FINANCIAL ACCOUNTING AND REPORTING PART 2

PAS17 – LEASES
(OLD STANDARD FOR LEASE)

DEFINITION OF LEASE:
It is an agreement whereby the lessor conveys to the lessee in return for a payment or series of
payments the right to use an asset for an agreed period of time. It is classified into:
(a) Finance lease is a lease that transfers substantially all the risks and rewards incidental to
ownership of an asset. Title may or may not eventually be transferred; and
(b) Operating lease is a lease other than a finance lease.

LIMITATION OF PAS 17 :
1. Leases to explore for or use minerals, oil, natural gas and similar non-regenerative resources; and
2. Licensing agreements for such items as motion picture films, video recordings, plays, manuscripts,
patents and copyrights.
Also, not applicable as to Measurement Basis for:
1. Property held by lessees that is accounted for as investment property (PAS 40);
2. Investment property provided by lessors under operating leases (PAS 40);
3. Biological assets held by lessees under finance leases (PAS 41); and
4. Biological assets provided by lessors under operating leases (PAS 41).

DIFFERENCE BETWEEN INCEPTION & COMMENCEMENT OF THE LEASE TERM:

The inception of the lease is the earlier of the date of the lease agreement and the date of commitment
by the parties to the principal provisions of the lease. As at this date:
(a) a lease is classified as either an operating or a finance lease; and
(b) in the case of a finance lease, the amounts to be recognized at the commencement of the lease
term are determined.

The commencement of the lease term is the date from which the lessee is entitled to exercise its
right to use the leased asset. It is the date of initial recognition of the lease (i.e. the recognition of the
assets, liabilities, income or expenses resulting from the lease, as appropriate).

The lease term is 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.

DIFFERENCE BETWEEN ECONOMIC & USEFUL LIFE:

Economic life is either:

(a) the period over which an asset is expected to be economically usable by one or more users; or
(b) the number of production or similar units expected to be obtained from the asset by one or more
users.

Useful life is the estimated remaining period, from the commencement of the lease term, without
limitation by the lease term, over which the economic benefits embodied in the asset are expected to
be consumed by the entity.
 FINANCIAL ACCOUNTING AND REPORTING PART 2

DIFFERENCE BETWEEN GUARANTEED & UNGUARANTEED RESIDUAL VALUE:

Guaranteed residual value is:

(a) for a lessee, that part of the residual value that is guaranteed by the lessee or by a party related to
the lessee (the amount of the guarantee being the maximum amount that could, in any event,
become payable); and
(b) for a lessor, that part of the residual value that is guaranteed by the lessee or by a third party
unrelated to the lessor that is financially capable of discharging the obligations under the guarantee.

Unguaranteed residual value is that portion of the residual value of the leased asset, the realization
of which by the lessor is not assured or is guaranteed solely by a party related to the lessor.

OTHER RELATED TERMINOLOGIES:

Minimum lease payments are the payments over the lease term that the lessee is or can be required
to make, ecluding contingent rent, costs for services and taxes to be paid by and reimbursed to the
lessor, together with:
(a) for a lessee, 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 by:
(i) the lessee;
(ii) a party related to the lessee; or
(iii) a third party unrelated to the lessor that is financially capable of discharging the obligations
under the guarantee.

However, if the lessee has an option to purchase the asset at a price that is expected to be sufficiently
lower than fair value at the date the option becomes exercisable for it to be reasonably certain, at the
inception of the lease, that the option will be exercised, the minimum lease payments comprise the
minimum payments payable over the lease term to the expected date of exercise of this purchase
option and the payment required to exercise it.

Fair value is the amount for which an asset could be exchanged, or a liability settled, between
knowledgeable, willing parties in an arm’s length transaction.

Initial direct costs are incremental costs that are directly attributable to negotiating and arranging a
lease, except for such costs incurred by manufacturer or dealer lessors.

Gross investment in the lease is the aggregate of:

(a) the minimum 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 is the gross investment in the lease discounted at the interest rate implicit
in the lease.

Unearned finance income is the difference between:

(a) the gross investment in the lease, and
(b) the net investment in the lease.

The interest rate implicit in the lease is the discount rate that, at the inception of the lease, causes
the aggregate present value of (a) the minimum lease payments and (b) the unguaranteed residual
value to be equal to the sum of (i) the fair value of the leased asset and (ii) any initial direct costs of the
lessor.

The lessee’s incremental borrowing rate of interest is 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
 FINANCIAL ACCOUNTING AND REPORTING PART 2

lessee would incur to borrow over a similar term, and with a similar security, the funds necessary to
purchase the asset.

Contingent rent is that 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 (e.g. percentage of future
sales, amount of future use, future price indices, future market rates of interest).

CLASSIFICATION OF LEASES:

The classification of leases adopted in this Standard is based on the extent to which risks and rewards
incidental to ownership of a leased asset lie with the lessor or the lessee. Risks include the possibilities
of losses from idle capacity or technological obsolescence and of variations in return because of changing
economic conditions. Rewards may be represented by the expectation of profitable operation over the
asset’s economic life and of gain from appreciation in value or realization of a residual value.

1. FINANCE LEASE – transfers substantially all the risks and rewards incidental to ownership.

Examples of situations that individually or in combination would normally lead to a lease being classified
as a finance lease are:
(a) the lease transfers ownership of the asset to the lessee by the end of the lease term;
(b) the lessee has the option to purchase the asset at a price that is expected to be sufficiently lower
than the fair value at the date the option becomes exercisable for it to be reasonably certain, at the
inception of the lease, that the option will be exercised;
(c) the lease term is for the major part of the economic life of the asset even if title is not transferred;
(d) at the inception of the lease the present value of the minimum lease payments amounts to at least
substantially all of the fair value of the leased asset; and
(e) the leased assets are of such a specialized nature that only the lessee can use them without major
modifications.

Indicators of situations that individually or in combination could also lead to a lease being classified as
a finance lease are:
(a) if the lessee can cancel the lease, the lessor’s losses associated with the cancellation are borne
by the lessee;
(b) gains or losses from the fluctuation in the fair value of the residual accrue to the lessee (for
example, in the form of a rent rebate equaling most of the sales proceeds at the end of the lease);
and
(c) the lessee has the ability to continue the lease for a secondary period at a rent that is substantially
lower than market rent.

A non-cancelable lease is 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 lessee of such an additional amount that, at inception of the lease,
continuation of the lease is reasonably certain.

Recognition in the Financial Statements of Lessee – lessees shall recognize finance leases as
assets and liabilities in their balance sheets at amounts equal to the fair value of the leased property
or, if lower, the present value of the minimum lease payments, each determined at the inception of the
lease. The discount rate to be used in calculating the present value of the minimum lease payments is
the interest rate implicit in the lease, if this is practicable to determine; if not, the lessee’s incremental
borrowing rate shall be used. Any initial direct costs of the lessee, such as negotiating and securing
 FINANCIAL ACCOUNTING AND REPORTING PART 2

leasing arrangements, are added to the amount recognized as an asset. The costs identified as
directly attributable to activities performed by the lessee for a finance lease are added to the amount
recognized as an asset.

Minimum lease payments shall be apportioned between the finance charge and the reduction of the
outstanding liability. The finance charge shall be allocated to each period during the lease term so as
to produce a constant periodic rate of interest on the remaining balance of the liability. Contingent rents
shall be charged as expenses in the periods in which they are incurred.

A finance lease gives rise to depreciation expense for depreciable assets as well as finance expense
for each accounting period. The depreciation policy for depreciable leased assets shall be consistent
with that for depreciable assets that are owned. If there is no reasonable certainty that the lessee will
obtain ownership by the end of the lease term, the asset shall be fully depreciated over the shorter of
the lease term and its useful life. If there is reasonable certainty that the lessee will obtain ownership
by the end of the lease term, the period of expected use is the useful life of the asset.

Recognition in the Financial Statements of Lessor – lessors shall recognize assets held under a
finance lease in their balance sheets and present them as a receivable at an amount equal to the net
investment in the lease. Initial direct costs are often incurred by lessors and include amounts such as
commissions, legal fees and internal costs that are incremental and directly attributable to negotiating
and arranging a lease. For finance leases other than those involving manufacturer or dealer lessors,
initial direct costs are included in the initial measurement of the finance lease receivable and reduce
the amount of income recognized over the lease term.

Lease payments relating to the period, excluding costs for services, are applied against the gross
investment in the lease to reduce both the principal and the unearned finance income.

Manufacturer or dealer lessors shall recognize selling profit or loss in the period, in accordance with
the policy followed by the entity for outright sales. Costs incurred by manufacturer or dealer lessors in
connection with negotiating and arranging a lease shall be recognized as an expense when the selling
profit is recognized.

Manufacturers or dealers often offer to customers the choice of either buying or leasing an asset. A
finance lease of an asset by a manufacturer or dealer lessor gives rise to two types of income:
(a) profit or loss equivalent to the profit or loss resulting from an outright sale of the asset being leased,
at normal selling prices, reflecting any applicable volume or trade discounts; and
(b) finance income over the lease term.

The sales revenue recognized at the commencement of the lease term by a manufacturer or dealer
lessor is the fair value of the asset, or, if lower, the present value of the minimum lease payments
accruing to the lessor, computed at a market rate of interest. The cost of sale recognized at the
commencement of the lease term is the cost, or carrying amount if different, of the leased property less
the present value of the unguaranteed residual value. The difference between the sales revenue and
the cost of sale is the selling profit, which is recognized in accordance with the entity’s policy for outright
sales.

Costs incurred by a manufacturer or dealer lessor in connection with negotiating and arranging a
finance lease are recognized as an expense at the commencement of the lease term because they are
mainly related to earning the manufacturer’s or dealer’s selling profit.

2. OPERATING LEASE – does not transfer substantially all the risks and rewards incidental to ownership.
 FINANCIAL ACCOUNTING AND REPORTING PART 2

Recognition in the Financial Statements of Lessor – Lease payments under an operating lease
shall be recognized as an expense on a straight-line basis over the lease term unless another
systematic basis is more representative of the time pattern of the user’s benefit.

For operating leases, lease payments (excluding costs for services such as insurance and
maintenance) are recognized as an expense on a straight-line basis unless another systematic basis
is representative of the time pattern of the user’s benefit, even if the payments are not on that basis.

Recognition in the Financial Statements of Lessee – Lessors shall present assets subject to
operating leases in their balance sheets according to the nature of the asset.

Lease income from operating leases shall be recognized in income on a straight-line basis over the
lease term, unless another systematic basis is more representative of the time pattern in which use
benefit derived from the leased asset is diminished.

Costs, including depreciation, incurred in earning the lease income are recognized as an expense.
Lease income (excluding receipts for services provided such as insurance and maintenance) is
recognized on a straight-line basis over the lease term even if the receipts are not on such a basis,
unless another systematic basis is more representative of the time pattern in which use benefit derived
from the leased asset is diminished.

Initial direct costs incurred by lessors in negotiating and arranging an operating lease shall be added
to the carrying amount of the leased asset and recognized as an expense over the lease term on the
same basis as the lease income.

The depreciation policy for depreciable leased assets shall be consistent with the lessor’s normal
depreciation policy.

A manufacturer or dealer lessor does not recognize any selling profit on entering into an operating lease
because it is not the equivalent of a sale.

ACCOUNTING FOR LAND AND BUILDING LEASE:

Land and building are treated separately by applying the classification criteria. However, for lease of
land and buildings in which the amount that would initially be recognized for the land element is
immaterial, the land and buildings may be treated as a single unit for the purpose of lease classification.
In such a case, the economic life of the building is regarded as the economic life of the entire leased
asset. In another case, separate measurement of land and building is not required when the lessee’s
interest in both land and building is treated as investment property.

ACCOUNTING FOR SALE AND LEASEBACK:

Definition – A sale and leaseback transaction involves the sale of an asset and the leasing back of the
same asset. The lease payment and the sale price are usually interdependent because they are
negotiated as a package. The accounting treatment of a sale and leaseback transaction depends upon
the type of lease involved.

If a sale and leaseback transaction results in a finance lease, any excess of sales proceeds over
the carrying amount shall not be immediately recognized as income by a seller-lessee. Instead, it shall
be deferred and amortized over the lease term.
If the leaseback is a finance lease, the transaction is a means whereby the lessor provides finance
to the lessee, with the asset as security. For this reason it is not appropriate to regard an excess of
sales proceeds over the carrying amount as income. Such excess is deferred and amortized over the
lease term.
 FINANCIAL ACCOUNTING AND REPORTING PART 2

If a sale and leaseback transaction results in an operating lease, and it is clear that the transaction
is established at fair value, any profit or loss shall be recognized immediately.
If the sale price is below fair value, any profit or loss shall be recognized immediately except that,
if the loss is compensated for by future lease payments at below market price, it shall be deferred and
amortized in proportion to the lease payments over the period for which the asset is expected to be
used.
If the sale price is above fair value, the excess over fair value shall be deferred and amortized
over the period for which the asset is expected to be used.
If the leaseback is an operating lease, and the lease payments and the sale price are at fair value,
there has in effect been a normal sale transaction and any profit or loss is recognized immediately.
For operating leases, if the fair value at the time of a sale and leaseback transaction is less than
the carrying amount of the asset, a loss equal to the amount of the difference between the carrying
amount and fair value shall be recognized immediately.
For finance leases, no such adjustment is necessary unless there has been an impairment in
value, in which case the carrying amount is reduced to recoverable amount.

Illustrative Examples of Sale and Leaseback Transactions that result in Operating Leases

Sales price Carrying amount Carrying amount Carrying amount

at fair value equal to fair value less than fair value above fair value

Profit No profit Recognize profit Not applicable

immediately
Loss No loss Not applicable Recognize loss
immediately
Sales price
below fair value

Profit No profit Recognize profit No profit (note 1)

immediately
Loss not compen- Recognize loss Recognize loss (note 1)
sated for by future immediately immediately
lease payments at
below market price

Loss compensated Defer and amortize Defer and amortize (note 1)

for by future lease loss loss
payments at below
market price

Sales price
above fair value

Profit Defer and amortize Defer and amortize Defer and amortize
profit excess profit (note 3) profit (note 2)
Loss No loss No loss (note 1)

Note 1 These parts of the table represent circumstances dealt with for operating leases, if the fair value
at the time of a sale and leaseback transaction is less than the carrying amount of the asset. It
is required that the carrying amount of an asset to be written down to fair value where it is subject
to a sale and leaseback.
Note 2 Profit is the difference between fair value and sales price because the carrying amount would
have been written down to fair value in accordance with note 1 above.
 FINANCIAL ACCOUNTING AND REPORTING PART 2

Note 3 The excess profit (excess of sales price over fair value) is deferred and amortized over the period
for which the asset is expected to be used. Any excess of fair value over carrying amount is
recognized immediately.

PROFORMA JOURNAL ENTRIES:

OPERATING LEASE

LESSOR LESSEE

a. Acquisition of property:
Property xx None.
Cash xx
b. Payment of initial direct costs (costs of negotiating and arranging the lease such as commissions,
legal fees and internal costs):
Property xx None.
Cash xx
c. Receipt of security deposit:
Cash xx Rent deposit (asset) xx
Rent deposit (liability) xx Cash xx
d. Receipt of rentals:
Cash xx Rent expense xx
Rent income xx Cash xx
e. Receipt of lease bonus:
Cash xx Prepaid rent xx
Un. rent income xx Cash xx
f. Payment of repairs and maintenance and other executory costs such as insurance and taxes):
Repairs & maint. xx Repairs & maint. xx
Cash xx Cash xx
g. Construction of leasehold improvements by lessee:
None. Leasehold impr. xx
Cash xx
Year-end adjustments:

h. Depreciation of leased property:

Dep’n. expense xx None.
Acc. dep’n. xx
i. Depreciation of leasehold improvements (over lease term or life of leasehold improvements –
whichever is shorter):
None. Dep’n. – LI xx
AD – LI xx
j. Amortization of lease bonus (over the lease term):
Un. rent income xx Rent expense xx
Rent income xx Prepaid rent xx
k. Amortization of initial direct costs (over the lease term):
Amort. expense xx None.
Property xx

For unequal lease payments under operating lease, total cash payments for the lease term shall
be amortized uniformly on the straight line basis as rent expense or rent income.

Cash xx Rent expense xx

Rent receivable xx Cash xx
Rent income xx Rent payable xx
 FINANCIAL ACCOUNTING AND REPORTING PART 2

FINANCE OR CAPITAL LEASE

LESSOR LESSEE

a. Payment of initial direct costs (costs of negotiating and arranging the lease such as
commissions, legal fees and internal costs):
Direct financing lease
Property xx None.
Cash xx
Sales-type lease
Expenses xx None.
Cash xx

b. Acquisition of property:
Lease receivable (gross)* xx Property xx
Property (net)/Sales** xx Lease liability* *** xx
Unearned int. income*** xx

Cost of sales xx
Inventory xx

* Gross investment in lease under a finance lease is aggregate minimum lease payments plus any
residual value, whether guaranteed or unguaranteed.

** Sales (the shorter between FV and PV of min. lease payments) xx

Less: Cost or carrying amount of property xx
Manufacturer’s or dealer’s profit xx

*** Gross investment (lease receivable) xx

Less: Net investment in the lease –
√ Sales type lease (PV of minimum lease payments plus
any guaranteed or unguaranteed residual value)
Direct financing type lease (cost or carrying amount) xx
Unearned interest income xx

√ Guaranteed residual value scenario, PV of guaranteed residual value is included in sales

because the lessor knows that the entire asset has been sold.

Unguaranteed residual value scenario, PV of unguaranteed residual value is not included

in sales but deducted in cost of sales since the leased asset is not sold because the lessor
will be receiving it back at end of lease term. Thus, gross profit is computed as:
Sales (excluding PV of unguaranteed res. value) xx
Less: Cost of sales (excluding PV of unguar. res. value) xx
Initial direct costs xx
Gross profit xx

**** FV at inception of lease or PV of minimum lease payments, whichever is lower.

PV of minimum lease payments is equal to:
a. rental payments
b. bargain purchase option (sufficiently lower than FV at exercise date)
c. guaranteed residual value

c. Receipt of rentals:
Cash xx Interest expense xx
Lease receivable xx Lease liability xx
Cash xx
 FINANCIAL ACCOUNTING AND REPORTING PART 2

Unearned int. income xx

Interest income xx

Schedule of amortization (effective interest method)

Date Payment Interest Principal Carrying value

(CV x Rate) (Paid-Int.) (CV-Principal)
xx xx xx xx xx
xx xx xx xx xx
xx xx xx xx xx

d. Receipt of contingent rents:

Cash xx Rent expense xx
Rent income xx Cash xx

e. Payment of repairs and maintenance and other executory costs such as insurance and
taxes):
Repairs & maint. xx Repairs & maint. xx
Cash xx Cash xx

f. Bargain Purchase Option:

If exercised
Cash xx Lease liability xx
Lease receivable xx Cash xx
If not exercised
Unearned int. income xx Lease liability xx
Property (net) xx Loss on fin. lease xx
Lease receivable xx Property (net) xx
Gain on finance xx

g. Return of property to lessor if there is no transfer of title nor bargain purchase option:
Unearned int. income xx Lease liability xx
Property (net) xx Property (net) xx
Lease receivable xx

If fair value of leased asset is lower than guaranteed residual value

Cash xx Loss on fin. lease xx
Property xx Cash xx
Lease receivable xx
If fair value of leased asset is lower than unguaranteed residual value
Loss on finance xx
Property xx None.
Lease receivable xx

h. Return of property to lessor whether or not there is a guaranteed or unguaranteed residual

value under sales-type lease:
Inventory xx Lease liability xx
Lease receivable xx Property (net) xx

If fair value of leased asset is lower than guaranteed residual value

Cash xx Lease liability xx
Inventory xx Property xx
Lease receivable xx Cash xx
If fair value of leased asset is lower than unguaranteed residual value
Loss on finance xx
 FINANCIAL ACCOUNTING AND REPORTING PART 2

Inventory xx None.
Lease receivable xx
Year-end adjustments:
a. Depreciation of leased property:
None. Dep’n. expense* xx
Acc. dep’n. xx
* If there is transfer of title and bargain purchase option, useful life of leased property is used.
Otherwise, the shorter between the lease term and useful life of leased property is used.

SALE & LEASEBACK

OPERATING LEASE -
SELLER -LESSEE PURCHASER-LESSOR

a. Sale/ Purchase:
Cash xx Property xx
Acc. Depn. xx Cash xx
Property xx
Gain on sale & leaseback xx
b. Periodic Rentals:
Rent expense xx Cash xx
Cash xx Rental income xx
c. Depreciation:
None. Depreciation xx
Accum. Deprn. xx

FINANCE LEASE -
SELLER -LESSEE PURCHASER-LESSOR

a. Sale/ Purchase:
Cash xx Property xx
Acc. Depn. xx Cash xx
Property xx
Deferred gain on S & L xx
b. Leaseback:
Property xx Lease receivable xx
Lease liability xx Property xx
Unearned int. inc. xx
c. Periodic Rentals & Interest:
Interest expense xx Cash xx
Lease liability xx Lease receivable xx
Cash xx Unearned int. inc. xx
Interest income xx
d. Depreciation:
Depreciation xx None.
Accum. Deprn. xx
e. Amortization of deferred gain:
Deferred gain on S & L xx None.
Gain on sale & leaseback xx