ACCO 20103

IFRS 16 – Leases
Notes Part II – Accounting by Lessor (Direct Financing)

Introduction
A lessor shall classify each of its leases as either an operating lease or a finance lease.
- A lease is classified as a finance lease if it transfers substantially all the risks and rewards
incidental to ownership of an underlying asset.
- A lease is classified as an operating lease if it does not transfer substantially all the risks
and rewards incidental to ownership of an underlying asset. (IFRS 16 par. 62)

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

Examples of situations that individually or in combination would normally lead to a lease being
classified as a finance lease are: (at least one should be met)
a. the lease transfers ownership of the underlying asset to the lessee by the end of the lease
term;
b. the lessee has the option to purchase the underlying asset at a price that is expected to be
sufficiently lower than the fair value at the date the option becomes exercisable for it to
be reasonably certain, at the inception date, that the option will be exercised;
If the option to purchase is given, but no indication of its purchase price is below
the fair value of the asset is given, then it should be assumed that the price offered
is not lower than the fair value of the said asset.
c. the lease term is for the major part (majority or more than half) of the economic (useful)
life of the underlying asset even if title is not transferred;
lease term/economic life of the underlying asset = above 50%
d. at the inception date, the present value of the lease payments amounts to at least
substantially all (at least 90%) of the fair value of the underlying asset (because it is as if
the lessee paid the full amount of the asset); and
e. the underlying asset is of such a specialized nature that only the lessee can use it without
major modifications.

If the lease is a finance lease to the lessor, then it is a finance lease to the lessee and vice versa.

Operating Leases
Operating lease is a lease that does not transfer substantially all the risks and rewards incidental
to ownership of an underlying asset.
- A lessor shall recognize lease payments from operating leases as income on either a
straight-line basis or another systematic basis. If the income incurred is greater than the
amount collected, it shall give rise to a receivable. If the collection is greater than the
income incurred, then unearned revenue is recognized.
- A lessor shall recognize costs, including depreciation, incurred in earning the lease
income as an expense. (If it is a finance lease and the asset put into lease, then

作成した/終わった: 05-09-2021
Alcera, Vincent Luigil C.
 derecognition is incurred. But for operating leases, the lessor should record depreciation
for the asset put into lease).
- A lessor shall add initial direct costs incurred in obtaining an operating lease to the
carrying amount of the underlying asset and recognize those costs as an expense over the
lease term on the same basis as the lease income.
When the lessee pays initial indirect costs, it is added to the right-of-use asset. For
the exceptions under the lessee, initial direct costs incurred and paid by the lessee
related to the lease, then it is recognized as rent expense.
For lessors, initial direct costs incurred (finder’s fee, legal fees, etc.) are
added to the carrying amount of the underlying asset, which is then
expensed over the lease term. (The asset is depreciated over its economic
life while initial direct costs are depreciated over the lease term)
- The depreciation policy for depreciable underlying assets subject to operating leases shall
be consistent with the lessor’s normal depreciation policy for similar assets.
- A lessor shall present underlying assets subject to operating leases in its statement of
financial position according to the nature of the underlying asset. For the lessee, the right-
of-use asset shall be presented as a separate line item regardless of its nature.

Example 1: Operating Leases

Black Pink Inc. purchased a machine on January 1, 2019 amounting to P2,000,000 with a useful
life of 10 years. The company entered into an operating lease for the machine that commenced
on July 1, 2019 for a three-year period. Total rentals for the three years are P2,232,000, payable
as follows:

12 months at P50,000 per month P600,000

Annual rental is a straight-line amount of P744,000 (2,232,000 = 3 years), or P62,000 per month.

作成した/終わった: 05-09-2021
Alcera, Vincent Luigil C.
Example 2: Operating Lease

Jisoo Company, lessor, grants Jennie Co., a lessee, first six months free rent under a five-year
operating lease as an inducement to enter the lease. The lease is effective September 1, 2019 and
provides for a monthly rental payment of P10,000 to begin on March 1, 2020. For the year 2019,
rent revenue reported by the lessor is P36,000, computed as follows:

Total rent payments during the 5-year lease term (10,000 x 54) 540,000
Divide: lease period 5 years
Annual rent 108,000
Period covered from September 1 to December 31 4/12
Rent revenue for 2019 36,000

If the lease contains a rent-free period, convert the actual amount to be paid (the amount that
excludes the rent-free period) by the original years indicated in the lease contract as seen from
the example.

or

Monthly rental 10,000

Finance Lease
The lessor can classify the lease as:
a. Manufacturer’s (dealer) lease
b. Direct Financing Lease

作成した/終わった: 05-09-2021
Alcera, Vincent Luigil C.
Direct Financing Lease
- The lessor is a financing company that acquires the asset specifically for leasing.
- The cost of the leased asset is equal to its fair market value.
- The lessor recognizes only one type of revenue; that is, interest revenue. (Lessee = incurs
interest expense, while lessor = incurs interest revenue) (if the lessor is a manufacturer,
interest and gross profit is recognized)
- The total interest revenue is equal to the excess of the gross investment/receivable over
the fair market value (or cost) of the leased property and should be amortized as interest
revenue over the term of the lease using interest method.
- Gross profit is not recognized by the lessor. (Only for the manufacturer-type of lease)
- Gross investment in the lease (gross receivable, amount to collect + any guaranteed
residual value + bargain purchase option) is the undiscounted amount of the minimum
lease payments.
- Executory costs are charged to expense when incurred. (initial direct costs = costs in
obtaining the particular lease while executory costs = costs related to the execution of that
lease after the initial cost was incurred)
- Initial direct costs are added to the net investment in the lease and amortized over the life
of the lease as a yield adjustment (reduction from interest revenue). This decreases
unearned revenue when incurred. (Net investment or amount to be presented in the
financial statement = FLR or Gross Investment - any discount on finance lease receivable
or unearned revenue or interest income) (unearned interest income becomes interest
revenue during amortization).

Nothing is stated about depreciation in direct financing lease because the recording of the asset is
already on the lessee’s part. For the lessor under direct financing lease, the asset is derecognized
subject to lease. Derecognition for the lessor is due to the expected transfer of ownership.

Example 1: Direct Financing Lease

Rose Inc. leased an equipment from Lisa Corp. The lease term is 8 years starting on January 2,
2019. Equal annual payments under the lease are P900,000. The first payment was made on
January 2, 2019 and subsequent payments are to be made every January 2 thereafter. The
equipment costs P5,281,200 which is the fair value of the asset on that date. The implicit rate in
the lease is 10%. The journal entries in 2019 are as follows:

Unearned interest revenue (contra-FLR) = discount on finance lease receivable (contra-FLR)

作成した/終わった: 05-09-2021
Alcera, Vincent Luigil C.
Unearned interest revenue or discount on finance lease receivable =/= payable

Example 2: Direct Financing Lease

On August 1, 2020, Ice Cream Company leased a machine to How You Like That Company for
a six-year period requiring payments of P100,000 at the beginning of each lease year. The
machine costed P480,000, which is the fair value at the lease date and has a useful life of 8 years
with no residual value. The Ice Cream provides lessee an option to purchase the machine for
P5,000 which is significantly lower than expected value of the asset at that time. Ice Cream
incurred and paid initial direct cost of P1,900. Ice Cream Company’s implicit interest rate is
10%. Ice Cream appropriately recorded the lease as direct financing lease.

Lease term = 6 years, while remaining useful life of asset = 8 years. Therefore, the lease term is
for the major part of the economic life of the underlying asset, a finance lease.

作成した/終わった: 05-09-2021
Alcera, Vincent Luigil C.