5rd Sessiom - Audit of Lease

1 College of Accounting Education 3F Facundo Hall, Business and Engineering Building Matina Campus, Davao City Phone No.: (082) 305-0645 Local 137

Auditing Problems

L. Eddie I. Aguilar, CPA, MBA

Audit of Long-Term Liability (Leases) SUMMARY OF ACCOUNTING STANDARDS AFFECTING LEASES

Lessee Accounting (PFRS 16 Leases)

 A lease is a contract or part of a contract that conveys the right to control the use the underlying asset for a period of time in exchange for consideration.  IFRS 16 provides that at the commencement date, a lessee shall recognize a Right of Use Asset (debit) and a Lease Liability (credit). The lessee shall be accounted all leases as a finance lease under IFRS 16.  Exemption in Using Finance Lease (this is discretionary) - Short-term lease – a lease that has a term of 12 months or less at the commencement date of the lease. This shall be made by class of underlying asset. - Low-value lease – a leased asset will not quality as low value if the nature of the asset is such that the asset is not of low value when new. A typically low value assets include personal computers and office furniture/equipment. If the lessee elects operating lease, the lessee will recognize the lease payment as an expense in either a straight line basis over the lease term or another systematic basis (IFRS 16, par. 6).  Initial Measurement of Right of Use Asset - The amount of initial measurement of the lease liability or the PV of lease payments. - Lease payments made to lessor at or before commencement date, such as lease bonus, less any lease incentives received. - Initial direct costs incurred by the lessee. - Estimate of cost of dismantling, removing and restoring the underlying asset for which the lessee has a present obligation. Components of Lease Payments - Fixed lease payment less any lease incentives - Variable lease payments - Exercise price of a purchase option if the lessee is reasonably certain to exercise the option - Amount expected to be payable by the lessee under a residual value guarantee - Termination penalties if the lease term reflects the exercise of a termination option Lease incentives are payments by the lessor to the lessee associated with the lease contract. Example is the commission paid by the lessee to a broker. Improvements on the lease are not part of the initial direct costs, therefore, not part of the cost of the Right to Use Asset. These improvements are part of the PAS 16. Any security deposit refundable upon the lease expiration is accounted for an asset by the lessee, therefore, not part of the cost of the Right to Use Asset. Executory costs such as maintenance, taxes and insurance for the underlying asset are expensed immediately. Case in Point 1:

Pre-Review Class – Applied Auditing

3rd Session – Audit of LT Debt (Leases)

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2 Ganade Company closed a lease contract for newly constructed terminals and freight storage facilities on January 1, 2017. Although the terminals have a composite life of 20 years, the lease runs for 5 years. The annual lease payment is P1,000,000 payable at the end of each year starting December 31, 2017. The lessee must also make an annual payment of P75,000 for taxes and P125,000 for insurance. The lessee incurred initial direct cost of P150,000 including P50,000 commission paid to the broker that arranged the lease. As an incentive to the lessee, the lessor agreed to reimburse the lessee for the commission of P50,000. The contract was negotiated to assure the lessor a 10% rate of return. The PV of an ordinary annuity of 1 at 10% for five periods is 3.79. PV value of 1 at 10% for 5 periods is 0.62. The PV of an annuity of 1 in advance at 10% for 5 periods is 4.17. Required: Prepare the necessary journal entry. Right of Use Asset Lease Liability Cash

3,890,000 3,790,000 100,000

Fixed payment 1,000,000 x 3.79 = 3,790,000 Initial direct cost = 100,000 Cost of right of use asset = 3,890,000 Payment

Interest

Principal

Amort. Cost 3,790,000

1/1/2017

1,000,000

379,000

621,000

3,169,000

12/31/2017

1,000,000

316,900

683,100

2,485,900

12/31/2018

1,000,000

248,590

751,410

1,734,490

12/31/2019

1,000,000

173,449

826,551

907,939

12/31/2020

1,000,000

92,061

907,939

-

12/31/2021

Lease Liability 621,000 Interest expense 379,000 Cash 1,000,000 Depreciation 778,000 Accum. Dep’n. 778,000 (Lease term because no bargain purchase option) At the end of the least term, the entry will be: Accum. Dep’n. 3,890,000 Right of Use Asset 3,890,000

Case in Point 2: Using the same information in CIP#1, except that the annual lease payment is made at the beginning of each lease year. Assume further that there is a guaranteed residual value of P300,000 at the end of the lease term. Required: Prepare the necessary journal entry. Right of Use Asset Lease Liability Cash

4,456,000 4,356,000 100,000

Fixed payment 1,000,000 x 4.17 = 4,170,000 Guaranteed Res. Value 300,000 x 0.62 = 186,000 Initial direct cost = 100,000 Cost of right of use asset = 4,456,000



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3 Payment

Interest

1,000,000

Principal

4,356,000

1/1/2017

1,000,000

3,356,000

1/1/2017

1,000,000

335,600

664,400

2,691,600

1/1/2018

1,000,000

269,160

730,840

1,960,760

1/1/2019

1,000,000

196,076

803,924

1,156,836

1/1/2020

1,000,000

115,684

884,316

272,520

1/1/2021

300,000

27,480

272,520

Lease liability Cash

-

Amort. Cost

-

1/1/2022

1,000,000 1,000,000

Depreciation 831,200 Accum. Dep’n. 831,200 4,456,000 – 300,000 / 5 yrs = 831, 200 Interest expense 335,600 Accrued interest 335,600 2018 Accrued interest Lease liability Cash

335,600 664,400 1,000,000

Interest expense 269,160 Accrued interest 269,160 Depreciation Accum. Dep’n.

831,200 831,200

At the end of the lease term, the terminals will be returned to the lessor. Supposing that on that year, the fair value of the asset is P500,000, the entry to record the returned is: Accum. Dep’n. 4,156,000 Lease liability 272,520 Accrued interest 27,480 Right of Use Asset 4,456,000 Here, the fair value is higher than the residual value guarantee, there will be no additional entry necessary since there is no cash settlement. Supposing that on the end of the lease term, the fair value of the asset is P200,000. Here, the loss is reported for the difference and the lessee must make up for the difference with a cash payment. The entry would be: Accum. Dep’n. 4,156,000 Lease liability 272,520 Accrued interest 27,480 Right of Use Asset 4,456,000 Loss on finance lease 100,000 Cash 100,000 As long as there is a residual value guarantee, there is no more purchase option because the asset will revert to the lessor upon the expiration of the lease.

Case in Point 3: Using the same information in CIP#1, except that the company has the option to purchase the terminal upon the lease expiration by paying P500,000. It reasonably certain that the lessee will exercise the purchase option at the commencement date of the lease. Required: Prepare the necessary journal entry. Right of Use Asset

4,200,000



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4 Lease Liability Cash

4,100,000 100,000

PV of payment – 1,000,000 x 3.79 = 3,790,000 PV of purchase option – 500,000 x 0.62 = 310,000 Initial direct cost = 100,000 Cost of the Right of Use Asset = 4,200,000 Payment

Interest

Principal


1/1/2017

1,000,000

410,000

590,000

3,510,000

12/31/2017

1,000,000

351,000

649,000

2,861,000

12/31/2018

1,000,000

286,100

713,900

2,147,100

12/31/2019

1,000,000

214,710

785,290

1,361,810

12/31/2020

1,000,000

138,190

861,810

500,000

12/31/2021

Interest expense Lease liability Cash

410,000 590,000 1,000,000

Depreciation 210,000 Acccum. Dep’n. 210,000 4,200,000 / 20 yrs = 420,000 The asset is depreciated over the useful life of the asset since it is certain that purchase option will be exercised. If the option is exercised at the end of the lease term, the journal entry would be: Lease liability Cash

500,000 500,000

If the option is not exercised, the loss is recognized equal to the difference between the carrying amount of the Right of Use Asset and the Lease Liability. The entry would be: Accum. Dep’n. 1,050,000 Lease liability 500,000 Loss on finance lease 2,650,000 Right of Use Asset 4,200,000

Case in Point 4: Using the same information in CIP#1, except that the lease contained an option for the lessee to extend for a further 5 years. At the commencement date, the extension option is not reasonably certain. After 2 years, On January 1, 2020, the lessee decided to extend the lease for a further 3 years. Additional relevant information: New annual rental payable at the end of each year New implicit rate

1,200,000 8%

Required: Prepare the necessary journal entry. 2017 Right of Use Asset Lease Liability Cash

3,890,000 3,790,000 100,000

Fixed payment 1,000,000 x 3.79 = 3,790,000 Initial direct cost = 100,000 Cost of right of use asset = 3,890,000



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5

Payment

Interest

Principal


1/1/2017

1,000,000

379,000

621,000

3,169,000

12/31/2017

1,000,000

316,900

683,100

2,485,900

12/31/2018

1,000,000

248,590

751,410

1,734,490

12/31/2019

Lease Liability 621,000 Interest expense 379,000 Cash 1,000,000 Depreciation 778,000 Accum. Dep’n. 778,000 Jan. 1, 2020 Remeasurement of Lease Liability PV as of Jan. 1, 2020: Annual rental for remaining 2 years of old lease term – 1,000,000 x 1.78 = 1,780,000 Annual rental for 5 years starting January 1, 2020 – 1,200,000 x 3.99 = 4,788,000 X PV of 8% for two periods = 0.86 PV of rentals of extended lease term = 4,117,680 PV of the remaining 2 years of old lease PV of extended lease term Total PV as of Jan. 1, 2020 Less: Amortized cost as of 12/31/2019 Increase in lease liability as of 1/1/2020 Right of Use Asset Lease liability

= 1,780,000 = 4,117,680 = 5,897,680 = 1,734,490 = 4,163,190

4,163,190 4,163,190

New amortization table: Payment

Interest

Principal

Amortized cost 5,897,680

1/1/2020

1,000,000

471,814

528,186

5,369,494

12/31/2020

1,000,000

429,560

570,440

4,799,054

12/31/2021

1,200,000

383,924

816,076

3,982,978

21/31/2022

1,200,000

318,638

881,362

3,101,617

12/31/2023

1,200,000

248,129

951,871

2,149,746

12/31/2024

1,200,000

171,980

1,028,020

1,121,726

12/31/2025

1,200,000

78,274

1,121,726

Lease liability Interest expense Cash

528,186 471,814

Depreciation Accum. Dep’n.

817,027

-

12/31/2026

1,000,000

817,027

CV – 12/31/19 (3,890,000 – 2,334,000) 1,556,000 Increase in lease liability – 1/1/2020 4,163,190 CV – 1/1/2020 5,719,190 Divided by: remaining life 7 years Annual depreciation 817,027

Case in Point 5: Using the same information in CIP#1, except that on January 1, 2020, Ganade Company purchased the terminal and freight storage facility that it had been leasing for P5,000,000. Required: Prepare the necessary journal entry.



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6 Terminal and Freight Storage Accum. Depreciation Lease liability Right of Use Asset Cash

4,821,510 2,334,000 1,734,490 3,890,000 5,000,000

The cost of the asset purchased is equal to the carrying amount of the leased asset plus cash payment minus the balance of the lease liability.

Case in Point 6: On January 1, 2017, Gavino Company entered into a 5-year lease of a floor of a building with the following terms: Annual rental for the first two years payable at the end of each year Annual rental for the next three years payable at the end of each year Initial direct cost paid by the lessee Leasehold improvements Estimated cost of restoration required at the end of the lease contract Useful life of the building Implicit interest rate

200,000 300,000 100,000 250,000 50,000 20 years 8%

Compute the following: a. Cost of the Right of Use Asset b. Initial lease liability c. Depreciation for 2017 d. Interest expense for 2017 Annual rental for the first two years – 200,000 x 1.78 = 356,000 Annual rental for the next three years – 300,000 x 2.58 = 774,000 X PV of 8% for 2 period 0.86 PV of rental for the next three years 665,640 PV of annual rental for the first two years = 356,000 PV of annual rental for the next three years = 665,640 Lease liability = 1,021,640 Initial direct cost = 100,000 Estimated cost of restoration = 50,000 Cost of the Right to Use Asset = 1,171,640 Right of Use Asset 1,171,640 Lease liability 1,021,640 Cash 100,000 Est. liability for restoration 50,000 Leasehold improvement Cash

Lessor Accounting

250,000 250,000

 IFRS 16 provides that a lessor shall classify leases as either an operating lease or a finance lease.  Lease Classified as Finance Lease (any of the following will qualify as finance lease) - The lease transfers ownership to the lessee at the end of the lease term. - 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. The certainty of exercising the option shall be made at the inception of the lease. - The lease term is for the major part of the economic life of the underlying asset even if title is not transferred. - 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.



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7  The above four criteria are determinative in nature, the following may also suggests finance lease (suggestive in nature): - The underlying asset is of such specialized nature that only the lessee can use it without major modification. - If the lessee can cancel the lease, the lessor’s losses associated with the cancelation are borne by the lessee. - Gains or losses from the fluctuation in the fair value of the residual accrue to the lessee. - The lessee has the ability to continue the lease for a secondary period at a rent that is substantially lower than market rent.  Operating Lease - Lease payments from the lessee is recognized as income either on a straight line basis or another systematic basis if this is more representative of the patterns in which benefit from the use of the underlying asset is diminished. - Initial direct cost incurred by the lessor is 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. - Security deposit refundable upon the lease expiration is accounted for as liability by the lessor. (Noncurrent asset for lessor, Noncurrent liability for lessee) - Lease bonus received by the lessor from the lessee is recognized as unearned rent income to be amortized over the lease term. Case in Point 7: Sablay Company purchased a machine on January 1, 2017 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, 2017, Sablay Company leased the machine to Sacramento Company for P1,200,000 a year for a 4-year period ending February 28, 2021. Below is the pertinent information in relation to the lease: Security deposit received from Sacramento Lease bonus Initial direct costs incurred by Sablay Company

500,000 200,000 300,000

During the year, the company paid repair and maintenance of P25,000. Required: Compute the following: 1. Rent income for 2017 2. Carrying amount of the machine. 3. Unearned rent income at December 31, 2017. 4. Prepare the necessary journal entries. Rent income – 3/1/2017 to 12/31/17 = 1,000,000 Amort. of lease bonus – 200,000 / 4 x 10/12 = 41,667 Rent income – 2017 = 1,041,667 Cost of the machine Depreciation – 2017 – 5M / 10 yrs Deferred Initial direct costs – 300,000 – [300,000 / 4 x 10/12] Carrying value of the machine – 12/31/2017

= 5,000,000 = ( 500,000)

Unearned rent income – [200,000 – 41,667]

= 158,333

Machinery Cash

= 237,500 = 4,737,500

5,000,000 5,000,000



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8 Rent Receivable/Cash 1,000,000 Rent income 1,000,000 Cash 500,000 Liability for security deposit 500,0000 Cash 200,000 Unearned rent income

200,000

Deferred initial direct costs 300,000 Cash 300,000 Repairs and maintenance Cash

25,000

Depreciation Accum. Depreciation 5M / 10 x = 500,000

500,000

25,000

500,000

Amortization of lease bonus and deferred initial direct costs: Unearned rent income Rent income

41,667 41,667

Amortization – initial direct costs 62,500 Deferred initial direct costs 62,500

- Unequal Rental Payments If payment of the lease cannot be recognized as income on a straight line basis, the lessor will use another systematic basis in recognizing income. If the lease is payable in an unequal manner, the total cash payments for the lease term shall be amortized uniformly on the straight line basis as rent income over the lease term. Case in Point 8: Cabrera 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, Cabrera Company agreed to lease 1,000 square meter to Calacar Company at P1,200 per square meter for the first year of a three-year operating lease. Rent for the remaining years will be at the P3,000 rate. As an inducement to enter the lease, Cabrera Company granted Calacar Company the first six months of the lease rentfree. Required: Prepare the necessary journal entries. Total rent for the lease 1st year – 1,200,000 x 6/12 2nd year – 1,000 x 3,000 3rd year – 1,000 x 3,000 Total rental for 3 years

= 600,000 = 3,000,000 = 3,000,000 = 6,600,000

1st year Cash 600,000 Rent receivable 1,600,000 Rent income 2,200,000 2nd year Cash 3,000,000 Rent receivable 800,000 Rent income 2,200,000 3rd year Cash 3,000,000 Rent receivable


800,000


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9 Rent income

Finance Lease (Lessor Accounting)

2,200,000

 Finance lease is either: - Direct financing lease – recognizes only interest income - Sales type lease – recognizes both interest income and gross profit on sale.  Direct Financing Lease - The lessor in this type is actually engaged in the financing business. 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 consideration  Gross investment – the gross rentals for the entire lease term plus the absolute amount of the residual value, whether guaranteed or unguaranteed.  Net investment in the lease – the cost of the asset plus any initial direct cost paid by the lessor.  Unearned interest income – the difference between the gross investment and net investment in the lease.  Initial direct cost – for 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.  Annual rental – if not given, shall be computed by dividing the net investment by present value factor of an annuity of 1 for a number of periods using the desired rate of return. - PFRS 16 states that the lessors shall recognize assets held under a finance lease as a receivable at an amount equal to the net investment in the lease minus the unearned interest income. Case in Point 10: Capin 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. On January 1, 2017, an equipment is leased to Cardente Company, the lessee, with the following information: Cost of equipment to the lessor Residual value – unguaranteed Annual rental payable in advance Initial direct cost incurred by the lessor Useful life and least term Implicit interest rate First lease payment

5,000,000 600,000 900,000 250,000 8 years 12% January 1, 2017

Required: 1. What is the gross investment in the lease? 2. What is the net investment in the lease? 3. What is the total interest income over the lease term? 4. What is the interest income for 2017? 5. Prepare the necessary journal entry for 2017. Gross rentals – 900,000 x 8 = 7,200,000 Residual value = 600,000 Gross investment = 7,800,000 Cost of asset Initial direct cost Net investment

= 5,000,000 = 250,000 = 5,250,000

Gross investment = 7,800,000 Less: Net investment = 5,250,000 Unearned interest income Total financial revenue = 2,550,000



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10

Payment

Interest

Principal

900,000

Amortized cost 5,250,000

1/1/2017

900,000

4,350,000

1/1/2017

900,000

522,000

378,000

3,972,000

1/1/2018

900,000

476,640

423,360

3,548,640

1/1/2019

900,000

425,837

474,163

3,074,477

1/1/2020

900,000

368,937

531,063

2,543,414

1/1/2021

900,000

305,210

594,790

1,948,624

1/1/2022

900,000

233,835

666,165

1,282,459

1/1/2023

900,000

153,895

746,105

536,354

1/1/2024

600,000

63,646

536,354

-

1/1/2025

Equipment Cash

5,000,000 5,000,000

Equipment Cash

250,000 250,000

Lease receivable 7,800,000 Equipment 5,250,000 Unearned interest income 2,550,000 Cash Lease receivable

900,000

Unearned interest income Interest income

900,000 522,000 522,000

At the end of the lease term, the entry to revert the machine to the lessor would be: Equipment 600,000 Lease receivable 600,000

Case in Point 11: Using the same information in CIP#10. Assume that at the end of the lease term, the fair value of the equipment is P400,000. Prepare the journal entry to revert the machine to the lessor. Equipment 400,000 Loss on finance lease 200,000 because it is unguaranteed (lessor side) Lease receivable 600,000

Case in Point 12: Using the same information in CIP#10, except that the residual value is guaranteed. Assume further that at the end of the lease term, the fair value of the equipment is P400,000. Prepare the journal entry to revert the machine to the lessor. Equipment 400,000 Cash 200,000 Lease receivable 600,000

Case in Point 13: Cardona Company is engaged in leasing equipment. Such an equipment was delivered to a lessee at the beginning of the current year under a direct financing lease with the following provisions: Cost of equipment Unguaranteed residual value Useful life and lease term Implicit interest rate


4,361,200 200,000 8 years 10%


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11 PV of an ordinary annuity of 1 for 8 periods at 10% PV of 1 for 8 periods at 10%

5.335 0.466

The annual rental is payable at the end of each year. The equipment will revert to the lessor upon the lease expiration. Questions: a. What is the net investment in the lease to be recovered from rental? b. What is the annual rental over the lease term? c. What amount of interest income should be recognized for the current year? Cost of the equipment 4,361,200 PV of residual value (200,000 x 0.466) ( 93.200) Net investment to be recovered from rental 4,268,000 Divided by PV of an ordinary annuity 5.335 Annual rental 800,000 Payment

Interest

Principal


800,000

436,120

363,880

3,997,320

year 1

800,000

399,732

400,268

3,597,052

year 2

800,000

359,705

440,295

3,156,757

year 3

800,000

315,676

484,324

2,672,433

year 4

800,000

267,243

532,757

2,139,676

year 5

800,000

213,968

586,032

1,553,644

year 6

800,000

155,364

644,636

909,008

year 7

800,000

90,992

709,008

200,000

year 8

Case in Point 14: Using the same information in CIP#13, except that the residual value is guaranteed. Prepare the amortization schedule. Payment

Interest

Principal


800,000

436,120

363,880

3,997,320

year 1

800,000

399,732

400,268

3,597,052

year 2

800,000

359,705

440,295

3,156,757

year 3

800,000

315,676

484,324

2,672,433

year 4

800,000

267,243

532,757

2,139,676

year 5

800,000

213,968

586,032

1,553,644

year 6

800,000

155,364

644,636

909,008

year 7

800,000

90,992

709,008

200,000

year 8

200,000

-

year 8

200,000

Case in Point 15: Using the same information in CIP#13, except that the lease provides for a transfer of title to the lessee at the end of the lease term. Questions: a. What is the net investment in the lease to be recovered from rental? b. What is the annual rental over the lease term? c. What amount of interest income should be recognized for the current year? Cost of the equipment/net investment Divided by PV of an ordinary annuity Annual rental


4,361,200 5.335 817,470


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12 Note: residual value is completely ignored in the computation since the equipment will not revert to lessor. Payment

Interest

Principal


817,470

436,120

381,350

3,979,850

year 1

817,470

397,985

419,485

3,560,365

year 2

817,470

356,037

461,434

3,098,932

year 3

817,470

309,893

507,577

2,591,355

year 4

817,470

259,135

558,335

2,033,020

year 5

817,470

203,302

614,168

1,418,852

year 6

817,470

141,885

675,585

743,267

year 7

817,470

74,203

743,267

-

year 8

 Sales Type Lease - The lessor in a sales type lease is actually a manufacturer that uses the lease as a means of facilitating the sale of product. - The accounting for sales type lease is generally the same with the direct financing lease except that the sale type lease involves the recognition of a manufacturer’s profit on the transfer of the asset to the lessee in addition to the interest income that will be earned by the lessor. - Accounting Considerations:  Gross investment – equal to the gross rental for the entire term plus the residual value, whether guaranteed or not.  Net investment – equal to the present value of the gross rentals plus the present value of the residual value, whether guaranteed or not.  Unearned interest income – difference between the gross investment and net investment in the lease.  Sales – equal to the net investment in the lease or the fair value of the asset, whichever is lower.  Cost of goods sold – equal to the cost of the asset sold plus the initial direct cost paid by the lessor.  Initial direct cost – expense immediately as a component of cost of goods sold. Case in Point 16: Enola Company used leases as the primary method of selling products. The entity’s main product is a small helicopter that is very popular among government officials and corporate executives. Enola Company constructed such a helicopter for a government official at a cost of P8,000,000. The terms of the lease provided for annual rental of P3,328,710 to be paid over 5 years every December 31 of each year with the ownership of the helicopter transferring to the lessor at the end of the lease term. The useful life of the helicopter is 8 years. It is estimated that the helicopter will have an unguaranteed residual value of P500,000 after 5 years. Enola Company incurred initial direct costs of P200,000 in finalizing the lease with the lessee. Financing the construction was at a 12% rate. Round off present value factor to three decimal points. Required: a. Compute the total unearned financial revenue. b. Compute the manufacturer profit to be recognized immediately. c. Compute the interest income for the first year. d. Prepare the necessary journal entry to record the transactions.



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13 e. Prepare the entry to revert the helicopter to lessor. Assume that the fair value the asset on that year is only P400,000. Gross rentals (3,328,710 x 5) 16,643,550 Unguaranteed residual value 500,000 Lease receivable – gross investment 17,143,550 PV of rentals (3,328,710 x 3.605) 12,000,000 PV of unguaranteed residual value (500,000 x 0.567) 283,500 Total present value – net investment 12,283,500 Lease receivable 17,143,550 Total present value 12,283,500 Unearned interest income 4,860,050 Cost of helicopter 8,000,000 PV of unguaranteed residual value 283,500 Cost of sales 7,716,500 Initial direct cost 200,000 Total COS 7,916,500 Sales Cost of goods sold Gross profit

12,000,000 7,916,500 4,083,500

Cost of goods sold 7,916,500 [(8,000,000 – 283,500) + 200,000] Lease receivable 17,143,550 Sales 12,000,000 Unearned interest income 4,860,050 Inventory 8,000,000 Cash 200,000 Cash Lease receivable

3,328,710

Unearned interest income Interest income

1,474,020

Payment

3,328,710

Interest

1,474,020 Principal


3,328,710

1,474,020

1,854,690

10,428,810

year 1

3,328,710

1,251,457

2,077,253

8,351,557

year 2

3,328,710

1,002,187

2,326,523

6,025,034

year 3

3,328,710

723,004

2,605,706

3,419,328

year 4

3,328,710

409,382

2,919,328

500,000

year 5

Entry to revert the helicopter to lessor: Inventory Loss on finance lease Lease receivable

400,000 100,000 500,000

Case in Point 17: Using the same information in CIP#16, except that the residual value is guaranteed. Required: a. Compute the total unearned financial revenue. b. Compute the manufacturer profit to be recognized immediately. c. Compute the interest income for the first year. d. Prepare the necessary journal entry to record the transactions. e. Prepare the entry to revert the helicopter to lessor. Assume that the fair value the asset on that year is only P400,000.



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Gross rentals (3,328,710 x 5) 16,643,550 guaranteed residual value 500,000 Lease receivable – gross investment 17,143,550 PV of rentals (3,328,710 x 3.605) PV of guaranteed residual value (500,000 x 0.567) Total present value – net investment

12,000,000 283,500 12,283,500

Lease receivable 17,143,550 Total present value 12,283,500 Unearned interest income 4,860,050 Cost of helicopter Initial direct cost Total COS Sales Cost of goods sold Gross profit

8,000,000 200,000 8,200,000 12,283,500 8,200,000 4,083,500

Cost of goods sold Lease receivable Sales Unearned interest income Inventory Cash

8,200,000 17,143,550 12,283,500 4,860,050 8,000,000 200,000

Entry to revert the helicopter to lessor: Inventory Cash Lease receivable

400,000 100,000 500,000

Case in Point 18: Using the same information in CIP#16, except that the asset will not revert to the lessor. Required: a. Compute the total unearned financial revenue. b. Compute the manufacturer profit to be recognized immediately. c. Compute the interest income for the first year. d. Prepare the necessary journal entry to record the transactions. - If the underlying asset will not revert to the lessor, the residual value is completely ignored by the lessor in the computation of unearned interest income and gross profit on the sale. - The underlying asset will remain with the lessee if the lease provides for either a purchase option that is reasonably certain to be exercised or transfer of title to the lessee upon the lease expiration. Gross rentals (3,328,710 x 5) PV of rentals (3,328,710 x 3.605) Unearned interest income Cost of helicopter Initial direct cost Total COS Sales Cost of goods sold Gross profit


16,643,550 12,000,000 4,643,550 8,000,000 200,000 8,200,000

12,000,000 8,200,000 3,800,000


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15 Cost of goods sold Lease receivable Sales Unearned interest income Inventory Cash

8,200,000 16,643,550 12,000,000 4,643,550 8,000,000 200,000

Case in Point 19: Using the same information in CIP#16, except that the residual value is now the purchase option. It is reasonably certain that the lessee will exercise the purchase on at the end of the lease term. Required: a. Compute the total unearned financial revenue. b. Compute the manufacturer profit to be recognized immediately. c. Compute the interest income for the first year. d. Prepare the necessary journal entry to record the transactions. e. Prepare entry on the exercise of the option. f. Prepare entry on the nonexercise of the option. Assume the fair value of the helicopter on that date is P400,000. Gross rentals (3,328,710 x 5) 16,643,550 Purchase option 500,000 Lease receivable – gross investment 17,143,550 PV of rentals (3,328,710 x 3.605) 12,000,000 PV of purchase option (500,000 x 0.567) 283,500 Total present value – net investment 12,283,500 Lease receivable 17,143,550 Total present value 12,283,500 Unearned interest income 4,860,050 Cost of helicopter Initial direct cost Total COS

8,000,000 200,000 8,200,000

Sales Cost of goods sold Gross profit

12,283,500 8,200,000 4,083,500

Cost of goods sold Lease receivable Sales Unearned interest income Inventory Cash Payment

8,200,000 17,143,550

Interest

12,283,500 4,860,050 8,000,000 200,000 Principal


3,328,710

1,474,020

1,854,690

10,428,810

year 1

3,328,710

1,251,457

2,077,253

8,351,557

year 2

3,328,710

1,002,187

2,326,523

6,025,034

year 3

3,328,710

723,004

2,605,706

3,419,328

year 4

3,328,710

409,382

2,919,328

500,000

year 5

Entry in the exercise of the option: Cash Lease receivable

500,000


500,000


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16 Nonexercise of the option: Inventory Loss on finance lease Lease receivable

400,000 100,000 500,000

Case in Point 20: On January 1, 2017, Timbal Company leased equipment to another entity. The terms of the lease called for annual payment of P500,000 to be made at the end of each year. The lease term is 5 years which is the useful life of the equipment. The lease is appropriately recorded as a sales type lease. The cost of the equipment is P1,000,000. The implicit rate in the lease is 12%. The PV of an ordinary annuity of 1 at 12% for 5 periods is 3.60. On July 1, 2019, Timbal Company actually sold the equipment to the lessee for P1,200,000. Required: Prepare the necessary journal entries. - When a lessor actually sells an asset that is has been leasing under a finance lease, the difference between the sales price and the carrying amount of the lease receivable (balance of lease receivable minus the unearned interest income) is recognized in profit or loss. Gross rentals (500,000 x 5) PV of gross rentals (500,000 x 3.60) Unearned interest income

2,500,000 1,800,000 700,000

Cost of Sales 1,000,000 Lease receivable 2,500,000 Sales 1,800,000 Unearned interest income 700,000 Inventory 1,000,000 Payment

Interest

Principal


1/1/2017

500,000

216,000

284,000

1,516,000

12/31/2017

500,000

181,920

318,080

1,197,920

12/31/2018

71,875

841,670

7/1/2019

469,795 Sales price CV of lease receivable: Lease receivable 1,500,000 Unearned int. receiv. (700,000 – 469,795) 230,205 Loss on sale of leased equipment

1,200,000

1,269,795 69,795

Cash 1,200,000 Unearned interest income 230,205 Loss on sale 69,795 Lease receivable 1,500,000



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PROBLEMS Problem 1 On January 1, 2017, Geldore Company entered into a lease with Genaldo Company, a lessor, for a new equipment. The lease stipulates that annual payments of P1,000,000 will be made for five years starting December 31, 2017. Gedlore Company guaranteed a residual value of P474,000 at the end of the 5-year period. The equipment will revert to Genaldo Company 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. Note: PVOA : 3.27 PV of 1 : 0.48 Required: 1. Prepare a schedule of the annual payments. 2. Prepare journal entry on the books of Geldore Company and Genaldo Company for 2017 and 2018. 3. Prepare journal entry on December 31, 2021, end of lease term, to record the return of the equipment to Genaldo Company. Assume the fair value of the equipment is equal to the guaranteed residual value. 4. Prepare journal entry on December 31, 2021 to record the return of the equipment to Genaldo Company assuming the fair value of the equipment is only P300,000. 5. Prepare journal entry on December 31, 2021 to record the return of the equipment to Genaldo Company assuming the fair value of the equipment is P500,000. Problem 2 Giangan Company entered into a lease of building on January 1, 2017 with the following information: Annual rental payable at the end of each year Lease term Useful life of building Implicit interest rate

600,000 5 years 20 years 9%

The lease contained an option for the lessee to extend the lease for a further 5 years. At the commencement date, the exercise of the extension option is not reasonably certain. After 3 years on January 1, 2020, the lessee decided to extend the lease for a further 5 years. Effective January 1, 2020, the new annual rental is at P800,000 and the new implicit rate is 12%. Required: 1. Prepare a schedule of payment for 2017 to 2019. 2. Compute the lease liability as of January 1, 2020. 3. Prepare a new schedule of payment as of January 1, 2020 to end of the lease term. Problem 3 On January 1, 2017, Golusinda Company leased an equipment from Gomez Heavy Equipment with the following pertinent information: Annual lease payable at the end of each year Lease term Useful life of equipment Implicit interest rate

500,000 8 years 10 years 10%

The entity has the option to purchase the equipment on January 1, 2025 by paying P500,000. There is reasonable certainty that the entity shall exercise the option. On January 1, 2017, the entity incurred initial direct costs of P200,000. Questions: 1. What is the initial cost of the Right to Use Asset?



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18 a. P 0

b. P 2,865,000

c. P 2,900,000

d. P 3,100,000

2. What is the interest expense for 2017? a. P 266,500 b. P 290,000

c. P 310,000

d. P 316,500

3. What is the lease liability on December 31, 2017? a. P 2,398,500 b. P 2,690,000

c. P 2,848,500

d. P 2,790,000

4. What is the depreciation for 2017? a. P 290,000 b. P 310,000

c. P 362,500

d. P 387,500

Problem 4 On January 1, 2017, Calamba Company leased a machine to another entity for a four-year period. The annual rentals will be paid by the lessee beginning December 31, 2017. The lease agreement called for a 10% increase in annual rental per annum. The rental due on December 31, 2020 was P133,100. Questions: 1. What is the rental payment due on December 31, 2018? a. P 90,909 b. P 100,000 c. P 110,000

d. P 121,000

2. What is the renal payment due on December 31, 2017? a. P 100,000 b. P 105,477 c. P 110,000

d. P 116,025

Problem 5 Calanza Company leased an office to Campilan Company for a five-year term beginning January 1, 2017. Under the terms of the operating lease, rent for the first year is P800,000 and rent for the years 2 through 5 is P1,250,000 per annum. However, as an inducement to enter the lease contract, Calanza Company granted Campilan Company the first six months of the lease rent-free. What amount should be reported as rental income for 2017? a. P 800,000 b. P 1,080,000 c. P 1,160,000 d. P 1,200,000

Problem 6 At the beginning of current year, Carmona Company leased a machine to Carnaje 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 financial lease. The annual lease payments of P1,730,541 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 P400,000. The residual value is unguaranteed. The PV of at 15% for 5 periods is 0.4972 and the PV of an ordinary annuity of 1 at 15% for 5 periods is 3.3522. Questions: 1. At the commencement of the lease, what would be the net lease receivable on the part of the lessor? a. P 5,600,000 b. P 5,801,120 c. P 6,000,000 d. P 6,400,000 2.

What is the gross investment in the lease? a. P 6,000,000 b. P 8,252,705

c. P 8,652,705

d. P 9,052,075

3. What is the total unearned interest income? a. P 2,252,705 b. P 2,652,705

c. P 3,052,705

d. P 6,000,000

4. What is the interest income for the current year? a. P 870,168 b. P 900,000

c. P 1,297,905

d. P 1,357,905

Problem 7 Ebe 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 financial lease.



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19 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 0.572 and the PV of an ordinary annuity of 1 at 15% for 4 periods is 2.855. What is the annual rental payment? a. P 2,000,000 b. P 2,599,650 c. P 2,800,000 d. P 3,000,560 Problem 8 At the beginning of the current year, Edombingo Company signed a ten-year noncancelable lease agreement to lease a storage building from Eneluna 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 Eneluna Company is P2,455,000. 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 Edombingo Company. The incremental borrowing rate of Edombingo Company is 12% per year. Eneluna Company set the annual rental to ensure 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 PV factor to three decimal places. Questions: 1. What is the annual lease payment? a. P 400,000 b. P 435,044 2.

What is the total annual lease payment? a. P 420,000 b. P 455,044

c. P 480,000

d. P 522,053

c. P 500,000

d. P 542,053

3. What is the unearned interest income of the lessor at the beginning of the current year? a. P 1,542,000 b. P 1,850,000 c. P 2,342,000 d. P 2,542,000 Problem 9 Bigoy Company is a dealer of equipment. On January 1, 2017, an equipment was leased to another entity with the following provisions: Annual rental payable at the end of each year Lease term and useful life of machinery Cost of equipment Residual value – unguaranteed Implicit interest rate PV of an ordinary annuity of 1 at 12% for 5 periods PV of 1 at 12% for 5 periods

1,500,000 5 years 4,000,000 500,000 12% 3.60 0.57

At the end of the lease term on December 31, 2021, the equipment will revert to the lessor. The entity incurred initial direct cost of P200,000 in finalizing the lease agreement. Questions: 1. What is the gross investment in the lease? a. P 4,000,000 b. P 4,500,000

c. P 7,500,000

d. P 8,000,000

2. What is the net investment in the lease? a. P 3,500,000 b. P 4,000,000

c. P 5,400,000

d. P 5,685,000

3. What interest income should be reported for 2017? a. P 648,000 b. P 682,200 c. P 900,000


d. P 960,000


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20 4. What amount should be reported as gross profit on sale? a. P 1,485,000 b. P 1,685,000 c. P 3,500,000

d. P 4,000,000

Problem 10 Bulay-og Company adopted the policy of leasing as the primary method of selling products. The entity’s main product is a small cargo vessel. Bulay-og Company constructed such a cargo vessel for Claud Company at a cost of P8,500,000. The terms of the lease provided for annual advance payments of P2,500,000 to be paid over 10 years with the ownership transferring to Claud Company at the end of the lease period. It is estimated that the cargo vessel will have a residual value of P1,600,000 at that date. The lease payments began January 1, 2017. Bulay-og Company incurred initial direct cost of P500,000 in financing the lease agreement with Claud Company. The sales price of the cargo vessel is P14,875,000. Financing the construction was at a 14% rate. The present value of an annuity due of 1 at 14% for 10 periods is 5.95. Questions: 1. What amount should be reported as gross profit on sale for 2017? a. P 4,275,000 b. P 4,775,000 c. P 5,875,000

d. P 6,375,000

2. What is the unearned interest income on January 1, 2017? a. P 8,525,000 b. P 9,625,000 c. P 10,125,000

d. P 11,725,000

3. What is the interest income for 2017? a. P 1,732,500 b. P 1,956,500

d. P 2,306,500

c. P 2,082,500

Problem 11 On December 31, 2017, Conarco Company, a lessor, actually sold a machinery that it had been leasing under a sales type lease. On January 1, 2017 after receipt of the lease payment for the year, the following account balances were associated with the lease: Gross lease receivable Unearned interest income

5,850,000 1,000,000

The interest rate implicit in the lease is 10%. On December 31, 2017, Conarco Company actually sold the leased machinery to the lessee for P3,250,000 cash. Questions: 1. What is the interest income for 2017? a. P 0 b. P 325,000

c. P 485,000

d. P 585,000

2. What is the carrying amount of the lease receivable on December 31, 2017? a. P 4,850,000 b. P 5,335,000 c. P 5,365,000 d. P 5,850,000 3. What is the loss on sale of the machinery that should be recognized on December 31, 2017? a. P 1,600,000 b. P 2,015,000 c. P 2,085,000 d. P 2,600,000

Honor Your Choice Don’t become overwhelmed by all the possible choices. Consider the options, pick one, and go with it. Pre-Review Class – Applied Auditing


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The possibilities do not create their own fulfillment. That’s your job, and it’s a great one, though necessarily difficult at times. When the challenges come, don’t slide into the trap of wishing you had chosen differently. Push on ahead, stick to the road you’re on, and build the value you’ve decided to build. Every achievement worth achieving takes effort, sacrifice, time and resources. Every possibility worth bringing to life will demand the best of you. Instead of wishing for an easier ride, reaffirm your commitment with new action, a smarter strategy, a more positive attitude. Honor your choice by seeing it through. Possibilities have value only to the degree you act upon them. Choose the best, give your best, and live the unmatched experience of bringing great value into being. -

Ralph Marston



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5rd Sessiom - Audit of Lease

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