UNIT 6

AUDIT OF LEASES
Estimated Time: 3.0 HOURS
*Use Louwers 4th edition

Discussion Questions 6-1: Nature of Lease

1. Discuss the following items:

a. Lease
b. Inception of the lease
c. Operating lease
d. Finance lease
e. Sale and leaseback
2. What is the main difference between operating and finance lease? What are the
considerations to qualify a lease as finance lease?
3. Briefly explain treatment of initial direct cost for finance lease.

Discussion Questions 6-2: Substantive Procedures for Leases (Audit Simulation)

Please refer to Louwers Exercise 10.49

Problem 6-1: Accounting for Operating Lease

InterAfrica Development Company had a lease contract with the city government.
The lease contract of the Company is covered by a City Resolution enacted by the
City Council. The resolution enumerates the following:
Term of the lease - July 1, 2000 to July 1, 2025
Lease payments

September 1, 2001 to July 31, 2003 (P15,000 per month)

August 1, 2003 to July 31, 2005 (P10,000 per month)
August 1, 2005 to July 1, 2025 (P15,000 per month)

As of December 31, 2011, the Bank has paid a total of P1,650,000. There has been
no accrual set up during the year and rent expense for the period ended December
31, 2011 amounted to P180,000.
Required:
a. Considering the information enumerated above, what do you think is the
accounting policy being employed by the Company?
b. How much rental expense should have been recognized during the period?
c. What is the correct balance accrued/prepaid rent expense as of December 31,
2011?
d. Propose adjusting journal entries to correct the errors noted, if necessary.
e. Assuming a lease bonus has been paid upon inception of the lease, what
would be its treatment under IAS 17?

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Problem 6-2: Sale and Operating leaseback

Justin Timberleke entered into an operating sale and leaseback transaction. Details
of the transaction are as follows:
Sales Price
Carrying Amount
Monthly lease payment

P 420,000
520,000
37,316

Estimated Life
Lease Term
Implicit Rate

12 years
1 year
12%

The Company deferred the loss despite the absence of future cheap rentals to offset
the loss.
Required:
a. Should the loss be deferred? If no, under what circumstances should the loss
be deferred. Propose adjusting journal entry.
b. Assuming fair value and sales price is P530,000, how much gain should be
recognized in profit or loss and how much be deferred?
c. Assuming sales price is P540,000, fair value of the equipment is P530,000,
how much gain should be deferred?

Problem 6-3: Accounting for Finance Lease; Initial Recognition and Subsequent
Measurement
On January 1, 2012, Judee Co. leased a machine from Explorer Co. The lease
qualifies as finance lease and requires 10 annual payments of P 100,000 beginning
immediately. The lease specifies an interest rate of 12% and a purchase option of P
10,000 at the end of the tenth year, even though the machines estimated value on
that date is P 20,000. Judee Co.s incremental borrowing rate is 14%. The useful life
of the equipment is 10 years.
Required:
a. What should Spicy Co. record as lease liability at the beginning of the lease
term?
b. What is the carrying value of the lease liability as of December 31, 2012?
c. What is the carrying value of the equipment as of December 31, 2012?

Problem 6-4: Finance Lease; with executory costs

On January 1, 2012, ChooChoo, Corp. entered into a 5-year non-cancelable lease of

a warehouse. The following are the details of the agreement:
a. Rental payments amounts to P750,000 starting January 1, 2012.
b. The building has an estimated economic life of 5 years.
c. The company uses straight-line method of depreciation
d. Lease is non-renewable. At the termination of the lease, the building reverts to
the lessor.
e. Amortization is booked every payment date.
f. KSCs incremental borrowing rate is 12% per year and the lessors implicit
rate is not known by KSC.
g. The yearly rental payment includes P54,705 of executory costs related to
taxes on the property.
h. Due to the failure to evaluate upon inception of the lease, the Company
accounted for this as operating lease.

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Required:
Compute for the following:
1. Cost of the warehouse.
2. Carrying value of lease liability had it been booked as finance lease as of
December 31, 2012
a. Current
b. Noncurrent
3. Propose adjustments assuming books are not yet close for the year ended
December 31, 2012

Problem 6-5:
Direct Financing Lease, Initial Recognition and Subsequent
Measurement, Reconstruction

On December 31, 2012, Sir Kit, Inc. (SKI) purchased machinery for P1.5 million and
delivered the same to So Sir, Inc. (SSI), the lessee. The following are the related
information for the lease:
a. SKIs implicit rate is 11%, which is known to SSI. SSI incremental borrowing
rate is 14% at December 31, 2012.
b. The machinery has an estimated useful life of 8 years, which is also the lease
term. At the expiration of the lease, the machinery which has a nonguaranteed residual value of P150,000 will revert to SKI.
c. Lease rentals consist of 8 equal annual payments starting December 31,
2012.
d. Both use the straight line basis for depreciation. SKI accounts this as a direct
financing lease while SSI accounts this as finance lease.
Compute for the following:
1. Annual lease payment
2. SSIs depreciation expense in 2013.
3. SSIs interest expense in 2013.
4. Unearned interest income by SKI at the start of the lease.

Problem

6-6:

Direct

Financing,

with

residual

value;

Reconstruction

Peter Pan Corporation is in the business of leasing new sophisticated computer

systems. As a lessor of computers, Peter Pan purchased a new system on December
31, 2012. The system was delivered the same day (by prior arrangement) to Captain
Hook Company, a lessee. Tick-Tock, the financial analyst, revealed the following
information relating to the lease transaction:
Cost of system to Peter Pan
P 875,000
Estimated useful life and lease term
9 years
Expected residual value (unguaranteed)
P 77,000
Peter Pans implicit rate of interest
13%
Captain Hooks incremental borrowing rate
15%
Date of first lease payment
Dec. 31, 2012
Additional information:
i. At the end of the lease, the system will revert to Peter Pan.
ii. Captain Hook is aware of Peter Pans implicit rate of interest.
iii. The lease rental consists of equal annual payments.
Required:
Based on the above and the result of your audit, answer the following:
1. How much is the annual lease payment?
2. How much is the total financial revenue to be earned by the lessor over the
lease term?
3. How much is the interest income to be recognized by the lessor in 2013?
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4. What is the amount of liability under finance lease to be reported under

current liabilities as of December 31, 2012?
5. What is the amount of total expenses related to the lease that will be
recognized by the lessee in 2013?

Problem 6-7: Sales Type Lease, Initial Recognition and Subsequent Measurement

Gryffindor, Inc. leases equipment to its customers under non-cancelable leases. On

January 1, 2012, Gryffindor leased equipment costing P3,900,000 to Snape Co., for
nine years. The rental cost was P440,000 payable in advance semiannually (January
1 and July 1), plus P30,000 semiannually for executory costs. The equipment had an
estimated life of 15 years and sold for P5,312,740 with an estimated unguaranteed
residual value of P750,000. The implicit interest rate is 12%.

Required:

Based on the foregoing and the result of your audit, compute for the following:
1. How much is the total interest income from lease that will be earned by Gryffindor,
Inc.?
2. How much should Gryffindor, Inc. report as profit on the sale?
3. How much should be reported by Snape Co. as liability under finance lease as of
December 31, 201?
4. How much should be reported by Snape Co. under current liabilities as liability
under finance lease as of December 31, 2012?
5. How much interest expense should be reported by Snape Co. in relation to the
lease for the year ended December 31, 2012?

Problem 6-8 : Preparation of Audit Working Paper

Jaime Zobel De Sy, a very well known business magnate, acquired land and
constructed a multi-purpose hall for a total amount of P6,750,000. On January 2,
2010, when the construction was already completed, the facility and land on which it
was constructed were sold to a Coach Events Inc. for P7,500,000. Immediately after
the sale, Jaime entered into a 10 year non cancelable lease agreement with the
events company that requires equal annual lease payments at the end of each year
beginning December 31, 2010. The interest rate implicit on the lease is 10%. Straight
line depreciation is used for a period of 15 years. Title to the property will be
transferred to Jaime at the termination of the lease agreement.
During the period, Jaimes new accountant derecognized the asset, erroneously
charged all payments as rental expense. Depreciation has not been recognized and
there was no initial set up of finance lease liability.
Required:
Prepare an audit working paper for the year ended December 31, 2010 to summarize
the correct balance of finance lease liability, property plant and equipment, and
expenses related to the lease. Prepare necessary audit adjustments.

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