CHAPTER 13

DIRECT FINANCING LEASE-LESSOR

TECHNICAL KNOWLEDGE

To know the finance lease classification on the part of lessor.

To define a direct financing lease.
To distinguish a direct financing lease from a sales type lease.
To understand gross investment and net investment in a direct financing lease.
To recognize interest income in a direct financing lease using the effective interest method.

FINANCE LEASE CLASSIFICATION

On the part of the lessor, a finance lease is either:
a. Direct financing lease
b. Sales type lease
The main distinction between the two is the presence or absence of a manufacturer or dealer
profit or loss.
A direct financing lease recognizes only interest income.
A sales type lease recognizes interest income and gross profit

Direct financing lease

The lessor in a direct financing lease is actually engaged in the financing business. Thus, a direct
financing lease is an arrangement between a financing entity and a lessee.
The income of the lessor is only in the form of interest income.
No dealer profit is recognized because the fair value and the cost of the asset are equal.

Accounting considerations
a. Gross investment - This is equal to the gross rentals for the entire lease term plus the absolute
amount of the residual value, whether guaranteed or unguaranteed.
b. Net investment in the lease - This is equal to the cost of the asset plus any initial direct cost
paid by the lessor.
c. Unearned interest income - This is the difference between the gross investment and net
investment in the lease.
d. Initial direct cost - In a direct financing lease, the initial direct cost paid by the lessor is added
to the cost of the asset to get the net investment in the lease.
The initial direct cost would effectively spread the initial direct cost over the lease term and
reduce the amount of interest income.

Illustration - Direct financing lease

On January 1, 2020, Lessor Company leased a machinery to another entity with the following
details:

Cost of machinery 1,518,650

Annual rental payable at the end of each year 500,000
Lease term 4 years
Useful life of machinery 4 years
Implicit interest rate 12%
Present value of annuity of 1 for 4 years a 12% 3.0373

The initial problem is the determination of the annual rental which will give the lessor a fair rate
of return on the net investment in the lease.
The procedure is to divide the "net investment in the lease to be recovered from rental" by
present value factor of an annuity of 1 for a number of periods using a desired rate of return to
get the annual rental.

Computation
The annual rental is computed by dividing the amount of P1,518,650 by the present value factor,
3.0373, of an annuity of 1 for 4 years at 12%, or P500,000.

Gross rentals or lease receivable (500,000 x 4 years) 2,000,000

Present value of gross rentals (equal to the net
investment in the lease or cost of the machinery) 1,518,650
Unearned interest income 481,350

Lease receivable 2,000,000

Machinery 1,518,650
Unearned interest income 481,350
The annual collection of the rental is recorded as follows:

Cash 500,000
Lease receivable 500,000

Table of amortization
The unearned interest income of P431,350 is recognized over the lease term following the
effective interest method.
Date Payment Interest Principal Present value
Jan. 1, 2020 1,518,650
Dec. 31, 2020 500,000 182,238 317,762 1,200,888
Dec. 31, 2021 500,000 144,107 355,893 844,995
Dec. 31, 2022 500,000 101,399 398,601 446,394
Dec. 31, 2023 500,000 53,606 446,394 -

Payment represents the annual rental.

Interest is equal to the preceding present value times the interest rate. Thus, for 2020, P1,518,650
times 12% equals P182,238.
Principal is the portion of the rental payment after deducting the interest. Thus, for 2020,
P500,000 minus P182,238 equals P317,762
Present value is the balance of the present value after deducting the principal payment.
Thus, on December 31, 2020, P1,518,650 minus P317,762 equals P1,200,888.

Recognition of interest income

The effective interest method is used in recognizing interest income.
IFRS 16, paragraph 75, states that the lessor shall recognize finance income over the lease term
based on pattern reflecting a constant periodic rate of return on the lessor's net investment in the
lease.

2020
Dec. 31 Unearned interest income 182,238
Interest income 182,238

2021
Dec. 31 Unearned interest income 144,107
Interest income 144,107

Direct financing lease - with initial direct cost

On January 1, 2020, Lessor Company leased a machinery to another entity with the following
details:

Cost of machinery 1,518,650

Annual rental payable at the end of each year 500,000
Lease term 4 years
Useful life of machinery 4 years
Implicit interest rate 12%
Present value of annuity of 1 for 4 years a 12% 3.0373

On January 1, 2020, Lessor Company paid initial direct cost of P66,300.

The initial direct cost is added to the cost of the machinery to determine the net investment in the
lease.
Cost of machinery 1518,650
Initial direct cost 66,300
Net investment in the lease 1,584,950

The inclusion of the initial direct cost in the net investment in lease will have the effect of
spreading the initial direct cost over the lease term and reduce the interest income from the
finance lease.
Gross rentals 2,000,000
Net investment in the lease 1,584,950
Unearned interest income` 415,050

Consequently, the initial direct cost would decrease implicit interest rate in the lease.
The problem therefore is the determination of the reduced implicit interest rate.
The original implicit interest rate of 12% cannot be applied anymore because of the added initial
direct cost.

Computation of new implicit rate

The new implicit rate is computed by trial and error or through the interpolation process.
The new interest rate is definitely lower than 12% and it could be 11%, 10% or 9%.
The procedure is determine the present value of gross rentals that would equate the net
investment in the lease of P1,584,950 using a particular rate.
Using 11%, the present value of an ordinary of 1 at 11% for 4 periods is 3.1024.
Thus, the present value of gross rentals is equal to P500,000 multiplied by 3.1024 or P1,551,200.
This amount is not the same as the net investment in the lease. The new interest rate is not 11%.
Using 10%, the present value of an ordinary annuity of 1 at 10% for 4 periods is 3.1699.
Thus, the present value of gross rentals is equal to P500,000 multiplied by 3.1699 or P1,584,950.
Coincidentally, this amount is the same as the net investment in the lease.
In conclusion, the new interest rate is 10%.
Accordingly, the reduced interest rate of 10% is used in determining the annual interest income.

Journal entries
Machinery (initial direct cost) 66,300
Cash 66,300
Lease receivable 2,000,000
Machinery 1,584,950
Unearned interest income 415,050
The annual collection of the rental is recorded as:
Cash 500,000
Lease receivable 500,000
The unearned interest income of P415,050 is recognized as income over the lease term following
the effective interest method of amortization.

Table of amortization
Date Payment Interest Principal Present value
Jan. 1, 2020 1,584,950
Dec. 31, 2020 500,000 158,495 341,505 1,243,445
Dec. 31, 2021 500,000 124,344 375,656 867,789
Dec. 31, 2022 500,000 86,779 413,221 454,568
Dec. 31, 2023 500,000 45,432 454,568 -

Payment represents the annual rental.

Interest is equal to the preceding present value times the interest rate.
Thus, for 2020, P1,584,950 times 10% equals P158,495.
Principal is the portion of the rental payment after deducting the interest.
Thus, for 2020, P500,000 minus P158,495 equals P341,505.
Present value is the balance of the preceding value after deducting the principal payment.
Thus, oh December 31, 2020, P1,584,950 minus P341,505 equals P1,243,445.

Journal entries
The recognition of interest income for the first two years is recorded as:

2020
Dec. 31 Unearned interest income 158,495
Interest income 158,495
2021
Dec. 31 Unearned interest income 124,344
Interest income 124,344
If a statement of financial position is prepared by the lessor on December 31, 2020, the lease
receivable of P1,500,000 would be reported as partly current and partly noncurrent.

Current portion
Lease receivable 500,000
Unearned interest income (124,344)
Carrying amount 375,656

Noncurrent portion
Lease receivable 1,000,000
Unearned interest income ( 132,211)
Carrying amount 867,789

IFRS 16, paragraph 67, states that lessors shall recognize assets held under a finance lease as a
receivable at an amount equal to the net investment in the lease.
Note that the unearned interest income which is realizable within one year from December 31,
2020 is deducted from the current lease receivable.
The remaining portion is deducted from the noncurrent lease receivable.
Unearned interest income 415,050
Realized in 2020 (see table) 158,495
Balance, December 31, 2020 256,555
Realizable in 2021 124,344
Realizable beyond 2021 132,211

Direct financing lease - with residual value

On January 1, 2020, Lessor Company leased a machinery to another entity with the following
details:
Cost of machinery 3,194,410
Residual value 500,000
Useful life and lease term 4 years

The machinery will revert to the lessor at the end of the lease term because there is neither a
transfer of title nor a purchase option.
The problem is the determination of the annual rental. The annual rental is payable at the end of
each year with the first payment on December 31, 2020. The relevant present value factors are:
PV of 1 at 10% for 4 periods .6830
PV of an ordinary annuity of 1 at 10% for 4 periods 3.1699
Cost of machinery 3,194,410
Present value of residual value (500,000 x .683) (341,500)
Net investment to be recovered from rental 2,852,910
Divide by PV of an ordinary annuity of 1 at
10% for 4 periods 3.1699
Annual rental 900,000
Note that the present value of the residual value is deducted from the cost of the asset if the
machinery will revert to the lessor at the end of the lease term.
Otherwise, if the machinery will not revert to the lessor at the end of the lease term, the residual
value is completely ignored.
Gross rentals (900,000 x 4) 3,600,000
Residual value (whether guaranteed or unguaranteed) 500,000
Gross investment 4,100,000
Cost of machinery - net investment (3,194,410)
Unearned interest income 905,590

Table of amortization
Date Payment Interest Principal Present value
1/1/2020 3,194,410
12/31/2020 900,000 319,441 580,559 2,613,851
12/31/2021 900,000 261,385 638,615 1,975,236
12/31/2022 900,000 197,524 702,476 1,272,760
12/31/2023 900,000 127,240 772,760 500,000
Interest is equal to the preceding present value times the interest rate. Thus, for 2020, P3,194,410
x 10% equals P319,441.
Principal is the portion of the rental after deducting interest.
Thus, for 2020, P900,000 minus P319,441 equals P580,559.
Present value equals the balance of the present value minus the principal payment.
Thus, on December 31, 2020, P3,194,410 minus P580,559 equals P2,613,851.

Journal entries for 2020

1. To record the direct financing lease:
Lease receivable 4,100,000
Machinery 3,194,410
Unearned interest income 905,590

2. To record the collection of annual rental:

Cash 900,000
Lease receivable 900,000

3. To record the interest income:

Unearned interest income 319,441
Interest income 319,441
When the lease expires on December 31, 2023, the machinery will revert to the lessor.
Whether "guaranteed" or unguaranteed", the entry on the books of the lessor will be the same.
Machinery 500,000
Lease receivable 500,000

Accounting problem
The accounting problem is when the fair value of the machinery is P400,000 which is lower than
the residual value of P500,000
Under the guaranteed scenario, the lessee will pay for the difference. The journal entry of the
lessor is:
Cash 100,000
Machinery 400,000
Lease receivable 500,000
Under the unguaranteed scenario, the lessor shall recognize a loss for the difference.
Loss on finance lease 100,000
Machinery 400,000
Lease receivable 500,000

Direct financing lease - with residual value

On January 1, 2020, Lessor Company leased a machinery to another entity with the following
details:
Cost of machinery 3,760,100
Residual value guarantee 400,000
Useful life and lease term 4 Years
Implicit interest rate 10%
The annual rental is payable in advance on January 1 of each year starting January 1, 2020.
Since the residual value is guaranteed, the machinery will revert to the lessor at the end of the
lease term.
The relevant present value factors are:
Present value of 1 at 10% for 4 periods 0.6830
Present value of an annuity of 1 in advance
at 10% for 4 periods 3.4869
Computation of annual rental
Cost of machinery 3,760,100
Present value of residual value (400,000 x .683) (273,200)
Net investment to be recovered from rental 3,486,900
Divide by PV of annuity of 1 in advance
at 10% for 4 periods 3.4869
Annual rental 1,000,000

Note that the rental is payable in advance at the beginning of each year. Thus, the "annuity of 1
in advance factor" is used in the computation.
Gross rentals (1,000,000 x 4 years) 4,000,000
Residual value-guaranteed 400,000
Gross investment 4,400,000
Net investment -cost of machinery 3,760,100
Unearned interest income 639,900

Date Payment Interest Principal Present value

1/1/2020 3,760,100
1/1/2020 1,000,000 - 1,000,000 2,760,100
1/1/2021 1,000,000 276,010 723,990 2,036,110
1/1/2022 1,000,000 203,611 796,389 1,239,721
1/1/2023 1,000,000 123,972 876,028 363,693
1/1/2024 400,000 36,307 363,693 -
Interest is equal to the preceding present value times the interest rate. The first rental payment on
January 1, 2020 pertains to principal only.
Thus, on January 1, 2021, the interest is equal to P2,760,100 times 10% or P276,010. This
interest income pertains to 2020.
Principal is the portion of the rental payment minus the interest. Thus, on January 1, 2021,
P1,000,000 minus P276,010 equals P723,990.
Present value is the balance of the present value minus the principal payment.
Thus, on January 1, 2021, P2,760,100 minus P723,990 equals P2,036,110.

Journal entries
2020
Jan. 1 Lease receivable 4,400,000
Machinery 3,760,100
Unearned interest income 639,900
1 Cash 1,000,000
Lease receivable 1,000,000

Dec. 31 Unearned interest income 276,010

Interest income 276,010

2021
Jan. 1 Cash 1,000,000
Lease receivable 1,00,000
Dec. 31 Unearned interest income 203,611
Interest income 203,611

2022
Jan. 1 Cash 1,000,000
Lease receivable 1,00,000
Dec. 31 Unearned interest income 123,972
Interest income 123,972

2023
Jan. 1 Cash 1,000,000
Lease receivable 1,00,000
Dec. 31 Unearned interest income 36,307
Interest income 36,307

2024
Jan. 1 On this date, the fair value of the machinery is P300,000 only. Since the
guaranteed residual value is P400,000, the lessee will pay for the difference of
P100,000.
Cash 100,000
 Machinery 300,000
Lease receivable 400,000

Direct financing lease - transfer of title to lessee

On January 1, 2020, Lessor Company leased a machinery to another entity with the following
details:
Cost of machinery `3,449,600
Residual value 500,000
Useful life and lease term 5 years
Implicit interest rate 8%
The annual rental is payable in advance on January 1 of each year starting January 1, 2020.
The lease provides for a transfer of title to the lessee at the end of the lease term.
The present value of an annuity of 1 in advance at 8% for 5 periods is 4.312
Cost of machinery to be recovered from rental 3,449,600
Divide by PV of an annuity of 1 in advance
at 8% for 5 periods 4.312
Annual rental 800,000
Note well that if the machinery will not revert to the lessor at the end of the lease term because
the lease provides for a transfer of title to the lessee, the residual value is completely ignored in
the computation of the annual rental and the unearned interest income.
Note also that the annual rental is payable in advance.
Thus, the annuity of 1 in advance or annuity due factor is used in the computation.
Gross rentals (800,000 x 5 years) 4,000,000
Net investment - cost of machinery 3,449,600
Unearned interest income 550,400

Table of amortization
Date Payment Interest Principal Present value
1/1/2020 3,449,600
1/1/2020 800,000 - 800,000 2,649,600
1/1/2021 800,000 211,968 588,032 2,061,568
1/1/2022 800,000 164,925 635,075 1,426,493
1/1/2023 800,000 114,119 685,881 740,612
1/1/2024 800,000 59,388 740,612 -

Interest is equal to the preceding present value times the interest rate. The first rental payment on
January 1, 2020 pertains to principal only.
Thus, on January 1, 2021 the interest is equal to P2,649,600 times 8% or P211,968. This interest
income pertains to 2020.
Principal is the portion of the rental payment minus the interest. Thus, on January 1, 2021,
P800,000 minus P211,968 equals P588,032.
Present value is the balance of the present value minus the principal payment. Thus, on January
1, 2021, P2,649,600 minus P588,032 equals P2,061,568.
2020
Jan. 1 Lease receivable 4,000,000
Machinery 3,449,600
Unearned interest income 550,400
1 Cash 800,000
Lease receivable 800,000

Dec. 31 Unearned interest income 211,986

Interest income 211,986

2021
Jan. 1 Cash 800,000
Lease receivable 800,000
Dec. 31 Unearned interest income 164,925
Interest income 164,925

QUESTIONS
1. What are the two classifications of finance lease on the part of the lessor?
2. Explain a direct financing lease.
3. Distinguish direct financing lease from sales type lease.
4. Explain the following in a direct financing lease:
a. Gross investment
b. Net investment
c. Unearned interest income
5. What is the treatment of initial direct cost paid by the lessor in a direct financing lease?
6. What is the formula in computing annual rental?
7. Explain why the residual value is ignored in the computation of annual rental if the underlying
asset will not revert to the lessor at the end of lease term.
8. What is the method in recognizing interest income in a direct financing lease?
9. Explain the "trial and error" or interpolation approach of determining the implicit interest rate
if an initial direct cost is paid by the lessor in a direct financing lease.
10. Explain the presentation of the lease receivable in the statement of financial position.

PROBLEMS
Problem 13-1 (IAA)
Iceberg Company is in the business of leasing new sophisticated equipment.
At the beginning of current year, the an equipment was delivered to a lessee under a direct
financing lease with the following provisions:
Cost of equipment 3,390,000
Annual rental payable at the end of year 600,000
Useful life and lease term 10 years
Implicit interest rate 12%
Present value of an ordinary annuity of 1 at 12% for 10 years 5.650
Present value of an ordinary annuity of 1 at 11% for 10 years 5.889
The entity incurred and paid initial direct costs of P143,400 in negotiating and arranging the
lease.
The equipment will revert to Iceberg Company at the end of the lease.

Required:
1. Compute the total financial revenue to be recognized over the lease term.
2. Determine the new implicit rate that will be used in computing interest income.
3. Prepare journal entries on the books of Iceberg Company for the current year.

Problem 13-2 (IAA)

Jolo Company is in the business of leasing new sophisticated equipment. As lessor, Jolo
Company expects a 12% return on the net investment.
All leases are classified as direct financing,
At the end of the lease term, the equipment will revert to Jolo Company
On January 1, 2020, an equipment is leased to a lessee with the following information.
Cost of equipment to Jolo 5,250,000
Residual value – unguaranteed 600,000
Annual rental payable in advance 900,000
Useful life and lease term 8 years
Implicit interest rate 12%
First lease payment January 1, 2020

Required:
1. Compute the total financial revenue,
2. Prepare a table of amortization for the lease receivable and interest income.
3. Prepare journal entries for 2020 and 2021.
4. Prepare journal entries for 2027.
5. Prepare journal entry on January 1, 2028 to record the return of the equipment from the lessee.
The fair value of the equipment on this date is P500,000.

Problem 13-3 (IFRS)

Macedonia Company entered into a leasing business. The entity acquired a specialized machine
for P3,000,000 cash.
On January 1, 2020 the entity leased the machine to another entity for period of 6 years, after
which the machine is returned to Macedonia Company for disposition.
The expected unguaranteed residual value of the machine is P200,000
The lease terms are arranged so that a return of 12% is earned by Macedonia Company.
The first lease payment is made on January 1, 2020 and subsequent payments are made each
December 31. The relevant present value factors are:
PV of an annuity of 1 in advance at 12% for 6 periods 4.6048
PV of 1 at 12% for 6 periods .5066

Required:
1. Compute the annual rental payable in advance required to yield the desired return.
2. Prepare an amortization schedule for the lease receivable.
3. Prepare journal entries for 2020.
4. Prepare journal entry to recognize the interest income for 2025.
5. Prepare journal entry on December 31, 2025, end of six years, to record the return of machine
to the lessor.
The fair value of the machine on this date is the same as the unguaranteed residual value.

Problem 13-4 (AA)

Alpha Company buys equipment for leasing to various manufacturing entities.
On January 1, 2020, Alpha Company leased an equipment to another entity.
The cost of the equipment to Alpha Company was P1,377,480 which approximates the fair value
on the lease date. The expected economic life of the equipment is also 4 years.
The lease payments stipulated in the lease are P440,000 per
year in advance for a 4-year period of the lease. The payments include P40,000 executory costs
per year.
The title to the equipment remains in the hands of Alpha Company at the end of the lease term,
although only nominal residual value is expected at that time.
The implicit interest rate in the lease is 11%. The fiscal year of Alpha Company ends December
31.

Required:
1. Compute the total financial revenue.
2. Prepare an amortization schedule for the lease receivable and interest income.
3. Prepare journal entries for 2020, 2021, 2022 and 2023.

Problem 13-5 (IAA)

Desiree Company is in the business of leasing new sophisticated equipment. The lessor expects a
12% return on net investment.
All leases are classified as direct financing lease.
At the end of the lease term, the equipment will revert to the lessor.
At the beginning of current year, an equipment is leased to a lessee with the following
information:
Cost of equipment to the lessor 5,000,000
Residual value – unguaranteed 600,000
Annual rental payable at the beginning of each year 900,000
Initial direct cost incurred by the lessor 250,000
Useful life and lease term 8 years
Implicit interest rate 12%

1. What is the gross investment in the lease?

a. 7,200,000
b. 7,800,000
c. 5,000,000
d. 5,250,000
2. What is the net investment in the lease?
a. 5,000,000
b. 5,250,000
c. 4,400,000
d. 4,650,000
3. What is the total interest income over the lease term?
a. 2,550,000
b. 1,950,000
c. 3,150,000
d. 1,500,000
4. What is the interest income for the current year?
a. 594,000
b. 522,000
c. 630,000
d. 450,000

Problem 13-6 (IAA)

Oceanic Company is engaged in leasing equipment. Such an equipment was delivered to a lessee
at the beginning of current year under a direct financing lease with the following provisions:
Cost of equipment 4,361,200
Unguaranteed residual value 200,000
Useful life and lease term 8 years
Implicit interest rate 10%
Present value of an ordinary annuity of 1 for 8 years at 10% 5.335
Present value of 1 for 8 years at 10% 0.466
The annual rental is payable at the end of each year. The equipment will revert to the lessor upon
the lease expiration.
1. What is the net investment in the lease to be recovered from rental?
a. 4,361,200
b. 4,161,200
c. 4,268,000
d. 4,561,200
2. What is the annual rental over the lease term?
a. 800,000
b. 817,470
c. 779,980
d. 834,940
3. What amount of interest income should be recognized for the current year?
a. 436,120
b. 416,120
c. 426,800
d. 640,000

Problem 13-7 (IAA)

At the beginning of current year, Lessor Company leased a machine to Lessee Company. The
machine had an original cost of P6,000,000. The lease term was five years and the implicit
interest rate on the lease was 15%.
The lease is properly classified as a direct financing lease. The annual lease payments of
P1,750,000 are made each December 31.
The machine reverts to Lessor at the end of the lease term, at which time the residual value of the
machine will be P275,000. The residual value is unguaranteed.
1. At the commencement of the lease, what would be the net lease receivable on the part of the
lessor?
a. 6,275,000
b. 8,750,000
c. 6,000,000
d. 5,725,000
2. What is the gross investment in the lease?
a. 8,750,000
b. 9,025,000
c. 6,000,000
d. 8,475,000
3. What is the total unearned interest income?
a. 3,025,000
b. 2,750,000
c. 2,475,000
d. 6,000,000
4. What is the interest income for the current year?
a. 1,312,500
b. 1,353,750
c. 900,000
d. 450,000

Problem 13-8 (AA)

On January 1, 2020, Lyle Company entered into a direct financing lease. A third party
guaranteed the residual value of the asset under the lease estimated to be P1,200,000 on January
1, 2025, the end of the lease term.
Annual lease payments are P1,000,000 due each December 31, beginning December 31, 2020.
The last payment is due December 31, 2024.
The remaining useful life of the asset was six years at the commencement of the lease.
The lessor used 10% as the implicit interest rate. The PV of 1 at 10% for 5 periods is .62, and the
PV of an ordinary annuity of 1 at 10% for 5 periods is 3.79.
1. What is the net lease receivable of the lessor at the commencement of the lease?
a. 4,534,000
b. 3,790,000
c. 4,990,000
d. 2,590,000
2. What is the gross investment in the lease?
a. 5,000,000
b. 6,200,000
c. 3,800,000
d. 5,744,000
3. What is the total unearned interest income?
a. 2,410,000
b. 1,666,000
c. 1,210,000
d. 466,000
4. What is the interest income for 2020?
a. 379,000
b. 620,000
c. 453,400
d. 500,000

Problem 13-9 (AICPA Adapted)

Glade Company leases a computer equipment under a direct financing lease. The equipment has
no residual value at the end of the lease and the lease does not contain purchase option.
The entity wishes to earn 8% interest on a 5-year lease of equipment with a cost of P3,234,000.
The present value of an annuity due of 1 at 8% for 5 years is 4.312.
What total amount of interest revenue should be recognized over the lease term?
a. 1,293,600
b. 1,394,500
c. 516,000
d. 750,000

Problem 13-10 (IAA)

At the beginning of current year, Nueva Company, as lessor, leased an equipment for ten years at
an annual rental of P1,200,000, payable by Caster Company, the lessee, at the beginning of each
year. The lease is appropriately accounted for as finance lease.
The equipment had a cost of P8,400,000 with an estimated life of 12 years and no residual value.
The straight line depreciation is used. The implicit interest rate is 9%.
What amount of interest income should be reported in the income statement for the current year?
a. 500,000
b. 648,000
c. 756,000
d. 360,000

Problem 13-11 (IAA)

Cassandra Company is in the leasing business. The entity acquired a specialized packaging
machine for P3,000,000 cash and leased it for a period of six years, after which the machine is to
be returned to Cassandra Company for disposition. The guaranteed residual value of the machine
is P200,000.
The lease term was arranged so that a return of 12% is earned by Cassandra Company. The PV
of 1 at 12% for six periods is .51, and the present value of an annuity of 1 in advance at 12% for
six periods is 4.60.
What is the annual lease payment payable in advance required to yield the desired return?
a. 630,000
b. 652,174
c. 608,695
d. 732,000
Problem 13-12 (IAA)
Magnum Company had an asset costing P5,239,000. The asset was leased at the beginning of
current year to another entity. Five annual lease payments are due in advance at the beginning of
each lease year.
The lessee guaranteed the P2,000,000 residual value of the asset at the end of the 5-year lease
term.
The lessor's implicit interest rate is 8%. The PV of 1 at 8% for 5 periods is .68, and the PV of an
annuity of 1 in advance at 8% for 5 periods is 4.31.
What is the annual lease payment?
a. 1.215.545
b. 1,531,090
c. 900,000
d. 751,500

Problem 13-13 (IAA)

Ericson Company leased an asset to another entity. The cost of the asset was P7,994,000. Terms
of the lease specify four-year life for the lease, an annual interest rate of 15% and four year-end
rental payments. The lease qualified as a direct financing lease.
The lease provided for a transfer of title to the lessee at the end of the lease term.
After the fourth year, the residual value was estimated at P1,000,000
The PV of 1 at 15% for 4 periods is .572, and the PV of an ordinary annuity of 1 at 15% for 4
periods is 2.855.
What is the annual rental payment?
a. 2,000,000
b. 3,000,350
c. 2,800,000
d. 2,599,650

Problem 13-14 (IAA)

Irene Company acquired a specialized machine for P2,300,000. At the beginning of current year,
the entity leased the machine for a period of six years, after which title to the machine is
transferred to the lessee.
The six annual lease payments are due in advance at the beginning of each lease year. The
residual value of the machine is P200,000.
The lease terms are arranged so that a return of 12% is earned by the lessor. The present value of
1 at 12% for six periods is 0.51, and the present value of an annuity in advance of 1 at 12% for
six periods is 4.60.
What is the annual lease rental payable in advance?
a. 500.000
b. 477,826
c. 383,333
d. 460,000

Problem 13-15 (IAA)

At the beginning of current year, Yolk Company signed a ten-year noncancelable lease
agreement to lease a storage building from Warehouse Company. The agreement required equal
rental payments at the end of each year.
The fair value of the building at the inception of the lease is P2,949,600. However, the carrying
amount to Warehouse Company is P2,458,000. 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 Yolk Company. The
incremental borrowing rate of Yolk Company is 12% per year.
Warehouse 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 P20,000 of executory costs related to taxes on the
property. Round off present value factor to three decimal places.

1. What is the annual lease payment?

a. 400,000
b. 435,044
C. 480,000
d. 522,053
2. What is the total annual lease payment?
a. 420,000
b. 455,044
c. 542,053
d. 500,000
3. What is the unearned interest income of the lessor at the beginning of current year?
a. 1,850,400
b. 2,342,000
c. 1,542,000
d. 2,542,000

Problem 13-16 Multiple choice (IFRS)

1. Gross investment in the lease is equal to
a. Sum of the lease payments receivable by a lessor under a finance lease and any unguaranteed
residual value accruing to the lessor.
b. The lease payments under a finance lease of the lessor.
c. Present value of lease payments under a finance lease of the lessor and any unguaranteed
residual value.
d. Present value of the lease payments under a finance lease of the lessor.
2. Net investment in a direct financing lease is equal to
a. Cost of the asset
b. Cost of the asset plus initial direct cost paid by the lessor
c. Cost of the asset minus guaranteed residual value
d. Cost of the asset plus unguaranteed residual value
3. Which is the correct accounting treatment for a finance lease in the accounts of a lessor?
a. Treat as a noncurrent asset equal to net investment in lease and recognize all finance payments
in income statement:
b. Treat as receivable equal to gross amount receivable on lease and recognize finance payments
in cash by reducing debt.
c. Treat as a receivable equal to net investment in the lease and recognize finance payments by
reducing debt and taking interest to income statement.
d. Treat as a receivable equal to net investment in the lease and recognize finance payments in
cash by reduction of debt.
4. Lessors shall recognize asset held under a finance lease as a receivable at an amount equal to
the
a. Gross investment in the lease
b. Net investment in the lease
c. Gross rentals
d. Residual value, whether guaranteed or unguaranteed
5. The lease receivable in a direct financing lease is
a. The gross amount of lease payments.
b. The difference between the gross rentals and the fair value of the leased asset.
c. The present value of lease payments.
d. The cost of the asset less any accumulated depreciation
6. The primary difference between a direct financing lease and a sales type lease is the
a. Manner in which rental collections are recorded as rental income.
b. Depreciation recorded each year by the lessor.
c. Recognition of the manufacturer or dealer profit at the inception of the lease.
d. Allocation of initial direct costs incurred by the lessor over the lease term.
7. All of the following would be included in the lease receivable, except
a. Guaranteed residual value
b. Unguaranteed residual value
C. A purchase option that is reasonably certain
d. All would be included
8. Under a direct financing lease, the excess of aggregate rentals over the cost of the underlying
asset should be recognized as interest income of the lessor
a. In increasing amounts during the term of the lease
b. In constant amounts during the term of the lease
c. In decreasing amounts during the term of the lease
d. After the cost of the underlying asset has been fully recovered through rentals
9. In a direct financing lease, unearned interest income
a. Should be amortized over the lease term using the interest method.
b. Should be amortized over the lease term using the straight line method.
c. Does not arise.
d. Should be recognized at the lease expiration.
10. Which statement is true regarding initial direct costs incurred by the lessor?
a. In a direct financing lease, initial direct costs are added to the net investment in the lease.
b. In a sales type lease, initial direct costs are expensed as component of cost of goods sold.
c. In an operating lease, initial direct costs incurred by the lessor are deferred and allocated over
the lease term.
d. All of these statements are correct.