CHAPTER 12

OPERATING LEASE-LESSOR

TECHNICAL KNOWLEDGE

To understand lessor accounting in contrast to lessee accounting under the new lease
standard.

To define on operating lease and a finance lease.

To identify the criteria in determining a finance lease on the part of lessor.

To know the recognition of an operating lease on the part of lessor.

Introduction

Lessor accounting under the new lease standard is business as usual

Lessor accounting under IFRS 16 is substantially unchanged from the old lease standard under
IAS 17.

IFRS 16, paragraph 61, provides that a lessor shall classify leases as either an operating lease or
a finance lease.

Definitions

An operating lease is a lease that does not transfer substantially all the risks and rewards
incidental to ownership of an underlying asset.

A finance lease is a lease that transfers substantially all the risks and rewards incidental to
ownership of an underlying asset.

When is a lease classified as finance lease?

Whether a lease is a finance lease or an operating lease depends on the substance of the
transaction rather than the form of the contract.

Under IFRS 16, paragraph 63, among others, any of the

following situations would normally lead to a lease being
classified as a finance lease by the lessor.

a. The lease transfers ownership of the underlying asset to the lessee at the end of the lease term.

b. The lessee has an option to purchase the asset at a price which is expected to be sufficiently
lower than the fair value at the date the option becomes exercisable.
At the inception of the lease, it is reasonably certain that the option will be exercised.

c. The lease term is for the major part of the economic life of the underlying asset even if title is
not transferred.

d. The present value of the lease payments amounts to substantially all of the fair value of the
underlying asset at the inception of the lease.

These four major criteria are determinative in nature, meaning, any one of these would
normally result to a conclusion that the lease contract is a finance lease.

Major part

What percentage represents a major part?

Is it 60%, 75% or 80%?

It is unfortunate that the new lease standard does not a clear-cut definition of a major part.

Under USA GAAP, major part means at least 75% of the economic life of an asset.

Of course, right thinking persons can debate whether a major part implies a proportion lower
than 75%, for example, as little as 51%, or implies a higher proportion than 75%, such as 90%.

Substantially all

Under USA GAAP, substantially all means at least 90% of the fair value of the leased asset.

There is room for debate over whether substantially all implies a threshold lower than or higher
than 90%.

Other criteria

Paragraphs 63 and 64 provide that other situation that individually or in combination could also
lead to a lease being classified as finance lease are:

a. The underlying asset is of stich specialized nature that only the lessee can use it without
major modification.

b. If the lessee can cancel the lease, the lessor's losses associated with the cancelation are
borne by the lessee.

c. Gains or losses from the fluctuation in the fair value of

the residual accrue to the lessee.
 d. The lessee has the ability to continue the lease for a secondary period at a rent that is
substantially lower than market rent.

These other criteria are more suggestive in nature, meaning, these could also lead to a finance
lease classification.

Land and building lease

Application Guidance B55 provides that in classifying a lease on land and building, a lessor
normally considers the land and building elements separately.

In determining whether the land element is an operating lease or a finance lease, an important
consideration is that land normally has an indefinite economic life.

Application Guidance B56 provides that the lease payments are allocated between the land and
building elements in proportion to the relative fair value of the leasehold interests in the land and
building elements at the inception of the lease.

If the lease payments cannot be allocated reliably between the two elements, the entire lease is
classified as a finance lease, unless it is clear that both elements are operating leases.

For lease of land and building in which the amount for the land element is immaterial to the
lease, a lessor may treat the land and building as single unit for the purpose of lease
classification.

The single lease is classified as a finance lease or an operating lease applying the lease
classification criteria for lessor.

In such a case, the economic life of the building is regarded as the economic life of the entire
underlying asset.

Operating lease - Lessor

IFRS 16, paragraph 81, provides that a lessor shall recognize lease payments from operating
lease as income either on a straight-line basis or another systematic basis.

The lessor shall apply another systematic basis if this is more representative of the pattern in
which benefit from the use of the underlying asset is diminished.

Otherwise stated, the periodic rental received by the lessor in an operating lease is simply
recognized as rent income.

A lessor shall present an underlying asset subject to operating lease in the statement of financial
position according to the nature of the asset.
The underlying asset remains as an asset of the lessor. Consequently, the lessor bears all
ownership or executory costs such as depreciation of leased property, real property
taxes, insurance and maintenance.

However, the lessor may pass on to the lessee the payment for taxes, insurance and maintenance
cost.

The depreciation policy for depreciable leased asset shall be consistent with the lessor's normal
depreciation for similar asset.

Initial direct cost inourred by lessor in an operating lease shall be added to the carrying amount
of the underlying asset and recognized as an expense over the lease term on the same basis as the
lease income.

Any security deposit refundable upon the lease expiration shall be accounted for as liability by
the lessor.

Any lease bonus received by the lessor from the lessee is recognized as unearned rent income to
be amortized over the lease term.

Illustration

1. On January 1, 2020, Simple Company purchased a machinery for P3,000,000 cash for the
purpose of leasing it. The machine is expected to have a 10-year life and no residual value.

Machinery 3,000,000
Cash 3,000,000

2. On April 1, 2020, Simple Company leased the machine to another entity for 3 years at a
monthly rental of P50,000, payable at the beginning of every month.

Cash (50,000. x 9) 450,000

Rent income 450,000

3. On April 1, 2020, Simple Company received a security deposit of P600,000 to be refunded

upon the lease expiration.

Cash 600,000
Liability for rent deposit 600,000

4. In addition to the rental, Simple Company received from the lessee a lease bonus of P120,000
on January 1, 2020.

Cash 120,000
Unearned rent income 120,000
5. On April 1, 2020, Simple Company paid initial direct cost of P300,000. Such costs are directly
attributable to negotiating and arranging the operating lease.

Deferred initial direct cost 300,000

Cash 300,000

6. During the year, Simple Company paid repair and maintenance of P20,000.

Repair and maintenance 20,000

Cash 20,000

7. The lease bonus is amortized over 3 years or P40,000 annually.

Unearned rent income 30,000

Rent income (40,000 x 9/12) 30,000

8. The machinery is depreciated over 10 years or P300,000 annually.

Depreciation 300,000
Accumulated depreciation 300,000

Note that the depreciation is from the date of acquisition, January 1, 2020 and not from April 1,
2020, date of lease.

The reason is that the machinery is acquired for leasing purposes and already available for the
intended use, meaning for rental from January 1, 2020.

Idle property is subject to depreciation as long as it is available for the intended use.

9. The initial direct cost is recognized as expense over the lease term.

Amortization of initial direct cost 75,000

Deferred initial direct cost
(300,000/3 x 9/12) 75,000

The balance of the deferred initial direct cost shall be presented as an addition to the carrying
amount of machinery.

Unequal rental payments

IFRS 16, paragraph 81, provides that lease payments under an operating lease shall be
recognized as income on a straight-line basis or another systematic basis.

This simply means that where the operating lease requires unequal cash payments, the total cash
payments for the lease term shall be amortized uniformly on the straight line basis as rent income
over the lease term.

Illustration

Aye Company leased office space to another entity for a three-year period beginning January 1,
2020.

Under the terms of the operating lease, rent for the first year is P1,000,000 and rent for the next
two years, P1,250,000 annually.

However, as an inducement to enter the lease, Aye granted the lessee the first six months of the
lease rent-free.

Total rental for the lease term

2020 (1,000,000 x 6/12) 500,000

2021 1,250,000
2022 1,250,000

Total rental for 3 years 3,000,000

Average annual rental (3,000,000/3) 1,000,000

Books of Aye Company - Lessor

2020 Cash 500,000

Rent receivable 500,000
Rent income 1,000,000

2021 Cash 1,250,000

Rent income 1,000,000
Rent receivable
250,000

Rent income for 2020 and 2021 2,000,000

Rent collected (500,000 + 1,250,000) 1,750,000

Rent receivable 250,000

2022 Cash 1,250,000

Rent income 1,000,000
Rent receivable 250,000

Note that the rent receivable has a zero balance on December 31, 2022 and the recorded rent
income each year is P1,000,000.
QUESTIONS

1. Explain the lessor accounting model under the new lease standard.

2. What are the two kinds of lease?

3. Define an operating lease.

4. Define a finance lease.

5. When is a lease classified as finance lease or operating lease?

6. Explain the presentation of the underlying asset in an operating lease.

7. Explain the treatment of the following in connection with an operating lease on the part of
lessor:
a. Lease bonus
b. Executory cost
c. Initial direct cost incurred by lessor
d. Security deposit

8. Explain the treatment of unequal rental payments.

9. Explain the recognition of land and building lease.

PROBLEMS

Problem 12-1 (PHILCPA Adapted)

On January 1, 2020, Vim Company purchased an equipment for P3,000,000 cash for the purpose
of leasing it. The machine is expected to have a 10-year life from the date of purchase.

On April 1, 2020, the equipment was leased to Eloisa Company for a three-year period, at a
monthly rental of P40,000, payable at the end of every month.

Additionally, Eloisa Company paid P120,000 to Vim Company on April 1, 2020 as a lease
bonus. Vim Company paid repairs of P20,000 relating to 2020.

Required:

1. Prepare journal entries on the books of the lessor following the operating lease-model.

2. Compute the net rent income of the lessor for 2020.

Problem 12-2 (PHILCPA Adapted)

On January 1, 2020, Myriad Company purchased a tractor at a cost of P1,600,000 for the purpose
of leasing it.

The tractor is estimated to have a useful life of 5 years with residual value of P100,000.
Depreciation is on a straight-line basis.

On April 1, 2020, Myriad Company entered into a lease contract for the lease of the tractor for a
term of two years up to March 31, 2022. The lease fee is P50,000 a month and the lessee paid
P600,000, the lease fee for one year.

Myriad Company paid P120,000 commission associated with negotiating the lease, P15,000 for
minor repairs and P10,000 transportation of the tractor during 2020.

Required:

Prepare journal entries on the books of the lessor using the operating lease model.

Problem 12-3 (AICPA Adapted)

On March 20, 2020, Barnes Company purchased a machine for P2,400,000 for the purpose of
leasing it to others.

The machine is expected to have a 10-year life and no residual value. It will be depreciated on
the straight-line basis computed to the nearest month.

The machine was leased to Rally Company on April 1, 2020 for four years, at a monthly rental of
P36,000.

There is no provision for renewal of the lease or purchase of the machine by the lessee upon
expiration of the lease.

Barnes Company paid P240,000 initial direct costs associated with negotiating the lease in
March 2020.

Required:

1. Prepare journal entries on the books of the lessor for 2020.

2. Present the machinery in the statement of financial position of Barnes Company on December
31, 2020.
Problem 12-4 (IAA)

Dorey Company purchased a machine on January 1, 2020 for P5,000,000 for the express purpose
of leasing it.

The machine was expected to have a 10-year life with no residual value and the straight line
method of depreciation is used.

On March 1, 2020, Dorey Company leased the machine to Anne Company for P1,200,000 a year
for a 4-year period ending February 28, 2024.

Dorey Company paid a total of P60,000 for maintenance and received P1,200,000 from Anne
Company on March 1, 2020.

Dorey Company retains title to the property and plans to lease it to someone else after the 4-year
lease period.

Required:

1. Prepare journal entries on the books Dorey Company.

2. Determine the net rent income of Dorey Company.

Problem 12-5 (AICPA Adapted)

On January 1, 2020, Condor Company purchased a new machine for P3,600,000 and leased it to
West Company the same day.

The machine has an estimated useful life of 12 years and will be depreciated by the straight line
method.

The lease is for a three-year period expiring January 1, 2023 at an annual rental of P500,000.
Additionally, West Company paid P150,000 to Condor Company as a lease bonus to obtain
the three-year lease.

During 2020, Condor Company paid insurance of P50,000 for the leased machine.

Required:

Prepare journal entries on the books of the lessor for the year ended December 31, 2020.

Problem 12-6 (PHILCPA Adapted)

Manila Company is engaged in leasing heavy equipment. On December 1, 2020, the entity
bought a second hand heavy equipment for P375,000.

In December 2020, the entity incurred P75,000 for a major overhaul to put the equipment in
good running condition.

The equipment is available for the intended use on December 31, 2020. The equipment has an
estimated useful life of 5 years, Depreciation is on a straight line basis.

On April 1, 2021, Manila Company leased the equipment to Makati Company for 2 years up to
March 31, 2023.

The lease fee is P15,000 per month. Makati Company paid P180,000 on April 1, 2021, the lease
fee for one year.

During 2021, Manila Company spent P7,000 for minor repairs and P3,000 for transportation of
the equipment to Makati Company

Required:

Prepare journal entries on the books of lessor for 2020 and 2021

Problem 12-7 (AICPA Adapted)

As an inducement to enter a lease, Aris Company, a lessor, grants Ronald Company, a lessee,
nine months of free rent under a five year operating lease.

The lease is effective on April 1, 2020 and provides for monthly rental of P110,000 to begin
January 1, 2021.

Required:

Prepare journal entries on the books of the lessor over the 5-year lease term.

Problem 12-8 (AICPA Adapted)

On October 1, 2020, Dean Company leased office space at a monthly rental of P300,000 for 10
years expiring September 30, 2030.

As an inducement for Dean Company to enter into the lease, the lessor permitted Dean Company
to occupy the premises rent-free from October 1 to December 31, 2020.

Required:
Prepare journal entries on the books of the lessor for 2020, 2021 and the last year 2030.

Problem 12-9 (AICPA Adapted)

On January 1, 2020, Gee Company leased a delivery truck to Marr Company under a 3-year
operating lease.

Total rent for the term of the lease is P3,600,000, payable P50,000 monthly for 2020, P75,000
monthly for 2021, and P175,000 monthly for 2022. All payments were made when due.

Required:

Prepare journal entries on the books of the lessor over the 3-year lease term.

Problem 12-10 (AICPA Adapted)

Conn Company owns an office building and normally charges tenants P3,000 per square meter
per year for office space.

Because the occupancy rate is low, Conn Company agreed to lease 1,000 square meters to
Hanson Company at P1,200 per square meter for the first year of a three-year operating lease.
Rent for remaining years will be at the P3,000 rate.

Hanson Company moved into the building on January 1, 2020, and paid the first year's rent in
advance.

What amount of rental revenue should be reported in the income statement for the year ended
September 30, 2020?

a. 2,400,000
b. 1,200,000
C. 1,800,000
d. 900,000

Problem 12-11 (AICPA Adapted)

Wall Company leased an office to Fox Company for a five-year term beginning January 1, 2020.

Under the terms of the operating lease, rent for the first year is P800,000 and rent for years 2
through 5 is P1,250,000 per annum.

However, as an inducement to enter the lease, Wall Company granted Fox Company the first six
months of the lease rent-free.

What amount should be reported as rental income for 2020?

a. 1,200,000
b. 1,160,000
c 1,080,000
d. 800,000

Problem 12-12 (AA)

On January 1, 2020, Abba Company leased a building to Bee Company under a four-year
operating lease.

The monthly rental for 2020, 2021, 2022 and 2023 is P100,000, P150,000, P200,000 and
P250,000, respectively.

Rentals are payable at the end of each month. All rental payments within the year were made
when due.

What amount should be reported as rent receivable from Bee Company on December 31, 2021?

a. 1,000,000
b. 1,200,000
c. 600,000
d. 900,000

Problem 12-13 (IAA)

Abe Company, lessor, leased an equipment under an operating lease.

The lease term is 5 years and the lease payments are made in advance on January 1 of each year
as shown in the following schedule:

January 1, 2020 1,000,000

January 1, 2021 1,000,000
January 1, 2022 1,400,000
January 1, 2023 1,700,000
January 1, 2024 1,900,000

On December 31, 2021, what amount should be reported as rent receivable?

a. 1,400,000
b. 800,000
c. 400,000
d. 0

Problem 12-14 (AICPA Adapted)

At the beginning of current year, Wren Company leased building to Brill Company under an
operating lease for ten years at P500,000 per year, payable the first day of each lease
year. Wren Company paid P150,000 to a real estate broker as initial direct cost.

The building is depreciated P120,000 per year. Wren Company incurred insurance and property
tax expense totaling P90,000 for the current year.

What is the net rent income for the current year?

a. 275,000
b. 290,000
c. 350,000
d. 365,000

Problem 12-15 (AICPA Adapted)

At the beginning of current year, Rapp Company leased a new machine to Lake Company for 5
years: The annual rental is P900,000.

Additionally, Lake Company paid P500,000 to Rapp Company as a lease bonus and P250,000 as
a security deposit to be refunded upon expiration of the lease.

What amount should be reported as rent revenue for the current year?

a. 1,400,000
b. 1,250,000
c. 1,000,000
d. 900,000

Problem 12-16 (AICPA Adapted)

At the beginning of current year, Jade Company purchased a new machine for P4,800,000 and
leased it to East Company the same day.

The machine has an estimated 12-year life and will be depreciated P400,000 per year. The lease
is for a three-year period at an annual rental of P850,000.

Additionally, East Company paid P300,000 to Jade Company as a lease bonus to obtain the
three-year lease.

Jade Company incurred insurance expense of P80,000 for the leased machine during the current
year.

What is the operating profit of the lessor on the leased asset for the current year?
a. 670,000
b. 550,000
c. 470,000
d. 370,000

Problem 12-17 (AICPA Adapted)

On January 1, 2020, Glen Company leased a building to Dix Company for a ten-year term at an
annual rental of P500,000.

At inception of the lease, Glen Company received P2,000,000 covering the first two years' rent
of P1,000,000 and a security deposit of P1,000,000.

This deposit will not be returned to Dix Company upon expiration of the lease but will be
applied to payment of rent for the last two years of the lease.

What amount should be reported as current and noncurrent liability in the December 31, 2020
statement of financial position?

Current liability Noncurrent liability

a. 0 2,000,000
b. 500,000 1,000,000
c. 1,000,000 1,000,000
d. 1,000,000 500,000

Problem 12-18 (AICPA Adapted).

Barnel Company owns and manages apartments. On signing a lease, each tenant must pay the
first month and last month rent and a P50,000 refundable security deposit.

The security deposit is rarely refundable in total because cleaning costs of P15,000 per apartment
are almost always deducted.

About 30% of the time, the tenants are also charged for damages to the apartment which
typically cost P10,000.

If a one-year lease is signed on a P90,000 per month apartment, what amount should be reported
as refundable security deposit?

Problem 12-19 (IAA)

On July 1, 2020, Hutch Company leased equipment to Elder Company for a one-year period
expiring June 30, 2021 for P60,000 a month.
On July 1, 2021, Hutch Company leased this piece of equipment to Toil Company for a three-
year period expiring June 30, 2024 for P75,000 a month.

The original cost of the equipment was P4,800,000. The equipment, which has been continually
on lease since July 1, 2017, is being depreciated on a straight line basis over an eight-year period
with no residual value.

What is the amount of net rental income that would be reported by Hutch Company for the year
ended December 31, 2021?

a. 210,000
b. 450,000
c. 810,000
d. 360,000

Problem 12-20 (IAA)

On May 1, 2020, Hug Company leased equipment to Rave Company which expires on May 1,
2021. Rave Company could have bought the equipment from Hug for P3,200,000 instead of
leasing it.

Hug's accounting records showed a carrying amount for the equipment on May 1, 2020 of
P2,800,000. Hug's depreciation on the equipment in 2020 was P360,000.

During 2020, Rave Company paid P720,000 in rentals to Hug Company for the 8-month period.
Hug incurred maintenance and other related costs under the terms of the lease of P64,000 in
2020.

After the lease with Rave Company expires, Hug Company will lease the equipment to another
entity for two years.

What is the pretax income derived by Hug for 2020?

a. 296,000
b. 360,000
c. 656,000
d. 720,000

Problem 12-21 Multiple choice (AICPA Adapted)

1. Rent received in advance by the lessor in an operating lease should be recognized as revenue

a. When received
b. At the lease inception
c. At the lease expiration
d. In the period specified by the lease

2. When should a lessor recognize in income a nonrefundable lease bonus paid by a lessee?

a. When received
b. At the inception of the lease
c. At the lease expiration
d. Over the lease term

3. Lease payments under an operating lease shall be recognized as an income by the lessor on

a. Straight line basis over the lease term

b. Diminishing balance basis
c. Sum of units basis
d. Cash basis

4. In an operating lease that is recorded by the lessor, the equal monthly rental payments should

a. Recorded as reduction of depreciation.

b. Allocated between reduction in lease receivable and interest expense.
c. Recorded as reduction in the lease receivable.
d. Recorded as a rental income.

5. Which statement characterizes an operating lease?

a. The lessee records depreciation and interest.

b. The lessee records a lease obligation.
c. The lessor transfers title of the underlying asset to the lessee for the duration of the lease term.
d. The lessor records depreciation and lease revenue.

Problem 12-22 Multiple choice (IFRS)

1. The classification of a lease is normally carried out

a. At the end of the lease term

b. After a "cooling off" period of one year
c. At the inception of the lease
d. When the entity deems it to be necessary

2. The classification of a lease as either operating or finance lease is based on

a. The length of the lease.
b. The transfer of the risks and rewards of ownership.
c. The lease payments being at least 50% of fair value.
d. The economic life of the underlying asset.

3. All of the following situations would prima facie lead to a lease being classified as a finance
lease, except

a. Transfer of ownership to the lessee.

b. Option to purchase at a value below the fair value of the underlying asset.
c. The lease term is for a major part of the asset's life.
d. The present value of the lease payments is 50% of the fair value of the asset.

4. In case of lease of land and building, the lease payments should be split

a. According to relative fair value of the two elements.

b. Based on the useful life of the two elements.
c. Using the sum of digits method.
d. According to method devised by the entity.

5. Where there is a lease of land and building and the title to the land is not transferred, generally
the lease is treated as if

a. The land is finance lease.

b. The land is finance and the building is operating
c. The land is operating and the building is finance.
d. The land and building are an operating lease.

Problem 12-23 Multiple choice (IAA)

1. The accounting concept that is principally used to classify leases into operating and finance on
the part of lessor is

a. Substance over form

b. Prudence
c. Neutrality
d. Completeness

2. Which statement is correct regarding the lease capitalization criteria?

a. The lease transfers ownership to the lessor.

b. The lease contains a purchase option.
c. The lease term is equal to at least 75% of the economic life of the underlying asset.
d. The lease payments are at least 90% of fair value of asset.
3. Which condition would require lease capitalization?

a. The lease does not transfer title to the lessee.

b. There is an uncertain purchase option.
c. The present value of the lease payments is significantly more than the fair value of the asset.
d. The lease term is below the useful life of asset.

4. One of the four determinative criteria for a finance lease specifies that the lease term be equal
to or greater than

a. The economic life of the underlying asset.

b. 90 percent of the economic life of the asset.
c. 75 percent of the economic life of the asset.
d. 50 percent of the economic life of the asset.

5. One of the four determinative criteria for a finance lease is that the present value at the
beginning of the lease term of the lease payments equals or exceeds

a. The fair value of the underlying asset

b. 90 percent of the fair value of the underlying asset
c. 75 percent of the fair value of the underlying asset
d. 50 percent of the fair value of the underlying asset