REVIEWER FOR SECOND YEARS
Definition of Terms
Bargain purchase option (BPO) - allowing the lessee to purchase the asset at the end of
the lease for a A clause in the lease agreement preset amount, significantly less than the
expected residual value at the end of the lease term.
Bargain renewal option - A lease provision that allows for renewal of the lease by the
lessee at significantly reduced lease payments from the original lease, will be renewed, The
bargain terms strongly imply that the lease
Commencement of the lease term - The date from which the lessee is entitled to exercise
its right to use the leased asset (paragraph 4, IAS 17)
Contingent rent - The portion of the lease payments that is not fixed in amount but is
based on the future amount of a factor that changes other than with the passage of time
(paragraph 4, 1AS 17). Discount on finance lease receivable - The excess of the lessor's
gross investment in the lease over its present value: also called unearned interest revenue.
Economic life of leased property - Either the period over which the asset is expected to
be economically usable by one or more users, or the number of production or similar units
expected to be obtained
from the leased asset by one or more users (paragraph 4, IAS 17).
Executory costs - Costs to maintain leased property such as repairs and maintenance,
insurance, and taxes, whether incurred by the lessor or lessee.
Fair value of leased property - The amount for which an asset could be exchanged
between knowledgeable, willing buyer and a knowledgeable, willing seller in an arm's
length transaction. When the lessor is a manufacturer or dealer, the fair value of the
property at the inception of the lease will ordinarily be its normal selling price, net of any
volume or trade discounts. When the lessor is not a manufacturer or dealer, the fair value
of the property at the inception of the lease will ordinarily be its cost to the lessor, unless a
significant amount of time has elapsed between the acquisition of the property by the
lessor and the inception of the lease, in which case fair value should be determined in light
of market conditions prevailing at the inception of the lease. Thus, fair value may be greater
or less than the lessor's coat or the carrying amount of the property.
Finance lease - A lease that transfers substantially all the risks and rewards associated
with the ownership of an asset. The risks to ownership of an asset include the possibilities
of loss from capacity or technological obsolescence, and that flowing f variations in return
due to changing economic conditions, incidental to ownership of an asset include an
expectation profitable operation over the asset's economic life and gain from appreciation
in value or the ultimate realization of Title may or may not eventually be transferred, the
lessee under finance lease arrangements. Also termed as capital lease.
Gross Investment in lease - The aggregate of the minimum payments’ receivable by the
lessor under a finance lease, and say unguaranteed residual value accruing to the lessor
(paragraph 4, IAS 17)
Guaranteed residual value - That part of the residual value of leased asset guaranteed by
the lessee or a third party related to the lessee.
Implicit interest rate - The discount rate that, at the inception of the lease, causes the
aggregate present value of the minimum leas payments and the unguaranteed residual
value to be equal to the sum of the fair value of the leased asset and any initial direct costs
of the lessor (paragraph 4, IAS 17).
Inception of the lease - The earlier of the date of the lease agreement and the date of
commitment by the parties to the principal provisions of the lease (paragraph 4, IAS 17).
Incremental borrowing rate - The rate of interest the lessee would have to pay on a
similar lease or, if that is not determinable, the rate that (at the inception of the lease) the
lessee would incur to borrow over a similar term, and with a similar security, the funds
necessary to purchase the asset (paragraph 4, IAS 17).
Initial direct costs - Commissions and legal fees incurred by lessors in negotiating and
arranging a lease. These generally include (1) costs to originate a lease incurred in
transactions with independent third parties that (a) result directly from and are essential to
acquire that lease and (b) would not have been incurred had that leasing transaction not
occurred; and (2) certain costs directly related to specified activities performed by the lessor
for that lease, such as evaluating the prospective lessee's financial condition; evaluating and
recording guarantees, collateral, and other security, arrangements: negotiating lease terms;
preparing and processing lease documents; and closing the transaction.
Lease - An agreement whereby the lessor conveys to the less in return for a payment or
series of payments the right to use an asset for an agreed period of time.
Lease Term - The non-cancelable 'period for which the lessee has contracted to lease the
asset, together with any further terms for which the lessee has the option to continue to lease
the asset, with or without further payment, when at the inception of the lease it is reasonably
certain that the lessee will exercise the option.
Lessee - The party using property that is owned by another party (lessor).
Lessor - owner of leased property who transfers the right to use the property to a second
party (lessee).
Minimum lease payments (MLP) - The payments over the lease term that the lessee is or
can be required to make, excluding contingent rent, coats for services and taxes to be paid
by and reimbursed to the lessor, together with (a) for a lessen, any amounts guaranteed by
the lessee or by a party related to the lessee; or (b) for a lessor, any residual value guaranteed
to the lessor.
Net Investment in the lease - The difference between the lessor's gross investment in the
lease and the unearned finance income. In effect, this is the present value of the finance lease
receivable.
Non-cancellable lease - A lease that is cancelable only (a) upon the occurrence of some
remote contingency; (b) with the permission of the lessor; (c) if the lessee enters into a new
lease for the same or an equivalent asset with the same lessor; or (d) upon payment by the
of such an additional amount that, at inception of the makes the continuation of the lease
reasonably certain (paragraph 4, IAS 17).
Operating lease - A lease other than a finance lease.
Residual value of leased property - The fair value, estimated at the inception of the lease,
that the enterprise expects to obtain from the leased property at the end of the lease term.
Sale and leaseback - A transaction where the owner of the asset sells the asset and
immediate leases the asset from the buyer.
Unguaranteed residual value - That portion of the residual value of the asset, the
realization of which is not assured by the lessee or is guaranteed solely by a party related to
the lessee (paragraph 4, IAS 17).
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
Summary of Lease Accounting
A lease is an agreement whereby the lessor conveys in the less in return for a payment
or series of payments the right to use an asset for an agreed period of time.
When the lease transfers substantially all the risks and rewards of ownership to the
lessee, the lease is a finance lease. When the lease does not transfer substantially all
the risks and rewards of ownership to the lessee, the lease is an operating income.
The risks and rewards common to ownership of the asset are substantially
transferred to the lessee when the lease is non cancelable and any one of the following
indicators in zne: title passes to the lessee at the end of the lease term: there in bargain
purchase "option such that at the inception of the lease, it is reasonably certain that
the lessee will exercise its purchase option; the lease term is for the major part of the
economic life of the asset; the present value of the minimum lease payments amounts
to at least substantially all of the fair value of the leased asset; and the leased asset is
so special in nature that only the lessee can use it without major modification.
Lease classification is made at the inception of the lease. operating lease is accounted
by both the lessor and the lessee as a simple rental agreement. The lessee and the
lessor recognize the total of the minimum lease payment as rent expense and rent
income, respectively, over the lease term using the straight-line method, unless
another systematic basis is more presentative of the time pattern in which use benefit
derived from the asset is received. Contingent rents are recognized by lessee and
lessor in profit or loss in the period to which they relate. The lessor recognizes in its
statement of financial position the leased asset. Initial direct costs incurred by the
lessor shall be added to the carrying amount of the leased asset and recognized as
expense over the lease term on the same basis as lease income.

When the lease qualifies as finance lease, the lessee recognizes an asset, and a liability
at the lower amount of the fair value of the leased asset or the present value of the
minimum lease payments. The lessee's minimum lease payments include the periodic
payment plus any payment that may be required for bargain purchase option or
guaranteed residual value. The lessee shall discount the minimum lease payment
using the lessor's implicit rate. If the lessor's implicit cannot be determined, the lessee
shall use its incremental borrowing rate. The lessee shall follow its normal
depreciation policy rate to depreciate the leased asset if there is expected passage of
title; otherwise, guaranteed residual value is deducted from depreciable base and the
asset in depreciated over the lease term (which normally does not exceed the asset's
useful life).

From the point of view of the lessor, the gross investment in lease (which is the
undiscounted amount receivable on account of the finance lease) includes the
periodic payments, the bargain option price and the asset's residual value at the end
of the lease term, whether guaranteed or unguaranteed. The difference between gross
investment in lease and the adjusted balance of discount on finance lease receivable
is called the net investment in lease, which is the amortized cost of the receivable.

The lessor records finance lease either as a direct financing lease or dealer's lease or
manufacturer's lease. Generally, a finance lease is a direct financing lease if the lessor
is a financing company. At the date of lease inception, the fair value of the property
approximately equals the carrying value of the asset and equals the present value of
the minimum lease payment. The difference between the gross investment in lease
and the fair value of the property, which approximates its carrying value, is
recognized as discount on finance lease receivable. The discount on finance lease
receivable is allocated as interest revenue over the lease term using the effective
interest method. Initial direct cost incurred by the lessor increases the net investment
in lease and decreases the yield earned by the lessor.

If the present value of the minimum lease payments plus, if any, the present value of
the unguaranteed residual value (which is the fair value of the property at inception)
exceeds the carrying amount of the leased asset, a profit exists in the transaction. The
lease is a dealer's lease or manufacturer's lease, and the lessor uses the arrangement
as a means of selling its inventory. The lease is recorded as a sale and the cost of the
property is recorded as cost of sales. Any guaranteed residual value is added to the
gross investment in lease, while the present value of the guaranteed residual value is
included in the recorded sales. Any unguaranteed residual value also increases the
gross investment in lease and its present value is deducted from cost of sales. The
gross profit on dealer's lease a manufacturer's lease is recognized on date of
commencement, the discount on finance lease receivable is allocated over the lease
using the effective interest method. Cost incurred to consummate the lease contract
is recorded as an expense in the initial period of lease.

A sale and leaseback involves selling an asset and immediately leasing the asset from
the buyer. If a sale and leaseback results in a any finance lease, any excess of the sales
proceeds over the carrying amount of the asset shall be deferred and amortized over
the lease term. If a sale and leaseback results in an operating lease, and it is clear that
the sales price is at fair value, any profit or loss shall be recognized immediately. If
the sales price is below fair value, profit or loss shall be recognized immediately,
except that if the loss is compensated by lower future rental; in which case, the loss
shall be deferred and amortized over the period in which the asset is expected to be
used. If the sales price is above fair value, the excess over fair value is deferred and
amortized over the period for which the asset is to be used.

A lease on land is classified as finance lease when there is reasonable certainty that
title will be transferred to the lessee at the end of the lease term, that is, if that is so
provided in the lease contract or there is bargain purchase option. A combined lease
on land and building has to be split into the land component and building component,
generally based on fair value of the lease interest of each component. If the minimum
lease payment cannot be allocated between land and building, the whole lease
contract is treated as lease on building.
Comprehensive Problems
Problem 1 (Level – Medium) (AICPA Adapted)
Robbin Company leased a machine with remaining useful life of 14 years from Ready
Leasing Company. The lease required 10 annual payments of P1,000,000 beginning
immediately. The lease specified an interest rate of 12% and a purchase option of P900,000
at the end of the tenth year. The lessee is reasonably certain to exercise the purchase
option.
Present value of an annuity due (in advance) of 1 at 12% for 10 periods - 6.328
Present value of 1 at 12% for 10 periods - 0.322
1. What amount should be recorded initially as cost of the right of use asset?
a. 6,617,800
b. 7,328,000
c. 6,650,000
d. 5,650,000
2. What amount should be reported as annual depreciation of the right of use asset?
a. 665,000
b. 475,000
c. 632,800
d. 472,700
Question 1 Answer A
Present value of rentals (1,000,000 x 6.328)
= 6,328,000
Present value of purchase option (900,000 x .322)
= 289,800
Total cost of right of use asset and lease liability
6,617,800
Question 2 Answer D
Annual depreciation (6,617,800/14 years)
= 472,700
Problem 11-2 (IFRS)
At the beginning of current year, Panorama Company leased a building from a lessor with
the following pertinent information:
Annual rental payable at the end of each
year
Initial direct cost paid
Lease incentive received
Leasehold improvement
Purchase option that is reasonably certain
to be exercised
7,000,000
Lease term
Useful life of building
5 years
8 years
600,000
100,000
200,000
1,000,000
Implicit interest rate
PV of an ordinary annuity of 1 for 5 periods
at 10%
10%
3.79
Present value of 1 for 5 periods at 10%
0.62
1. What is the cost of the right of use asset?
a. 24,300,000
b. 26,580,000
c. 27,650,000
d. 27,150,000
2. What is the depreciation for current year?
a. 3,456,250
b. 3,500,250
c. 3,457,250
d. 3,455,250
3. What is the interest expense for current year?
a. 3,715,165
b. 2,705,000
c. 2,715,000
d. 2,715,600
4. What is the lease liability at year-end?
a. 22,865,000
b. 22,665,000
c. 4,285,000
d. 4,185,000
Solution 11-2
Question 1 Answer C
Present value of annual rental (7,000,000 x 3.79)
Present value of purchase option (1,000,000 x .62)
Initial lease liability
26,530,000
620,000
27,150,000*
Initial direct cost
600,000
Lease incentive received
(100,000)
Cost of right of use asset
27,650,000**
Reason:
The leasehold improvement is not part of the cost of right use asset but accounted for
separately as property, plant and equipment.
Question 2 Answer A
Depreciation (27,650,000**/ 8 years)
= 3,456,250
The depreciation is based on the useful life of the underlying asset because there is a purchase
option that is reasonably certain to be exercised.
Question 3 Answer C
Interest expense for current year (10% x 27,150,000*)
2,715,000***
=
Question 4 Answer a
Annual rental
Applicable to interest
7,000,000
(2,715,000)***
Applicable to principal
4,285,000
Lease liability-January 1
Principal payment
Lease liability-December 31
27,150,000*
(4,285,000)
22,865,000
Problem 3 (Level – Medium)
Trojan Company prepared the following lease payments schedule for the lease of a machine
from another entity. The machine had an economic life of six years. The lease agreement
required four annual payments of P33,000 and the machine will be returned to the lessor
at the end of the lease term.
July. 01, 2019
July. 01, 2020
July. 01, 2021
July. 01, 2022
July. 01, 2023
Lease
Payment
Interest
Expense
Reduction of
Liability
30,000
30,000
30,000
35,000
125,000
9,851
7,836,
5,620
3,181
26,488
20,149
22,164
24,380
31,819
98,512
Balance of
Liability
98,512
78,363
56,199
31,819
-
1. What is the amount of executory cost?
a 3,000
b. 5,000
c. 4,000
d. 0
2. What is the residual value guarantee?
a. 8,000
b. 5,000
c. 4,500
d. 0
3. On June 30, 2020, what would Trojan Company record in relation to the lease?
a. An interest expense of P9,851
b. An interest expense of nil
c. An interest payable of P9,851 d. An interest payable of P7,836
4. What is the annual depreciation expense?
a. 24,628
b. 16,419
c. 15,585
d. 23,378
Solutions
Question 1 Answer a
Annual payment
Lease payment
Executory cost
33,000
(30,000)
3,000
Question 2 Answer b
Total payment on July 1,2023
Lease payment
Residual value guarantee
35,000
(30,000)
5,000
Question 3 Answer C
There is an accrued interest of P9,851 from July 1, 2019 to June 30, 2020 to be paid on
July 1, 2020.
The best answer is interest payable rather than interest expense because the question
is on June 30, 2020, rather than for the year 2020.
Question 4 Answer D
Cost of right of use asset
Residual value guarantee
Depreciable amount
Annual depreciation (93,512/4 years)
98,512
(5,000)
93,512
23,378
The lease term of 4 years is used in computing depreciation because the machine will
be to the lessor at the end of the lease term.
Problem 4 (Level – Difficult)
On January 1, Yoga Company leased machine with the following information:
Annual rental payable at the end of each
year
Lease Term
Implicit rate in Lease
Present value of an ordinary annuity of 1 at
6% for 5 periods.
100,000
5 years
6%
4.2124
On January 1, the lessee and the lessor agreed to amend the original terms of the lease by
reducing the lease payment by P20,000 and increasing the implicit rate to 8%.
1. What amount should be reported as lease liability on December 31, 2022 before the
modification?
a. 421,240
b. 346,514
c. 267,305
d. 206,168
2. What amount should be reported as modified lease liability on January 1, 2023?
a. 206,168
b. 240,000
c. 200,000
d. 257,710
3. What amount should be reported as interest expense for 2023?
a. 16,493
b. 12,370
c. 21,384
d. 12,800
4. What amount should be reported as depreciation of the right of use assist for 2023?
a. 84,248
b. 50,549
c. 63,869
d. 89,102
Solutions:
Question 1 Answer C
Date
January 1,2021
December 31,
2021
December 31,
2022
Payment
6% Interest
Principal
100,000
25,274
74,726
Lease liability
421,240
346,514
100,000
20,791
79,209
267,305
Question 2 Answer A
Modified lease liability-January 1, 2023 (80,000 x 2.5771*)
= 206,168
*( Calculated using the Present Value of ordinary annuity of 1 for 3 periods)
Question 3 Answer A
Interest expense for 2023 (8% x 206,168)
= 16.493
Question 4 Answer c
Modified lease liability
Carrying amount of lease liability on January 1, 2023
Decrease in lease liability
206,168
267,305
(61,137)
Cost of right of use asset
Accumulated depreciation - January 1, 2023
((421,240/5)*2)
Carrying amount-January 1, 2021
Decrease in lease liability
Adjusted carrying amount
Depreciation for 2021 (191,607/3)
421,240
(168,496)
252,744
(61,137)
191,607
63.869
Problem 5 (Level – Difficult)
On January 1, 2021, Milan Company entered into a lease agreement with the following
information:
Floor space
Annual rental payable at the end of each
year
Implicit rate in the lease
Lease term
Present value of an ordinary annuity at
12% for 12 periods
1,500 square meters
200,000
12%
12 years
6.1944
On January 1, 2024, the lessee and the lessor agreed to amend the original terms of the
lease with the following information:
Additional floor space
Increase in rental payable at the end of
each year
Implicit rate in the lease
2,000 square meters
300,000
10%
1. What amount should be reported as lease liability on January 1, 2019?
a. 1,238,880
b. 1,151,800
c. 3,097,200
d. 1,727,700
2. What amount should be reported as additional lease liability on January 1, 2022?
a. 1,151,800
b. 2,879,500
c. 1,727,700
d. 2,700,000
3. What amount should be reported as total interest expense for 2022?
a. 300,649
b. 172,770
c. 207,324
d. 335,203
Solutions:
Question 1 Answer A
Lease liability - January 1, 2021 (200,000 x 6.1944)
= 1,238,880
Question 2 Answer C
Additional lease liability - January 1, 2024 (300,000 x 5.759 ( Calculated using the present
value of an ordinary annuity of I at 10% for 9 periods))
= 1,727,700
IFRS 16, paragraph 44, provides that the lessee shall account for the lease modification as a
separate lease under the following conditions: (a) The modification increases the scope of
the lease by adding the right to use one or more underlying asset; and (b) The rental
increases by an amount commensurate with the increase in scope and equivalent to the
current market rent.
Question 3 Answer a
ORIGINAL LEASE LIABILITY
Date
January. 01,
2021
December. 31,
2021
December. 31,
2022
December. 31,
2023
December. 31,
2024
Payment
12% Interest
Principal
Lease liability
1,238,880
200,000
148,666
51,334
1,187,546
200,000
142,505
57,495
1,130,051
200,000
135,606
64,394
1,065,657
200,000
127,879
72,121
993,536
ADDITIONAL LEASE LIABILITY
Date
Payment
10% Interest
Principal
Present value
January. 01,
2024
December. 31, 300,000
2024
1,727,700
172,770
127,230
Interest on old lease liability.
127,879
Interest on additional lease liability
172,770
Total interest expense for 2022
300,649
1,600,470.
THEORIES FOR FINANCE LEASE
Finance Lease
Initial measurement
A lessor recognizes an asset from a finance lease as receivable measured at an amount equal to
the net investment in the lease Under a finance lease, the lessor transfers substantially all the
risks and rewards incidental to ownership over the leased asset to the lessee. Thus, the lessor
derecognizes the leased asset and recognizes a finance lease receivable. The receivable is
treated as repayment of principal and finance income to reimburse and reward the lessor for
its investment and services
Gross investment in the lease (gross lease receivable)- "the sum of:
a. the lease payments receivable by the lessor under a finance lease, and
b. any unguaranteed residual value accruing to the lessor."
Net investment in the lease (net lease receivable) - "the gross investment in the lease
discounted at the interest rate implicit in the lease."
Unearned finance income (unearned interest income) - "the difference between:
a. the gross investment in the lease, and;
b. the net investment in the lease."
Lease payments Lease payments include the following
a Fixed payment, including in-substance fixed payments, any lease incentives payable
b. Variable lease payments that depend on an index or an initially measured using the index or
rate AT commencement date,
c. Guaranteed residual value;
d. The exercise price of a purchase option if the lesser is reasonably certain to exercise that
option; and
e. Payments of penalties for terminating the lease, if the lea term reflects the lessee exercising
an option to terminate the lease. (PFRS 16, 70)
Discount rate
The net investment is measured using the interest rate implicit the lease. In the case of a
sublease, if the interest rate implicit in the sublease cannot be readily determined, an
intermediate lesser may use the discount rate used for the head lease (adjusted for any initial
direct costs associated with the sublease) to measure the net investment in the sublease.
SUBSEQUENT MEASUREMENT
The net investment in the lease (net lease receivable) is subsequently measured similar to an
amortized cost financial asset Accordingly Finance Income (interest income) is computed using
the effective interest method and recognized in profit or lo Interest in each period reflects a
constant periodic rate of return on the lessor's net investment in the lease. Lease payments are
applied against the gross investment in the lease to reduce both the principal and the unearned
finance income.
Any of the following will lead to a finance lease classification.
1. Transfer of ownership
2. Bargain purchase option (BPO)
3. Lease term is at least 75% of the useful life of the leased asset.
4. Present value of minimum lease payments is at least 90% of the fair value of the leased asset
at the inception date.
5. Leased asset is of specialized nature
Gross investment = Lease payments + Unguaranteed residual value
Lease payments comprise the following:
1. Fixed lease payments, including in-substance, less lease incentives payable
2. Variable lease payments based on index or rate
3. Guaranteed residual value
4. Exercise price of purchase option, if reasonably certain
5. Termination penalty, if reasonably certain
Net investment Present value of Gross investment of (PV of lease payments + PV of
Unguaranteed residual value)
INITIAL DIRECT COSTS
Initial direct costs, other than those incurred by manufacturer or dealer lessors, are included
in the initial measurement of the net investment in the lease and reduce the amount of
income recognized over the lease term.
internal costs that are incremental and directly attributable to Initial direct costs include
commissions, legal fees and negotiating and arranging a lease. They exclude general
Overheads (sales and marketing team).
The interest rate implicit in the lease is defined in such way that the initial direct costs are
included automatically in the net investment in the lease; there is no need to add the
separately.
Interest rate implicit in the lease- the rate of interest that cause 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.
PV of lease payments + PV of Unguaranteed residual value = Fair value of underlying
asset + Initial direct costs
Initial direct costs - incremental costs of obtaining a lease that would not have been incurred
if the lease had not beer obtained, except for such costs incurred by a manufacturer or dealer
lessor in connection with a finance lease.
Direct costs incurred by a manufacturer or dealer lessor are excluded from the definition of
initial direct costs and therefore, are expensed immediately.
Initial direct costs are capitalized except direct costs incurred by a manufacturer or dealer
lessor under a sales type lease, which are expensed immediately.
CLASSIFICATION OF FINANCE LEASE BY THE LESSOR
A lessor classifies a finance lease as either:
a. Direct financing lease; or
b. Sales type lease
Direct financing lease
Under a direct financing lease, a lessor acquires assets and leases them with the intention of
generating income through interest. The lessor is neither the manufacturer nor a dealer of the
asset being leased. The previous illustrations pertain to direct financing lease.
Sales revenue-measured at the lower of the (a) present value of lease payments, discounted
using a market rate of interest, and the (b) fair value of the asset;
Cost of sale- equal to the cost, or carrying amount if different, of the underlying asset less the
present value of the unguaranteed residual value; and Gross profit- the difference between
revenue and cost of sale
Costs incurred in connection with obtaining a sales type finance lease are recognized
immediately as expense. Such costs are excluded from the definition of initial direct costs, and
therefore are excluded from the measurement of the net investment in the lease.
Problem 1 ( Level – Easy)
At the beginning of current year, Yolk Company signed a ten-year noncancelable lease
agreement to lease a storage building to a lessee under a sales type lease. The agreement
required equal rental payments at the end of each year.
The fair value of the building is P5,535,000. However, the carrying amount of the building
is P4,460,000.
The building has an estimated economic life of 10 years with no residual value. At the
termination of the lease, the title to the building will be transferred to the lessee.
Yolk Company set the annual rental to insure a 10% rate of return. The implicit rate of the
lessor is known by the lessee. The annual total lease payment included P130,667 of
executory cost related to taxes on the property.
1. What is the minimum annual lease payment?
a. 850,000
b. 900,000
c. 500,000
d. 600,000
2. What is the total annual lease payment?
a. 500,667
b. 1,070,333
c. 1,030,667
d. 600,667
Solution 16-8
Question 1 Answer B
Fair value of building
Divide by PV of an ordinary annuity of 1 at
10% for ten periods
Minimum annual lease payment
5,535,000
6.15
900,000
* The present value of an ordinary annuity of 1 at 10% for 10 periods is 6.15.
Question 2 Answer d
Minimum annual lease payment
Exectory cost
Total annual lease payment
900,000
130,667
1,030,667
Problem 2 (Level – Easy)
The Morena Company made the decision to get into leasing. The business paid P2,300,000
for a specialized packing machine. On January 1, 2019, the entity leased the machine
through direct financing for a term of six years, after which the lessee would become the
legal owner of the equipment.
The first of the six yearly lease payments, which are due on January 1 of each year, was
made on that day in 2019. The machine has a residual value of P200,000. The lease is
structured so that Morena Company will receive a 12% return..
What is the annual lease rental payable in advance required to yield the desired return?
Round off the rates by two 3 decimal places.
a. 500,000
b. 477,826
c. 383.333
d. 460,000
Solutions:
Answer: D
Cost of asset
2,116,000
Divide by PV of an annuity in advance of 1
4.60*
at 12% for six periods
Annual lease payment
460,000
*The present value of an annuity in advance of 1 at 12% for six periods is 4.60.
The residual value is ignored because title is transferred to the lessee at the end of
lease term.
Problem 3 (Level – Medium)
Romano Company is in the business of leasing new sophisticated equipment.
As lessor, the entity expects a 12% return. At the end of the lease term, the
equipment will revert to Kobid Company. On January 1, 2020 an equipment is leased to
another entity under a direct financing lease.
Cost of equipment to Kobid
Residual value-unguaranteed
Annual rental payable in advance
Useful life and lease term
Implicit interest rate
First lease payment
5,500,000
400,000
959,500
8 years
12%
January. 01, 2020
1.What is the gross investment in the lease?
a. 7,084,000
b. 9,088,000
c. 8,088,000
d. 8,076,000
2. What is the unearned interest income (total financial revenue) on January 1, 2020?
a. 2,556,000
b. 2,576,000
c. 2,565,000
d. 3,176,000
3. What is the interest income for 2020?
a. 544,360
b. 544,890
c. 544,750
d. None of the above
Solutions:
1. Answer: D
Gross rentals (959,500 x 8)
Residual value
Gross investment
7,676,000
400,000
8,076,000
2. Answer: B
Gross investment
Net investment-equal to the cost of
equipment
Unearned interest income
8,076,000
(5,500,000)
2,576,000
3. Answer: D
PV of rentals
1st payment on January 1, 2020
Lease receivable-January 1, 2020
5,500,000
(959,500)
4,540,500
Interest income for 2020 (4,540,500 x 12%) = 544,860
Problem 4 (Level – Easy)
Manjean Co. leased equipment to Kunrad Corp. on January 2, year 1, for an eight-year period
expiring December 31, year 8. Equal payments under the lease are 600,000 and are due
annually on January 2. On January 2 of the first year, the initial payment was made. The
equipment has a list selling price of 3,520,000 and a carrying cost on Manjean's books of
$2,950,000. The contract is correctly recorded as a sales-type lease. At an imputed interest
rate of 12% (Manjean's incremental borrowing rate), the present value of the lease payments
is $3,145,000. What percentage of the sale's earnings should Howe disclose for the fiscal year
that concluded on December 31st?
A. 720,000
B. 500,000
C. 90,000
D. None of the Above
Answer: D
Present value of lease payments
3,145,000
Carrying cost
(2,950,000)
195,000
Profit on sale
The excess of the present value of the selling price over its cost is recorded as profit.
COMPOUND FINANCIAL INSTRUMENTS
A compound financial instrument is a financial instrument that, from the issuer's
perspective, contains both a liability and an equity component. These components are
classified and accounted for separately.
An example of a compound instrument is convertible bonds.
Convertible bonds are bonds that can be converted into shares of stocks of the issuer. When
an entity issues convertible bonds, in effect, it is issuing two instruments - (1) a debt
instrument for the bonds payable and (2) an equity instrument for the equity conversion
feature. These two components are presented separately in the statement of financial
position.
Equity is defined as a residual amount. Therefore, to separate the debt and equity
components of a compound instrument, entity simply deducts from the fair value of the
whole instrument the fair value of the debt component without the equity feature; the
remaining amount represents the equity component. This procedure follows the basic
accounting equation.
Assets
Cash proceeds
from issuance
of compound
instrument
Less
Liabilities
Fair value of
debt
component
without
the
equity feature
=
equals
Equity
Equity
component
Note!
The sum of the carrying amounts allocated to the and equity components is always equal to
the fair value of the whole instrument. No gain or loss is recognized recognition on the initial
of the components.
The separate classifications of the components are not revised for subsequent changes in the
likelihood that the conversion option will be exercised.
Additional Notes
The conversion of the bonds is accounted for as equity set-off, meaning, the carrying amount
of the bonds is simply derecognized, the aggregate par value of the shares issued is credited
to "Share capital" and the difference is credited to "Share premium." No gain or loss is
recognized on the conversion.
The share issuance costs are treated as reduction to share premium.
The "share premium-conversion feature" is closed to the "share premium" general account
because all of the conversion privilege has been exercised.
Prior to the conversion of the bonds, the "share premium conversion feature" is part of share
premium but described as pertaining to the conversion feature. When the conversion feature
is exercised, such amount is just reclassified within equity (i.e., from one share premium
account to another share premium account).
The conversion increased equity by the carrying amount of the bonds on conversion date
less the transaction costs incurred, on the conversion.
Other Examples
Partial conversion - When only some, but not all, of the bonds are converted, only the
portion of the bonds that were converted is derecognized. Also, only the portion of the "Share
premium-conversion feature" pertaining to the converted bonds is transferred within
equity.
Conversion between interest payment dates - When bonds are converted between
interest payment dates, the accrued interest is usually settled separately in cash. Thus, only
the carrying amount of the bonds is accounted for when applying the equity set-off method.
The equity component is closed to the "share premium" general account because the
conversion feature is forfeited by the retirement of the bonds.
The equity component remains in equity whether the conversion feature is exercised or not.
However, it is reduced by any allocated retirement price.
Other scenarios:
Partial retirement - When only a portion of the bonds is retired, only that portion is
derecognized. Accordingly, the gain or loss is computed only on that portion. Also, only a
portion of the "Share premium conversion feature" is transferred within equity.
Bonds with share warrants
To improve salability, bonds are sometimes issued with share warrants. A share warrant
entitles the holder to purchase shares of stocks of the issuer at a fixed price. Generally, the
life of the warrants is 5 years, occasionally 10 years, and very occasionally an entity may
offer perpetual warrants.
Share warrants attached to bonds may be "detachable" or "non-detachable." A detachable
share warrant can be detached (separated) from the bond and traded as a separate security.
A non-detachable warrant cannot be sold separately from the bond.
Bonds issued with share warrants, whether detachable or not, are compound financial
instruments and are accounted for similar to convertible bonds. However, unlike convertible
bonds, the exercise of share warrants does not extinguish the bonds.
Problem 1 (Level – Easy)
Young Company issued 5,000 convertible bonds at the beginning of the current year. The
bonds had a four-year term with a stated rate of interest of 6%, and were issued at par with
a face amount of P1,000 per bond. Interest is payable annually on December 31. Each bond
is convertible into 50 ordinary shares with a par value of P10. The market rate of interest
on similar nonconvertible bond is 9% At the issuance date, the amount of P485,000 was
credited to share premium from conversion privilege. The bonds were not converted and
instead, the entity paid off the convertible bondholders at maturity What amount should be
recorded as gain or loss on the full payment of the convertible bonds at maturity?
a. 300,000 gain
b. 485,000 loss
c. 485,000 gain
d. None of the above
Solution:
Answer D
Account Titles and Explanation
To record the issuance of the convertible bonds:
DEBIT
Cash
5,000,000
CREDIT
485,000
Discount on bonds
payable
Bonds payable
Share premiumconversion privilege
5,000,000
485,000
To record the settlement of the convertible bonds at maturity date:
Bonds payable
5,000,000
Interest expense
(6% x 5,000,000)
300,000
Cash
Share premiumconversion privilege
Share premiumconversion privilege
Share premium-Issuance
5,300,000
485,000
485,000
Problem 2 (Level – Easy)
At year-end, Fort Company issued 5,000 8%, 10-year bonds, P1,000 face amount with
detachable share warrants at 110. Each bond carried a detachable warrant for ten ordinary
shares of Fort Company at a specified option price of P25 per share. The par value of the
ordinary share is P20.
Immediately after issuance, the market value of the bonds without the warrants was
P5,400,000 and the market value of the warrants was P600,000.
What is the carrying amount of bonds payable at year-end?
a. 5,000,000
b. 4,950,000
c. 4,900,000
d. 5,400,000
Solutions:
Answer D
Issue price of bonds payable IS equal to market value without the warrants
= 5,400,000
The issue of bonds payable with share warrants is accounted for as a compound financial
instrument.
Share warrants attached to a bond may be detachable or nondetachable.
Detachable warrants can be traded separately from the bond and nondetachable warrants
cannot be traded separately.
Problem 3 (Level – Medium)
On December 31, 2022, Green Company issued 3,000 convertible bonds with a nominal
interest rate of 7% at P3,000 each. Each bond can be converted into 5 new equity shares or
redeemed for cash, at the option of the holder, in 5 years’ time. The fair value of the date of
similar bonds without the convertibility option was estimated at P1,600 each. What is the
amount recognized in equity in respect of the issuance of convertible bonds on December
31, 2022?
A. 4,500,000
B. 5,600,000
C. 4,600,000
D. None of the above
Solution:
Answer: A
Issue price (4,000 x P3,000)
Fair value of bonds without option ( 4,000 x P1,600)
Equity component
12,000,000
6,400,000
5,600,000
Problem 4 (Level – Medium)
Kristie Company issued P5,000,000 face value 12% convertible bonds at 120 on January 1,
2022, maturing on January 1, 2027 and paying interest semiannually on January 1 and July
1. It is estimated that would sell only at 103 without the conversion feature. Each P1,000
bond is convertible into 10 ordinary shares with P100 par value. What is the increase in the
shareholders’ equity arising from the issuance of the convertible bonds on January 1, 2022?
a. 850,000
b. 500,000
c. 150,000
d. None of the Above
Solutions:
Answer: A
The issue of convertible bonds payable is also accounted for as a compound financial
instrument.
Accordingly, PAS 32, paragraph 29, mandates that the original issuance of convertible
bonds payable
shall be accounted for as partly liability and partly equity. The liability component is
equal to the market value of the bonds without the conversion privilege. The equity
component is the remainder or residual of the issue price of the bonds with conversion
privilege.
Issue price of bonds with conversion privilege (5,000,000 x 1.20)
6,000,000
Market value of the bonds without conversion privilege
(5,000,000 x 1.03)
Residual amount allocated to conversion privilege
5,150,000
850,000
Problem 5 (Level – Medium)
At year-end, Guadalupe Company issued 6,000 of 9%, 10-year, P1,000 face value bonds
with detachable share warrants at 110. Each bond carried a detachable warrant for ten
ordinary shares of Fort Company at a specified option price of P25 per share. The par value
of the ordinary share is P20.
Immediately after issuance, the market value of the bonds without the warrants was
5,950,000 and the market value of the warrants was P500,000.
a. 5,000,000
b. 5,950,000
c. 4,600,000
d. 6,400,000
Solution:
Answer: B
Issue price of bonds payable IS equal to market value without warrants
5,950,000
=