FINANCE LEASE

IFRS 16 is the new lease standard.

Definition
A lease is define as a contract or part of a contract that conveys the right to use the underlying
asset for a period of time in exchange for consideration.

Finance Lease Model for Lease

IFRS 16, paragraph 22, provides that at the commencement date, a lessee shall recognize a
right of use asset and a lease liability.

Lessee is required to initially recognize a right of use asset for the right to use the underlying
asset over the lease term and a lease liability for the obligation to make payments.

At Commence date
Right of Use Asset xxx
Lease liability xxx
(lease payment x PV)

Lease payment date

Lease liability xxx
Interest expense xxx
Cash xxx

Depreciation-End of Accounting Period

Depreciation expense xxx
Accumulated depreciation-Right of Use Asset xxx
PV of Lease Payment/ life (lease term period or
Life of asset whichever is shorter)

Operating Lease Model for Lease

IFRS 16, paragraph 5, provides that a lessee is permitted to make an accounting policy
election to apply the operating lease accounting not recognize an asset and lease liability in two
exceptional exemptions.
a. short-term lease
b. low value lease

Lease Payment Date

Rent expense or Lease expense xxx
Cash xxx

ILLUSTRATION 1

On January 1, 2018, an entity leased a machinery for 4 years which is the same as the useful
life of the machinery at annual rental or fixed payment of P200,000 payable at the end of each
year.

The lease provides for a transfer of ownership of the underlying asset to the lessee at the end of
the lease term.

The present value of annual payment of P200,000 for 4 years using 12% implicit interest rate is
computed as follows:
Present Value = Php200,000 x PV of an ordinary annuity of 1 for
Years at 12%
= Php200,000 x 3.0373
= Php607,460
 Date Payment Interest-12% Principal Carrying Value
01/01/2018 607,460
12/31/2018 Php 200,000 Php 72,895 127,105 480,355
12/31/2019 200,000 57,643 142,357 337,998
12/31/2020 200,000 40,560 159,440 178,558
12/31/2021 200,000 21,427 178,573
21,442 178,558 0

Jan 1, 2018 Right of use asset 607,460

Lease liability 607,460
To record finance lease at the commencement date of the lease.

Dec 31, 2018 Lease liability 127,105

Interest expense 72,895
Cash 200,000

Dec 31, 2019 Lease liability 142,357

Interest expense 57,643
Cash 200,000

Dec 31, 2020 Lease liability 159,440

Interest expense 40,560
Cash 200,000

Dec 31, 2021 Lease liability 178,558

Interest expense 21,442
Cash 200,000

ILLUSTRATION 2 – PURCHASE OPTION

Lessee has the option to purchase the asset upon the lease expiration. Also, lessee is
reasonably certain to exercise the purchase at the commencement date of the lease. Hence,
the asset is depreciated over the useful life because there is a purchase option that is
reasonably certain to be exercised.

Camil Company leased a machine on January 1, 2019 with the following pertinent information:
Fixed rental payment at the end of each year Php 2,000,000
Lease term 10 years
Useful life of machine 12 years
Incremental borrowing rate 14%
Implicit interest rate 12%
Present value of an ordinary annuity of 1 for 10 periods at
14% 5.216
12% 5.650
Present value of 1 for 10 periods at
14% 0.270
12% 0.322

Camil Company has the option to purchase the machine upon the lease expiration on January
1, 2029 by paying Php1,000,000.

Camil Company 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 if Php1,200,000.

Cost of Right of Use Asset

PV of lease payments (2,000,000 x 5.65) Php 11,300,000
PV of purchase option (1,000,000 x .322) 322,000
-------------------------
Total Php 11,622,000
===============
 Date Payment Interest Principal Present Value
01/01/2019 11,622,000
12/31/2019 Php 2,000,000 Php 1,394,640 Php 605,360 11,016,640
12/31/2020 2,000,000 1,321,997 678,003 10,338,637
12/31/2021 2,000,000 1,240,636 759,364 9,579,273
12/31/2022 2,000,000 1,149,513 850,487 8,728,786
12/31/2023 2,000,000 1,047,454 952,546 7,776,240
12/31/2024 2,000,000 933,149 1,066,851 6,709,389
12/31/2025 2,000,000 805,127 1,194,873 5,514,516
12/31/2026 2,000,000 661,742 1,338,258 4,176,258
12/31/2027 2,000,000 501,151 1,498,849 2,677,409
12/31/2028 2,000,000 321,289 1,678,711
322,591 1,677,409 1,000,000

Annual Depreciation = (11,622,000-1,200,000)/12

= 868,500

Journal Entries:
January 1, 2019 Right of Use Asset 11,622,000
Lease liability 11,622,000

Dec 31, 2019 Lease liability 605,360

Interest expense 1,394,640
Cash 2,000,000

Depreciation expense 868,500

Accumulated depreciation
- Right of Use Asset 868,500

Dec 31, 2020 Lease liability 678,003

Interest expense 1,321,997
Cash 2,000,000

Depreciation expense 868,500

Accumulated depreciation
- Right of Use Asset 868,500

Dec 31, 2021 Lease liability 759,364

Interest expense 1,240,636
Cash 2,000,000

Depreciation expense 868,500

Accumulated depreciation
- Right of Use Asset 868,500

Dec 31, 2022 Lease liability 850,487

Interest expense 1,149,513
Cash 2,000,000

Depreciation expense 868,500

Accumulated depreciation
- Right of Use Asset 868,500

Dec 31, 2023 Lease liability 952,546

Interest expense 1,047,454
Cash 2,000,000

Depreciation expense 868,500

Accumulated depreciation
- Right of Use Asset 868,500

Dec 31, 2024 Lease liability 1,066,851

Interest expense 933,149
Cash 2,000,000
 Depreciation expense 868,500
Accumulated depreciation
- Right of Use Asset 868,500

Dec 31, 2025 Lease liability 1,194,873

Interest expense 805,127
Cash 2,000,000

Depreciation expense 868,500

Accumulated depreciation
-Right of Use Asset 868,500

Dec 31, 2026 Lease liability 1,338,258

Interest expense 661,742
Cash 2,000,000

Depreciation expense 868,500

Accumulated depreciation
- Right of Use Asset 868,500

Dec 31, 2027 Lease liability 1,498,849

Interest expense 501,151
Cash 2,000,000

Depreciation expense 868,500

Accumulated depreciation
- Right of Use Asset 868,500

Dec 31, 2028 Lease liability 1,677,409

Interest expense 322,591
Cash 2,000,000

Depreciation expense 868,500

Accumulated depreciation
- Right of Use Asset 868,500

January 1, 2029 Lease liability 1,000,000

Cash 1,000,000

ILLUSTRATION 3

Assuming Camil Company did not exercise purchase option, what is the entry on January 1,
2029?

Accumulated depreciation 8,685,000

Lease liability 1,000,000
Loss on Finance Lease 1,937,000
Right of Use Asset 11,622,000

Computation of Loss on Finance Lease

Depreciation – Year 11 and year 12 (868,500 x 2) 1,737,000
Residual Value 1,200,000
Purchase option ( 1,000,000)
---------------------
1,937,000
============

ILLUSTRATION 4 – RESIDUAL VALUE GUARANTEE

As long as there is a residual value guarantee, there is no more purchase option because the
equipment will revert to the lessor upon expiration of the lease.

The residual value guarantee will not be paid by the lessee to the lessor because the underlying
asset is simply transferred by the lessee to the lessor to satisfy the liability for the residual value
guarantee.
The remaining carrying amount of the asset should be equal to the residual value
guarantee.

FMV of the underlying asset < Residual Value Guarantee : Loss on finance lease

Loss on Finance Lease xxx

Cash xxx

FMV of the underlying asset > Residual Value Guarantee; No additional entry is
necessary because there is no cash settlement

The initial direct cost and lease incentive received are included in the measurement of the cost
of right of use asset but excluded in the measurement of lease liability.

The initial direct cost is added and the lease incentive received is deducted in computing the
cost of right of use asset.

Pau Company leased an equipment on January 1, 2019 with the following information:
Annual fixed payment in advance at the
beginning of each lease year Php 2,000,000
Initial direct cost paid on January 1, 2019 500,000
Lease incentive received 300,000
Residual value guarantee 600,000
Lease term 5 years
Useful life of equipment 6 years
Implicit interest rate 8%
Present value of an annuity of a in advance
At 8% for 5 years 4.3121
Present value of 1 at 8% for 5 periods 0.6806

The equipment is returned by the lessee to the lessor upon the lease expiration on January 1,
2022.

On such date, the fair value of the asset is P800,000 which is higher than the guaranteed
residual value of P600,000.

Computation of Cost of Right of Use Asset

PV of rentals (2,000,000 x 4.3121) Php 8,624,200
PV of residual value guarantee (600,000 x 0.6806) 408,360
--------------------------
Lease Liability-January 1, 2019 9,032,560
Initial direct cot 500,000
Lease incentive received ( 300,000)
---------------------------
Cost of Right of Use Asset Php 9,232,560
===============

Date Payment Interest Principal Present Value

01/01/2019 9,032,560
01/01/2019 2,000,000 - 2,000,000 7,032,560
01/01/2020 2,000,000 562,605 1,437,395 5,595,165
01/01/2021 2,000,000 447,613 1,552,387 4,042,778
01/01/2022 2,000,000 323,422 1,676,578 2,366,200
01/01/2023 2,000,000 189,296 1,810,704 555,496
01/01/2024 600,000 44,440 555,560
44,504 555,496 0

Yearly Depreciation = (9,232,560-600,000)/5 yrs

= 1,726,512

Jan 1, 2019 Right of Use Asset 9,232,560

Lease liability 9,032,560
Cash (500,000-300,000) 200,000
To record the acquisition of equipment under finance lease.

Jan 1, 2019 Lease liability 2,000,000

 Cash 2,000,000
To record the first annual payment on January 1, 2019.

Dec 31, 2019 Depreciation expense 1,726,512

Accumulated depreciation
– Right of Use Asset 1,726,512
To record the depreciation for 2019.
Dec 31, 2019 Interest expense 562,605
Interest payable 562,605
To accrue interest for 2019.

Jan 1, 2020 Lease liability 1,437,395

Interest payable 562,605
Cash 2,000,000
To record the second annual payment on Jan 1, 2020.

Dec 31, 2020 Depreciation expense 1,726,512

Accumulated depreciation
- Right of Use Asset 1,726,512
To record the depreciation for 2020.

Dec 31, 2020 Interest expense 447,613

Interest payable 447,613
To accrue interest for 2020

Jan 1, 2021 Lease liability 1,552,387

Interest payable 447,613
Cash 2,000,000
To record the third annual payment on January 1, 2021.

Dec 31, 2021 Depreciation expense 1,726,512

Accumulated depreciation
- Right of Use Asset 1,726,512
To record depreciation for 2021.

Dec 31, 2021 Interest expense 323,422

Interest payable 323,422
To accrue interest for 2021

Jan 1, 2022 Lease liability 1,676,578

Interest payable 323,422
Cash 2,000,000
To record the fourth annual payment on January 1, 2022

Dec 31, 2022 Depreciation expense 1,726,512

Accumulated depreciation
- Right of Use Asset 1,726,512
To record depreciation for 2022

Dec 31, 2022 Interest expense 189,296

Interest payable 189,296
To accrue interest for 2022.

Jan 1, 2023 Lease liability 1,810,704

Interest expense 189,296
Cash 2,000,000
To record the fifth annual payment on January 1, 2023.

Dec 31, 2023 Depreciation expense 1,726,512

Accumulated depreciation
- Right of Use Asset 1,726,512
To record depreciation for 2023.

Dec 31, 2023 Interest expense 44,504

Interest payable 44,504
To accrue interest for 2023.
Jan 1, 2024 Accumulated depreciation 8,632,560
Interest payable 44,504
Lease liability 555,496
Right of Use Asset 9,232,560
To record the return of the equipment to the lessor.

ILLUSTRATION 5

Assuming on January 1, 2024, the fair value of the Asset is P450,000, What is the entry on
January 1, 2024 to record the return of the equipment to the lessor?

Jan 1, 2024 Accumulated depreciation 8,632,560

Interest payable 44,504
Lease liability 555,496
Right of Use Asset 9,232,560
To record the return of the equipment to the lessor.

Jan 1, 2024 Loss on Finance Lease 150,000

Cash 150,000
(600,000-450,000 = 150,000)

ILLUSTRATION 6 – UNGUARANTEED RESIDUAL VALUE

The present value of the residual value is not included in the lease liability because it is
unguaranteed.

The annual executory cost is treated as outright expense.

The unguaranteed residual value is ignored in computing the depreciable amount.

Depreciation period is either the lease term period or the life of the asset whichever is shorter.

Mari Company leased a warehouse on January 1, 2019 with the following information:
Annual rental payable at the end of each year Php 1,200,000
Unguaranteed residual value 400,000
Payment to lessor to obtain a long-term lease 448,000
Cost of restoring the asset as required by contract 800,000
Annual executory cost paid 100,000
Lease term 6 years
Useful life of equipment 8 years
Implicit interest rate 10%
Present value of an ordinary annuity of 1 at 10%
for 6 periods 4.36
Present value of 1 at 10% for 6 periods 0.56
The lease provides for neither a transfer of title to the lessee nor a purchase option.

Thus, the equipment will revert to the lessor upon the expiration of lease on January 1, 2025.

Computation

Lease liability (1,200,000 x 4.36) Php 5,232,000

Payment to lessor obtain lease 448,000
Estimated restoration cost 800,000
------------------------
Total Cost of Right of Use Asset Php 6,480,000
==============
 Date Payment Interest Principal Carrying Value
01/01/2019 5,232,000
12/31/2019 1,200,000 523,200 676,800 4,555,200
12/31/2020 1,200,000 455,520 744,480 3,810,720
12/31/2021 1,200,000 381,072 818,928 2,991,792
12/31/2022 1,200,000 299,179 900,821 2,090,971
12/31/2023 1,200,000 209,097 990,903 1,100,068
12/31/2024 1,200,000 110,068 1,089,932
99,932 1,100,068 0

Yearly Depreciation = 6,480,000/6 yrs

= 1,080,000

Jan 1, 2019 Right of Use Asset 6,480,000

Lease liability 5,232,000
Cash 448,000
Estimated liability for restoration 400,000
To take up the acquisition of the warehouse under finance lease.

Jan 1, 2019 Executory cost 100,000

Cash 100,000
To take up payment of executory cost.

Dec 31, 2019 Lease liability 676,000

Interest expense 523,200
Cash 1,200,000
To record the first rental payment on December 31, 2019

Dec 31, 2019 Depreciation expense 1,080,000

Accumulated depreciation
- Right of Use Asset 1,080,000
To record depreciation for 2019.

Dec 31, 2020 Lease liability 744,480

Interest expense 455,520
Cash 1,200,000
To record the second rental payment on December 31, 2020.

Dec 31, 2020 Depreciation expense 1,080,000

Accumulated depreciation
- Right of Use Asset 1,080,000
To record depreciation for 2020.

Dec 31, 2021 Lease liability 818,928

Interest expense 381,072
Cash 1,200,000
To record the third rental payment on December 31, 2021.

Dec 31, 2021 Depreciation expense 1,080,000

Accumulated depreciation
- Right of Use Asset 1,080,000
To record depreciation for 2021.

Dec 31, 2022 Lease liability 900,821

Interest expense 299,179
Cash 1,200,000
To record the fourth rental payment on December 31, 2022

Dec 31, 2022 Depreciation expense 1,080,000

Accumulated depreciation
- Right of Use Asset 1,080,000
To record depreciation for 2022.
Dec 31, 2023 Lease liability 990,903
Interest expense 209,097
Cash 1,200,000
To record the fifth rental payment on December 31, 2023.

Dec 31, 2023 Depreciation expense 1,080,000

Accumulated depreciation
- Right of Use Asset 1,080,000
To record depreciation for 2023.

Dec 31, 2024 Lease liability 1,089,932

Interest expense 110,068
Cash 1,200,000
To record the sixth rental payment on December 31, 2024.

Dec 31, 2024 Depreciation expense 1,080,000

Accumulated depreciation
- Right of Use Asset 1,080,000
To record depreciation for 2024.

Jan 1, 2025 Accumulated depreciation-Right of

Use Asset 6,480,000
Right of Use Asset 6,480,000
To record return of asset to Lessor.

EXERCISES

A. Pau Company leased a machine on January 1, 2019 with the following information
provisions:
Annual lease payment in advance at the
beginning of each year, starting January, 2019 P 2,000,000
Lease term 10 years
Useful life of machine 15 years
Implicit interest rate in the lease 12%
PV of an ordinary annuity of 1 at 12% for 10 periods 5.650
PV of an annuity of 1 in advance at 12% for 10 periods 6.328
PV of 1 at 12% for 10 periods 0.322
The entity has an option to purchase the machine on January 1, 2029 by paying P400,000.

At the commencement date , it is reasonably certain that the purchase option will be exercised.

Required: Prepare journal entries on the books of Pau Company for 2019 to 2021.

B. On January 1, 2019, Camil Company entered into a lease with Pau Company for a new
equipment.

The lease stipulates that annual payments of P2,000,000 will be made for five years starting
December 31, 2019.

Camil Company guaranteed a residual value of P948,120 at the end of the 5-year period. The
equipment will revert to the lessor at the lease expiration.

The implicit interest rate for the lease is 16% after considering the guaranteed residual value.

The economic life of the equipment is 10 years. The present value factors at 16% for five
periods are:
Present value of 1 0.4761
Present value of an ordinary annuity of 1 3.2743
Required:
1. Prepare a schedule of the annual payments showing reduction of liability every year.
2. Prepare journal entries on the books of Camil Company fro 2019 and 2020.
3. Prepare journal entry on December 31, 2023, end of lease term, to record the return of the
equipment to the lessor. Assume the fair value of the equipment is equal to the guaranteed
residual value.
4. Prepare journal entry on December 31, 2023 to record the return of the equipment to the
lessor assuming the fair value of the equipment is only P600,000.
5. Prepare journal entry on December 31, 2023 to record the return of the equipment to the
lessor assuming the fair value of the equipment is P1,000,000.

C. Mari Company has maintained a policy of acquiring equipment by leasing.

On January 1, 2019, Mari Company entered into a lease agreement for an equipment.

The lease stipulates an annual rental payment of P1,200,000 to be paid every December 31
starting December 31, 2019.

The lease contains neither a transfer of title to the lessee nor a purchase option.

The equipment has residual value of P600,000 at the end of the 5-year lease period but is
unguaranteed by the lessee. The economic life of the equipment is 8 years.

The implicit interest rate is 12% after considering the unguaranteed residual value.

The present value of an ordinary annuity of 1 at 12% for 5 periods is 3.60.

Required:
1. Prepare journal entries on the books of Mari Company for 2019 and 2020.
2. Prepare journal entry on December 31, 2023 to record the return of the equipment to the
lessor as required by the contract. The fair value of the equipment is P400,000.