Leases ( Lease Accounting FOR Lessee & Lessor) PDF

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COURSE FAR 3: INTERMEDIATE ACCOUNTING IIIDEVELOPER AND THEIRBACKGROUNDThis module is prepared by Mr. Jerry D. Mariano. He is a faculty member of Tarlac State University College of Business and Accountancy-Accountancy Department. He is a Certified Public Accountant. He teaches financial accounting an...

Description

COURSE DEVELOPER AND THEIR BACKGROUND

COURSE DESCRIPTION

COURSE OUTLINE

CHAPTER # TITLE RATIONALE

INSTRUCTION TO THE USERS

PRE-TEST LEARNING OBJECTIVES

CONTENT PREPARATORY ACTIVITIES

FAR 3: INTERMEDIATE ACCOUNTING III This module is prepared by Mr. Jerry D. Mariano. He is a faculty member of Tarlac State University College of Business and Accountancy-Accountancy Department. He is a Certified Public Accountant. He teaches financial accounting and tax courses. This course is the culmination of financial accounting courses. This will cover constructive accounting and special topics in financial accounting. This course shall thoroughly cover recognition, measurement and valuation, presentation and disclosure requirements for special topics such as leases, accounting for income tax, employee benefits (post-employment benefits) and share-based compensation. 5. Leases (Lease Accounting for Lessee& Lessor) 6. Operating Segment, Interim Financial Reporting and Events after reporting period 7. Cash and Accrual Basis and Single Entry 8. Statement of Cash Flows 9. Applicability and Salient Differences from PFRS of SMES, small entities and reporting for microenterprises 5 Leases (Lease Accounting for Lessee & Lessor) This course shall thoroughly cover recognition, measurement and valuation, presentation and disclosure requirements for special topic in accounting leases. It includes on how to account a lease as an operating lease or as a finance lease on the viewpoint of the lessee and the lessor. It explains how to measure and recognize the right of the on the underlying asset. This course also helps to understand the IFRS 16 that all leases shall be accounted by the lessee as a finance lease and when to apply the lease as operating lease in two optional exemptions. On the viewpoint of the lessor, the lease may classify as operating or finance lease. This module helps to understand the concept and rules of accounting for leases. In this module, illustrations and sample problems are also provided in an informative and comprehensive manner to be able to understand better the topics. To evaluate what the students have learned, this module provides work exercises (activity) at the closure activities section. To ensure that learning objectives are attained at the end of the semester, the learner/students are evaluated based on attendance, portfolio journal (activity), formative assessment and summative assessment. See evaluation for the details. For further readings, see assignment/agreement section. 1. Define and explain the concepts of lease accounting under the new standard, specifically the difference between lessor and lessee accounting 2. Identify and record criteria in determining finance lease on the part of the lessor, the optional application of operating lease on the part of the lessee 3. Solve and compute for the valuation of lease liability, right of use asset, interest income, interest expense, rent income 4. Classify and report each transaction affecting lease accounting This module covers the recognition, measurement, valuation and disclosure requirements on how account the lease. These basic requirements on how to account a transaction was already discussed on the previous financial accounting subjects from FAR 0 to FAR 2.

DEVELOPMENTAL ACTIVITIES

 Lessee Accounting

IFRS 16 is the new lease standard. A lease is defined as a contract or part of a contract that conveys the right to use the underlying asset

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for a period of time in exchange for consideration. Right to control the use of an asset a. Obtain substantially all of the economic benefits from the use of the identified asset b. Direct use of the identified asset IFRS 16, paragraph 22, provides that at the commencement date, a lessee shall recognize a right of use asset and a lease liability. Note: All leases shall be accounted for by the lessee as a finance lease under the new lease standard Right of Use Asset (ROU)- right to use the underlying asset over the lease term. Lease Liability (LL)- obligation to make payments over the lease term. Underlying Asset- subject of the lease. Lessee-obtains the right to use the underlying asset. Lessor-provides the right to use the underlying asset. Operating lease model for lessee IFRS 16, par. 5, provides that a lessee is permitted to make an accounting policy election to apply the operating lease accounting and not recognize an asset and lease liability in two optional exemptions. a. Short-term lease b. Low value lease -a lessee may or may not apply the operating lease accounting if the lease is short-term or low value. -the Operating Lease (OL) , the periodic rental is recognized as rent expense using the straight line basis over the lease term or another systematic basis. Short term lease- 12 months or less at the commencement date of the lease. A lease that contains a purchase option is not a short-term lease. Low value lease- the new lease standard does not provide for a quantitative threshold for low value asset. It is a matter of professional judgment. A lessee shall assess the value of the asset when it is new regardless of the age of the asset being used. Ex., a lease of car would not qualify as low value lease because a new car would typically not be of low value. IFRS16, par. 8, provides the election for low value lease on a lease by lease basis. Finance lease-Lessee Finance lease- is defined as a lease that transfers substantially all of the risks and rewards incidental to ownership of an underlying asset. At the commencement date, the lessee shall recognize a right of use (ROU) and lease liability (LL). Initial measurement of ROU IFRS16, par. 23, shall measure the ROU at Cost Par. 24, ROU comprises: a. The amount of initial measurement of the lease liability or the present value of lease payments b. Lease payments made to lessor at or before commencement date, such as lease bonus, less any lease incentives received c. Initial direct costs incurred by the lessee d. Estimate of cost of dismantling, removing and restoring the underlying asset for which the lessee has a present obligation. Lease incentives are payments by the lessor to the lessee associated with a lease or the reimbursement or assumption by the lessor of the costs of the lessee. Ex. The lessor agrees to reimburse the lessee for the commission paid by the lessee to a broker. Initial direct costs are incremental costs of obtaining a lease that would not have been incurred if the lease had not been obtained. Leasehold improvements are not initial direct costs and not included in the cost of ROU. These are separately accounted for in the PPE and depreciated over the shorter between the lease term and the life of the improvements. Security deposit refundable-upon the lease expiration is accounted for as an asset by the lessee. Subsequent measurement of ROU -cost model (cost less accumulated depreciation and impairment loss) -the carrying amount of the ROU is adjusted for any remeasurement of the lease liability. Presentation of ROU-separate line item in the statement of financial position. As an alternative, the lessee may include it under the PPE with appropriate disclosure. Other measurement models a. Fair value model-investment property b. Revaluation model- PPE Depreciation of ROU

IFRS 16, par. 32, provides that the lessee shall depreciate the ROU over the useful life of the underlying asset under the following conditions: a. The lease transfers ownership of the underlying asset to the lessee at the end of the lease term. b. The lessee is reasonably certain to exercise a purchase option.

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Note: In the absence of either of the two options, depreciate the ROU over the shorter between the useful life of the asset and the lease term. Measurement of lease liability IFRS 16, par. 26, provides that at the commencement date, the lessee shall measure the lease liability at the present value of lease payments. Interest rate implicit in the lease- the rate use in the lease. Lessee’s Incremental borrowing rate- will be used in the absence of the implicit rate. Components of lease payments a. Fixed lease payments less any lease incentives b. Variable lease payments c. Exercise price of a purchase option if the lessee is reasonably certain to exercise the option d. Amount expected to be payable by the lessee under a residual value guarantee e. Termination penalties if the lease term reflects the exercise of a termination option Other definitions Residual value guarantee is the guarantee made to the lessor by a party unrelated to the lessor. Unguaranteed residual value is that portion of the residual value of the underlying asset, the realization of the lessor is not assured or is guaranteed solely by a party related to the lessor. Executory costs are expensed immediately when incurred such as maintenance, taxes and insurance of the underlying asset. A Lease term is noncancelable if the lessee is reasonably certain to exercise the extension option or not to exercise the termination option. Illustration-Certain purchase option Isaiah Company lease a machine on January 1, 2019 with the following pertinent information: Fixed rental payment at the end of each year 1,000,000 Lease term 10 years Useful life of machine 12 years Incremental borrowing rate 14% Implicit borrowing rate 12% PV of an ordinary annuity of 1 for 10 periods at 14% 5.216 12% 5.650 PV of 1 for 10 periods at 14% 0.270 12% 0.322 Isaiah Company has the option to purchase the machine upon the lease expiration on January 1, 2029 by paying P500,000. The lessee is reasonably certain to exercise the purchase option at the commencement date of the lease. The estimated residual value of the machine at the end of the 12-year life is P600,000. PV of lease payments (1,000,000 x 5.65) 5,560,000 PV of purchase option (500,000 x .322) 161,000 Total lease liability 5,811,000 Journal entries for 2019 1. To record the acquisition of the machinery under a finance lease Right of use asset 5,811,000 Lease liability 5,811,000 2. To record the first annual rental payment on Dec. 31, 2019: Interest expense 697,320 Lease liability 302,680 Cash 1,000,000 3. To record the annual depreciation: Depreciation Accumulated depreciation (5,811,000-600,000 RV/12 years*)

434,250 434,250

Note: 12 years useful life will be used as the basis for depreciating the ROU because thelessee is reasonably certain to exercise the purchase option.

Amortization Table Date 1/1/2019

Payment

Interest

Principal

Present value 5,811,000

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12/31/2019 12/31/2020 12/31/2021 12/31/2022 12/31/2023 12/31/2024 12/31/2025 12/31/2026 12/31/2027 12/31/2028

1,000,000 1,000,000 1,000,000 1,000,000 1,000,000 1,000,000 1,000,000 1,000,000 1,000,000 1,000,000

697,320 660,998 620,318 574,756 523,727 466,574 402,563 330,871 250,575 161,297

302,680 339,002 379,682 425,244 476,273 533,426 597,437 669,129 749,425 838,703

5,508,320 5,169,318 4,789,636 4,364,392 3,888,119 3,354,694 2,757,257 2,088,128 1,338,703 500,000

Exercise of the purchase option (January 1, 2029) Lease liability 500,000 Cash 500,000 Nonexercise of purchase option (January 1, 2029) Accumulated depreciation 4,342,500 Lease liability 500,000 Loss on finance lease 968,500 Right of use asset 5,811,000 Illustration-Residual value guarantee Paul Company leased an equipment on January 1, 2019 with the following information: Fixed annual payment at the end of each lease year Lease term Useful life of equipment Implicit interest rate PV of an ordinary annuity of 1 for 4 periods at 10% PV of 1 for 4 periods at 10%

1,000,000 4 years 5 years 10% 3.16987 0.683

Paul Company has guaranteed a P200,000 residual value on December 31, 2022 to the lessor. Note: As long as there is a residual value guarantee, there is no more purchase option (vice versa) because the equipment will revert to the lessor upon the expiration of the lease on Dec. 31, 2022. PV of lease payments (1,000,000 x 3.16987) PV of residual value guarantee (200,000 x 0.683) Cost of ROU and LL Amortization Table Date 1/1/2019 12/31/2019 12/31/2020 12/31/2021 12/31/2022

Payment

3,169,870 136,600 3,306,470

Interest

1,000,000 1,000,000 1,000,000 1,000,000

Principal

330,647 263,711 190,082 109,090

Journal entries 1. To record the acquisition of the equipment Right of use asset 3,306,470 Lease liability

669,353 736,289 809,918 890,910

Present value 3,306,470 2,637,117 1,900,828 1,090,910 200,000

3,306,470

2. To record the first annual rental payment on Dec. 31, 2019: Interest expense 330,647 Lease liability 669,353 Cash 1,000,000 3. To record the annual depreciation: Depreciation Accumulated depreciation

776,617 776,617

Note: The asset is depreciated over the lease term of 4 years which is shorter than the useful life because

there is neither transfer of ownership or purchase option. Return of equipment to lessor on December 31, 2022 1. To record the final annual payment on December 31, 2022:

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Interest expense Lease liability Cash

109,090 890,910 1,000,000

2. To record the return of the equipment to the lessor: Accumulated depreciation *3,106,470 Lease liability 200,000 Right of use asset 3,306,470 *Accu. Depreciation 3,106,468 (adjusted to 3,106,470) If the FV of the underlying asset is less than the residual value guarantee, a loss is reported for the difference and the lessee must make up for the difference with a cash payment. Ex. FV is of the equipment on December 31, 2022 is only P150,000 which is P50,000 lower than the residual value guarantee Loss on finance lease Cash

50,000 50,000

Note:If the FV is higher than the RVG, no additional entry because there is no cash settlement. Illustration-Initial Direct Cost Emmanuel Company leased an equipment on January 1, 2019 with the following information: Annual fixed payment in advance at the beginning of each lease year 1,000,000 Initial direct cost paid on January 1, 2019 250,000 Lease incentive received 150,000 Residual value guarantee 300,000 Lease term 5 years Useful life of equipment 6 years Implicit interest rate 8% PV of an ordinary annuity of 1 in advance at 8% for 5 periods 4.3121 PV of 1 at 8% for 5 periods 0.6806 PV of rentals (1,000,000 x 4.3121) PV of residual value guarantee (300,000 x .6806) Lease liability-January 1, 2019 Initial direct cost Lease incentive received Cost of ROU Date 1/1/2019 1/1/2019 1/1/2020 1/1/2021 1/1/2022 1/1/2023 1/1/2024 *adjusted

Payment 1,000,000 1,000,000 1,000,000 1,000,000 1,000,000 300,000

Interest

281,302 223,807 161,711 94,648 *22,252

4,312,100 204,180 4,516,280 250,000 (150,000) 4,616,280

Principal 1,000,000 718,698 776,193 838,289 905,352 277,748

Present value 4,516,280 3,516,280 2,797,582 2,021,389 1,183,100 277,748 -

Journal Entries (2019) 1. To record the acquisition of the equipment under a finance lease: Right of use asset 4,616,280 Lease liability 4,516,280 Cash (250,000-150,000) 100,000 2. To record the first annual payment on January 1, 2019: Lease liability 1,000,000 Cash 1,000,000 3. To record the interest for 2019 (Dec 31, 2019) Interest expense 281,302 Accrued interest payable

281,302

4. To record the depreciation for 2019: Depreciation (4,316,280/5)

863,256

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Accumulated depreciation (4,616,280-300,000RV/5 years Lease Term)

863,256

Journal Entries (2020) 1. To record the second payment on January 1, 2020: Accrued interest payable 281,302 Lease liability 716,698 Cash

1,000,000

2. To record the interest for 2020 (Dec 31, 2020) Interest expense 223,807 Accrued interest payable

223,807

3. To record the depreciation for 2020: Depreciation (4,316,280/5) Accumulated depreciation

863,256

863,256

Return of the equipment by the lessee (January 1, 2024): If the FV of the asset is P400,000 which is higher than the RVG of P300,000, the entry to record the return of the equipment to the lessor is : Accumulated depreciation (863,256 x 5) Lease liability Accrued interest payable Right of use asset

4,316,280 277,748 22,252 4,616,280

Illustration-Unguaranteed residual value Aralmuna Company leased a warehouse on January 1, 2019 with the following information: Annual rental payable at the end of each year Unguaranteed residual value Payment to lessor to obtain a long-term lease (lease bonus) Cost of restoring the asset as required by contract Annual executory cost paid Lease term Useful life of equipment Implicit interest rate PV of an ordinary annuity of 1 at 10% for 6 periods PV of 1 at 10% for 6 periods

600,000 200,000 224,000 400,000 50,000 6 years 8 years 10% 4.36 0.56

The lease provides for neither a transfer of title to the lessee nor a purchase option. Lease liability (600,000 x 4.36) Payment to lessor to obtain lease Estimated restoration cost Total cost of ROU

2,616,000 224,000 400,000 3,240,000

Note: Unguaranteed RV is not included in the computation of Lease Liability. Annual executory cost is treated as outright expense. Journal Entries (2019) 1. To record the acquisition of the warehouse under a finance lease: Right of use asset 3,240,000 Lease liability 2,616,000 Cash 224,000 Estimated liability for restoration 400,000 2. To record the payment of executory cost: Executory cost 50,000 Cash 50,000 3. To record the first rental payment on Dec 31, 2019: Interest expense (10% x 2,616,000) 261,600 Lease liability 338,400 Cash

600,000

4. To record the depreciation for 2019: Depreciation (3,240,000/6) Accumulated depreciation

540,000

540,000

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-the unguaranteed residual value is ignored in computing the depreciable amount. Return of equipment to lessor (On January 1, 2025) Accumulated depreciation (540,000 x 6) 3,240,000 Equipment

3,240,000

*the lessee has no financial obligation but to return the asset to the lessor. Illustration-Extension option Papasa Company entered into a lease of building on January 1, 2019 with the ffg. Information: Annual rental payable at the end of each year Lease term Useful life of building Implicit interest rate PV of an ordinary annuity of 1 at 10% for 5 periods

500,000 5 years 20 years 10% 3.791

The lease contained an option for the lessee to extend for a further 5 years. At the commencement date, the exercise of the extension option is not reasonably certain. New annual rental payable at the end of each year New implicit interest rate PV of an ordinary annuity of 1 at 8% for 5 periods PV of 1 at 8% for 2 periods PV of an ordinary annuity of 1 at 8% for 2 periods Date 1/1/2019 12/31/201 9 12/31/202 0 12/31/202 1

Paymen t

500,000 500,000 500,000

Interes t

Princip al

189,55 310,450 0 158,50 341,495 5 124,35 375,645 5

600,000 8% 3.993 0.857 1.783

Present value 1,895,500 1,585,050 1,243,555 867,910

Remeasurement of lease liability On January 1, 2022, the lease liability is remeasured using the new implicit interest rate of 8%. Annual rental for remaining 2 years of old lease term 500,000 Multiply by PV of an OA of 1 at 8% for 2 periods 1.783 PV-January 1, 2022 891,500 Annual rental for 5 years starting January 1, 2024 Multiply by PV of an OA of 1 at 8% for 5 periods PV-January 1, 2024 Multiply by PV of 1 at 7% for 2 periods PV-January 1, 2022

600,000 3.993 2,395,800 0.857 2,053,200

The PV of the new rentals on January 1, 2024 is rediscounted for 2 periods on the date of extension on January 1, 2022. PV of rem...