaranteed. - Residual value guarantee is a guarantee made to a lessor
by a party unrelated to the lessor that the value of an underlying asset at
the end of the lease will be at least a specified amount. As to the lessee,
a residual value is guaranteed if it is:
a. Guaranteed by the lessee
b. Guaranteed by the party related to the lessee.
- The amount expected to be payable under residual value guarantee is a
lessee includes in the lease payments, but if no payment is expected so it
is not expected to fall below to the guaranteed amount and it’s not
include in the lease
Reassessment of the lease liability
It is the treatment when any subsequent change in the amount expected to
be payable on the guaranteed, and an adjustment to the carrying amount of
the right of-use asset.
Right-of-use asset - to recognize adjustment resulting from the reassessment
of the lease liability.
> Traditional Method (Old Standard)
Under traditional accounting, the total guaranteed residual value is included
in the ‘minimum lease payments’ rather than only the amount expected to
be payable, also the concept of reassessment of the lease liability is not
observed.

Reasonably certain
Is when the exercise option of purchase option is included in the lease payments.

Initial Direct cost

Are incremental cost of obtaining a lease they would not have been
incurred if the lease had not been obtained except for such costs
incurred by a manufacturer or dealer lessor in connection with a finance
lease.
A lease capitalizes initial direct cost as follows:
General recognition, treat as a part of the cost of right-of-use asset
and include in depreciation. While the recognition exemption, treat
as prepaid rent and recognize as expense in a straight line basis.
 Notes:
• The insurance cost is not treated as separate component of the
contract because it does not transfer goods or services to the lessee.
• The asset is depreciated over its useful life because the lease
provides for a purchase option that is reasonably certain to be
exercised.
Security Deposit
- Another form of payment made to the lessor of before commencement
date is called security deposit.

- Security deposits are intended to compensate for any damages caused

to the leased property, if no damages is made to the leased property
the lessor will return the security deposit to the lessee by the end of the
leased term.

- Security deposits do not affect the lessee’s lease liability and right-of-use asset.

- The initial recognition of security deposit can result to a ‘Day 1 gain or

loss’, deposits to be applied as rental payments at the end of the lease
term are not security deposit but rather advance rent.
Reassessment of the lease liability.

- A lease will re measures the lease liability and adjust the right-of-use
asset if there are subsequent change to the lease payments. However,
if the carrying amount of the right-of-use asset is reduced to zero and
there is a further reduction, the excesses.
Adjustment is charged to profit or loss.
> The lease liability is re measured by discounting the revised lease
payments using a revised discount rate if there is a:
a. Change in the lease term- the revised lease payments are determined
based on the revised lease term. Changes in the certainty or uncertainty
of the lessee exercising an extension option or not exercising the
termination option, result to a change in the lease term.
b. Change in the assessment of a purchase option - the revised lease
payments shall reflect the change in the amount payable under the
purchase option. The revised discount rate is the interest rate implicit in
the lease for remainder of the lease term, if the rate cannot be
determined the revised discount rate is the lessee’s incremental
borrowing rate at the end of reassessment. > The lease liability is re
measured by discounting the revised lease payments using a unchanged
discount rate if there is a:
a. Change in the residual value guarantee- the revised lease payments
shall reflect the change in the amount expected to be payable under
residual value guarantee.
b. Change in future lease payments resulting from a change in an index or
a rate used to determined those payments- the revised lease payments
 shall reflect the change in the contractual cash flow resulting from the
occurrence of the specified event or conditions.
Lease Modification
- is the change in the scope of the lease or the consideration for a lease,
that was not part of the original term and condition of the lease.
Depending on its nature, a lease modification is accounted
for as a: a. Separate lease;or
b. Remeasurement of the existing lease liability and right-of-use asset.
Separate lease - A lease modification is accounted as a separate lease if
both the scope and consideration in the lease are increased due to the
addition of right to use one or more underlying assets and the increase in
the consideration reflects the stand alone price for the increase of scope.
Not a separate lease - a lease modification that does not result in separate
lease is accounted for as a remeasurement of the existing lease liability and
right-of-use assets.

Thank you very much