LEASES
The minimum lease payments
Commencement of the lease term is the date from
which the lessee is entitled to exercise its right to use
the leased asset. It is the date of initial recognition of
the lease (i.e., the recognition of the assets, liabilities,
revenue, or expenses resulting from the lease, as
appropriate).
Contingent rent is that portion of the lease payments
that is not fixed in amount, but is based on the future
amount of a factor that changes other than with the
passage of time (e.g., percentage of future sales,
amount of future use, future price indices, future
market rates of interest).
Economic life is either the period over which an asset is
expected to yield economic benefits or service potential
to one or more users
Economic life is the number of production or similar
units expected to be obtained from the asset by one or
more users.
Finance lease is a lease that transfers substantially all
the risks and rewards incidental to ownership of an
asset. Title may or may not eventually be transferred.
Guaranteed residual value is for a lessee, that part of
the residual value that is guaranteed by the lessee, or
by a party related to the lessee (the amount of the
guarantee being the maximum amount that could, in
any event, become payable)
Guaranteed residual value is for a lessor, that part of
the residual value that is guaranteed by the lessee, or
by a third party unrelated to the lessor that is financially
capable of discharging the obligation under the
guarantee.
Inception of the lease is the earlier of the date of the
lease agreement and the date of commitment by the
parties to the principal provisions of the lease.
Initial direct costs are incremental costs that are directly
attributable to negotiating and arranging a lease, except
for such costs incurred by manufacturer or trader
lessors.
Interest rate implicit in the lease is the discount rate
that, at the inception of the lease, causes the aggregate
present value of:
1.
2. The unguaranteed residual value,
to be equal to the sum of (a) the fair value of the leased
asset and (b) any initial direct costs of the lessor.
Lease is an agreement whereby the lessor conveys to
the lessee, in return for a payment or series of
payments, the right to use an asset for an agreed period
of time.
Lease term is the non-cancelable period for which the
lessee has contracted to lease the asset, together with
any further terms for which the lessee has the option to
continue to lease the asset, with or without further
payment, when at the inception of the lease it is
reasonably certain that the lessee will exercise the
option.
Lessee’s incremental borrowing rate of interest is the
rate of interest the lessee would have to pay on a
similar lease or, if that is not determinable, the rate
that, at the inception of the lease, the lessee would
incur to borrow over a similar term, and with a similar
security, the funds necessary to purchase the asset.
Minimum lease payments are the payments over the
lease term that the lessee is, or can be, required to
make, excluding contingent rent, costs for services and,
where appropriate, taxes to be paid by and reimbursed
to the lessor, together with:
For a lessee, any amounts guaranteed by the lessee or
by a party related to the lessee
For a lessor, any residual value guaranteed to the lessor
by:
a. The lessee; b. A party related to the lessee; or c. An
independent third party unrelated to the lessor that is
financially capable of discharging the obligations under
the guarantee.
Net investment in the lease is the gross investment in
the lease discounted at the interest rate implicit in the
lease.
Operating lease is a lease other than a finance lease.
Unearned finance revenue is the difference between
the gross investment in the lease and the net
investment in the lease.
Unguaranteed residual value is that portion of the
residual value of the leased asset, the realization of
which by the lessor is not assured or is guaranteed
solely by a party related to the lessor.
Useful life is the estimated remaining period, from the
commencement of the lease term, without limitation by
the lease term, over which the economic benefits or
service potential embodied in the asset are expected to
be consumed by the entity.
Guaranteed Residual Value is refers to an additional
payment made by a lessee in property, cash, or both
when a lease terminates
Gross Investment in the Lease is the aggregate of, the
minimum lease payments receivable by the lessor under
a finance lease; and any unguaranteed residual value
accruing to the lessor. Also called as Lease Payments
Receivable.
Risks and Rewards means transfer of control of the
asset. It is the control of the asset that is important and
not the ownership of the asset that determines the
rightful person to report the asset in his books of
account.
Finance Lease is called if the risks and rewards (control)
of the asset are transferred to lessee therefore, it is a
finance lease. Lessee will record the asset in his books
even though he is not the owner.
Operating Lease is called if risks and rewards (control)
of the asset are not transferred. The lessor, who is the
owner of the asset, will record the asset in his books.
Risks include the possibilities of losses from idle
capacity, technological obsolescence or changes in
value because of changing economic conditions.
Rewards may be represented by the expectation of
service potential or profitable operation over the asset’s
economic life and gain from appreciation in value or
realization of a residual value.
Transfer of Risks and Rewards means transfer of control
of the asset. It is the control of the asset that is
important and not the ownership of the asset that
determines the rightful person to report the asset in his
books of account.
GROSS INVESTMENT IN THE LEASE IS THE AGGREGATE
OF:
1. The minimum lease payments receivable by the
lessor under a finance lease
2. Any unguaranteed residual value accruing to the
lessor.
INCEPTION OF THE LEASE, AS AT THIS DATE:
1. A lease is classified as either an operating or a finance
lease
2. In the case of a finance lease, the amounts to be
recognized at the commencement of the lease term are
determined.
NON-CANCELABLE LEASE – IS A LEASE THAT IS
CANCELABLE ONLY:
1. Upon the occurrence of some remote contingency;
2. With the permission of the lessor;
3. If the lessee enters into a new lease for the same or
an equivalent asset with the same lessor;
4. Upon payment by the lessee of such an additional
amount that, at inception of the lease, continuation of
the lease is reasonably certain.
LEASING ADVANTAGES:
1. Lease may avoid obsolescence of assets or the lessee
will have a better protection against technology
obsolescence.
2. Flexibility of contracting.
3. Lessor’s borrowing rate may be lesser than lessee’s.
4. Low or no down payment preserves the capital.
GENERALIZATION OF FINANCE LEASE:
1. The lease transfers ownership of the asset to the
lessee by the end of the lease term
2. The lessee has the option to purchase the asset at a
price that is expected to be sufficiently lower than the
fair value
3. The lease term is for the major part of the economic
life of the asset
4. The present value of the minimum lease payments
amounts to at least substantially all of the fair value of
the leased asset
5. The leased assets are of such a specialized nature
6. The leased assets cannot easily be replaced by
another asset
7. The lessor’s losses associated with the cancellation
are borne by the lessee
8. Gains or losses from the fluctuation in the fair value
of the residual (leased asset) accrue to the lessee
9. 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 OR FINANCE LEASE? five-year non-cancellable lease of a machine that has an
economic life of five years. On January 1, 2014 (the
Situation No. 1 (Finance Lease)
inception of the lease) the fair value (cash cost) of the
On January 1, 2014, an entity entered, as lessee, into a
machine is P100,000. On December 31 for each of the
five-year non-cancellable lease of a machine that has an
first four years of the lease term the lessee is required
economic life of five years. On the same date (the
to pay the lessor P23,000. Ownership of the machine
inception of the lease), the fair value of the machine is
does not automatically pass to the lessee at the end of
P100,000. On December 31 for each of the first four
the lease. Instead, the lease provides the lessee with an
years of the lease term, the lessee is required to pay the
option to acquire the machine from the lessor on
lessor P23,000. At the end of the lease term, ownership
January 1, 2019 for P1.
of the machine passes to the lessee upon payment of
At the inception of the lease, the lease transfers
the final lease payment of P23,539. The interest rate
substantially all the risks and rewards incidental to
implicit in the lease is 5 per cent per year. This rate
ownership from the lessor to the lessee. In substance,
approximates the lessee’s incremental borrowing rate.
the lessee owns the asset from the inception of the
On 1 January 2014, the lease transfers substantially all
lease—at the inception of the lease the lessee is
the risks and rewards incidental to ownership from the
expected to exercise its option to buy the machine for P1
lessor to the lessee. In substance, the lessee now owns
on 1 January 2019. The finance lease classification is
the machine. The lessee is the party that benefits from
evidenced by: the bargain purchase option at the end of
the use of the leased asset and changes in its fair value
the lease term, ie the option to buy the machine for P1
during its entire expected economic life.
when it has five years’ remaining useful life and at the
Situation No. 2 (Operating Lease) inception of the lease, the present value of the minimum
On January 1, 2014, an entity entered as lessee into a lease payments amounts to all of the fair value of the
five-year non-cancellable lease of farmland with a fair leased asset
value of P100,000. The lessee is required to pay the
Situation No. 5 (Finance Lease)
lessor P5,000 per year.
An entity entered, as lessee, into a two-year non-
The lease does not transfer substantially all the risks and
cancellable lease over a motor vehicle that has an
rewards incidental to ownership from the lessor to the
economic life of five years. At the inception of the lease,
lessee (e.g. gains and losses in the fair value of the
the present value of the minimum lease payments
farmland accrue to the lessor before and after entering
approximates the fair value of the motor vehicle.
into the lease agreement). The lessee merely has the
Ownership of the motor vehicle passes to the lessee at
temporary right of use of the farmland for a small part
the end of the lease term.
(five years) of the indefinite economic life of the
The lease transfers substantially all the risks and
farmland.
rewards incidental to ownership of the motor vehicle
Situation No. 3 (Operating Lease) from the lessor to the lessee (eg the risk of losses from
On January 1, 2014, an entity entered as lessee into a idle capacity and of gain or loss from change in the fair
five-day non-cancellable lease of a motor vehicle that value of a motor vehicle)
has an economic life of five years. On the same date
(the inception of the lease), the fair value (cash cost) of
the motor vehicle is P100,000. The lessor charges the
lessee P120 per day for the use of the motor vehicle. At
the end of the lease term, the lessee returns the motor
vehicle to the lessor.
The lease does not transfer substantially all the risks and
rewards incidental to ownership from the lessor to the
lessee. The lessee merely obtains the right to use the
lessor’s motor vehicle for five days.

Situation No. 4 (Finance Lease)

On January 1, 2014, an entity entered as lessee into a