(PFRS/IFRS 16) LEASES

1. A firm has just signed an 8-year lease on a typical new machine.

• Fair value of the machine is P100,000.
• Lease payments are P18,000 per year, payable at the end of the year.
• The machine has an estimated salvage value of P5,000 at the end of the lease term.
• The machine has a 10-year useful life.
• The firm's incremental borrowing cost is 8%.

This lease should be classified as:

a. Operating
b. Conventional
c. Unable to determine from information provided.
d. Finance

Solution: The useful life of the machine is 10 years and the lease is for 8 years. Because the lease period is for a major
part of the remaining economic life of the underlying asset (greater than 75% of the expected useful life of the asset),
it must be classified as a finance lease.

2. Which of the following conditions is not part of a finance lease?

a. The owner is responsible for all insurance on the property.
b. The lessee records an asset on its balance sheet.
c. The lessee pays for all maintenance on the property.
d. The lessee assumes the risks commonly held by an owner.

Solution: Under a finance lease, the lessee (person receiving the lease) assumes the risks and benefits of ownership.
This would include paying for insurance and maintenance. If the owner is responsible for paying all insurance, then
the lease is an operating lease and not a finance lease.

3. On July 1, 2020, South Co. entered into a ten-year operating lease for a warehouse facility. The annual minimum
lease payments are P100,000. In addition to the lease payment, South incurred building operating expenses of
P20,000 for the year ended June 30, 2021. In the notes to South's June 30, 2021, financial statements, what amounts
of subsequent years' lease payments should be disclosed?
a. P100,000 per annum for each of the next five years and P500,000 in the aggregate
b. P100,000 per annum for each of the next five years and P900,000 in the aggregate
c. P120,000 per annum for each of the next five years and P600,000 in the aggregate
d. P120,000 per annum for each of the next five years and P1,080,000 in the aggregate

Solution: South Co. should disclose a description of the lease agreement, annual lease payment obligations of
P100,000 per year for each of the next five years, and the P900,000 (P100,000 × 9 years) aggregate total future
payments. The P20,000 paid for annual operating cost are period expenses and would not be disclosed as a part of
the future lease obligations.

4. Which of the following statements that classify a lease as a finance lease is least accurate?
a. A bargain purchase option exists.
b. The lease period is for a major part of the remaining economic life of the underlying asset (greater than 75%
of the expected useful life of the asset).
c. The present value of the minimum lease payments exceeds substantially all of the fair value of the
underlying asset (greater than 80% of the fair market value of the asset).
d. The underlying asset is so specialized for the lessee that it is expected to have no alternative future use to the
lessor at the end of the lease term.

Solution: For a lease to be classified as a finance lease the present value of the minimum lease payments must
exceed substantially all of the fair value of the underlying asset, but the Financial Accounting Standards Board has
given a guideline of greater than 90% of the fair market value of the asset, not 80%.
5. On December 30, 2020, Haber Co. leased a typical new machine from Gregg Corp. The following data relate to
the lease transaction at the inception of the lease:

Lease term 10 years

Annual payment at the end of each lease year P100,000
Useful life of machine 12 years
Implicit interest rate 10%
Present value of annuity due P1 for 10 periods at 10% 6.76
Present value ordinary annuity P1 for 10 periods at 10% 6.15
Fair value of the machine P700,000

The lease has no purchase option, and the possession of the machine reverts to Gregg when the lease terminates. At
the inception of the lease, Haber should record a lease liability of:
a. P0.
b. P615,000.
c. P630,000.
d. P676,000.

Solution: The lease is a finance lease since the lease term is for a major part of the remaining economic life of the
underlying asset (greater than 75% of the expected useful life of the asset). Since the lease payments are made at the
end of the period, the present value factor for an ordinary annuity is used: 6.15 × P100,000 = P615,000.

6. On January 1, 2020, the Timble Corporation (Timble) leases a piece of typical equipment to use for eight years.
The equipment has an expected life of ten years and no anticipated salvage value. Timble has an incremental
borrowing rate of 5%. Annual payments for this asset are P9,000 with the first payment to be made immediately.
At the end of the eight years, Timble has the right to buy the asset for P10,000 in cash. This amount is expected to
be significantly below the expected fair value of the equipment on that date so it is reasonable to expect Timble to
pay this amount. Timble records depreciation based on the straight-line method and interest based on the effective
rate method. The present value of an annuity due of P1 at 5% for eight years is assumed to be 6.80. The present
value of an ordinary annuity of P1 at 5% for eight years is assumed to be 6.50. The present value of a single amount
of P1 at 5% in eight years is assumed to be 0.66. What amount of depreciation expense should Timble record for
2020?
a. P6,780
b. P6,120
c. P6,510
d. P9,000

Solution: Because the purchase option is expected to be paid, it is viewed as a bargain and is included as a cash flow
as well as makes the classification of this lease a finance lease. Timble expects to pay the P10,000 and use the asset
for its entire 10-year life and that is how the transaction should be recorded. Because the first payment is made
immediately, the annual payments represent an annuity due. The present value of the cash flows is P9,000 × 6.80
(P61,200) + P10,000 × 0.66 (P6,600) for a total of P67,800. The entity plans to use the asset for all ten years so the
depreciation expense each year is P6,780 (P67,800 ÷ 10).

7. On December 30, Year 1, Rafferty Corp. leased equipment under a finance lease. Annual lease payments of
P20,000 are due December 31 for 10 years. The equipment's useful life is 10 years, and the interest rate implicit in
the lease is 10%. The finance lease obligation was recorded on December 30, 2020, at P135,000, and the first lease
payment was made on that date. What amount should Rafferty include in current liabilities for this finance lease
in its December 31, Year 1, balance sheet?
a. P8,500
b. P6,500
c. P11,500
d. P20,000

Solution: Since the first lease payment is on the first day of the lease, the total lease liability at December 31, Year 1,
is P115,000, the total lease minus the first payment (P135,000 − P20,000). To divide the December 31 liability into
its current versus noncurrent portions, it is helpful to look at the Year 2 journal entry:
 Dr. Interest Expense P11,500
Dr. Lease Liability P8,500
Cr. Cash P20,000

The interest expense (P11,500) is calculated as the total lease liability at December 31, Year 1 (P115,000), multiplied
by the implicit interest rate (10%). The portion of P20,000 lease payment used to reduce the lease liability (P8,500)
in 2021 would be considered a current liability at December 31, Year 1.

8. On January 1, 2020, Babson, Inc. leased two automobiles for executive use. The lease requires Babson to make
five annual payments of P13,000 beginning January 1, 2020. At the end of the lease term, December 31, 2024,
Babson has the option to buy the automobiles for P10,000, which is considered a bargain. The lease qualifies as a
finance lease. The interest rate implicit in the lease is 9%.

Present value factors for the 9% rate implicit in the lease are as follows:
• For an annuity due with five payments: 4.240
• For an ordinary annuity with five payments: 3.890
• Present value of P1 for five periods: 0.650

Babson's recorded finance lease liability immediately after the first required payment should be:
a. P42,120
b. P35,620
c. P61,620
d. P48,620

Solution: Babson's recorded finance lease liability immediately after the first required payment should be P48,620,
as calculated below.
The bargain purchase option is considered part of the minimum lease payments.
Present value of lease payments (P13,000 × 4.240) P55,120
Less: Initial payment P13,000
P42,120
Present value of bargain purchase option (P10,000 × .65) P 6,500
Finance lease liability at 1/1/2020 P48,620

9. ABC Company wants its lease to be considered an operating lease instead of a finance lease. Which of these items
should ABC ensure occurs?
a. Leasing an asset with a 10-year life for 8 years.
b. Entering a lease where the present value of the lease payments is 95% of the asset's fair value.
c. Avoiding a transfer of ownership at the conclusion of the lease.
d. Writing a bargain purchase option into the lease.

Solution: If any of the conditions presented are met, the lease must be accounted for as a finance lease.
• The lease term is for a major part of the remaining economic life of the underlying asset (greater than 75%
of the expected useful life of the asset).
• There is a transfer of ownership to the lessee at the end of the lease term.
• There is an option to purchase the asset at a “bargain price” at the end of the lease term.
• The present value of the minimum lease payments exceeds substantially all of the fair value of the underlying
asset (greater than 90% of the fair market value of the asset).
• The underlying asset is so specialized for the lessee that it is expected to have no alternative future use to the
lessor at the end of the lease term.

10. On January 1, XYZ Company (lessee) entered into a finance lease with ABC Company (lessor). XYZ Company
will make an annual payment of P25,000 for five years as part of the lease, with the first payment due at the end
of the year. The assumed interest rate on the lease is 8% and the lease liability is P99,818. How much of the first
payment is interest expense and how much is a reduction of the lease liability?

Interest Expense Lease Liability

a. P17,015 P7,985
b. P7,985 P17,015
c. P0 P25,000
d. P25,000 P0
 Solution: If the assumed interest rate is 8%, then the interest expense for the first payment is P7,985 (P99,818 × 8%).
The remainder of the lease payment (P17,015) is a reduction of the lease liability.

11. Lease A does not contain a bargain purchase option, but the lease term is for a major part of the remaining economic
life of the underlying asset. Lease B does not transfer ownership of the property to the lessee by the end of the
lease term, but the present value of the minimum lease payments exceeds substantially all of the fair value of the
underlying asset. How should the lessee classify these leases? (Answers are in form of: Lease A, Lease B)
a. Finance lease, Finance lease
b. Finance lease, Operating lease
c. Operating lease, Finance lease
d. Operating lease, Operating lease

Solution: Since each lease has either a lease term for a major part of the remaining economic life of the underlying
asset or a present value of the minimum lease payments that exceeds substantially all of the fair value of the underlying
asset, each is classified as a finance lease.

12. On January 1, 2020, Harrow Co., as lessee, signed a five-year non-cancellable equipment lease with annual
payments of P100,000 beginning December 31, 2020. Harrow properly treated this transaction as a finance lease.
The five lease payments have a present value of P379,000 at January 1, 2020, based on the implicit interest rate of
10%. What amount should Harrow report as interest expense for the year ended December 31, 2020?
a. P27,900
b. P10,000
c. P37,900
d. P0
Solution: The interest expense for 2020 is P37,900, the implicit interest rate (10%) multiplied by the January 1, 2020,
present value (P379,000).

13. Which of the following describes a major difference between a guaranteed residual value and an unguaranteed
residual value?
a. A guaranteed residual value will cause the lessee to have a remaining lease liability at the end of the
lease term before the leased asset is returned, but the lease liability will be zero at the end of the lease
term if the residual value is unguaranteed.
b. An unguaranteed residual value will cause the lessee to have a remaining lease liability at the end of the lease
term before the leased asset is returned, but the lease liability will be zero at the end of the lease term if the
residual value is guaranteed.
c. A guaranteed residual value will cause the annual lease payments calculated by the lessor to be lower than
the annual lease payments with an unguaranteed residual value.
d. An unguaranteed residual value will cause the annual lease payments calculated by the lessor to be lower
than the annual lease payments with a guaranteed residual value.

Solution: Residual value refers to the estimated fair value of an asset at the end of a lease. A guaranteed residual
value means the lessee will “make up” any difference between actual residual value and the guaranteed value. The
lessee includes this when calculating the present value of minimum lease payments. An unguaranteed residual value
means the lessee will not “make up” any difference at the end of the lease. The lessee does not include any amount
for residual value in minimum lease payments if it is unguaranteed. The result is that the lessee will have a remaining
lease liability at the end of the lease term if the residual value is guaranteed and the liability will be zero at the end
of the lease if the residual value is unguaranteed.

14. What are the original accounting entries for recording a finance lease on the balance sheet?
a. Dr. Lease Expense, Cr. Lease Liability, Cr. Right-of-Use Asset
b. Dr. Amortization Expense, Cr. Right-of-Use Asset
c. Dr. Lease Liability, Cr. Cash.
d. Dr. Right-of-Use Asset, Cr. Lease Liability

Solution: This entry records an asset and a liability consistent with a finance lease.

15. If the lease term is less than 12 months, when may a lessee elect not to recognize the right-of-use asset and lease
liability?
a. The lease transfers ownership of the leased asset to the lessee by the end of the lease term.
b. The present value of the sum of (1) the lease payments and (2) any residual value guaranteed by the lessee is
90% or more of the fair value of the leased asset.
c. The lease does not include a purchase option that the lessee is reasonably certain to exercise
d. The term of the lease is for the major part of the remaining economic life of the leased asset.
 Solution: As an accounting policy for short-term leases, a lessee may elect not to recognize the right-of-use asset and
lease liability if, at the commencement date, the lease (1) has a term of 12 months or less and (2) does not include a
purchase option that the lessee is reasonably certain to exercise.

16. On January 1, 2020, Lessee entered into a 4-year lease that does not transfer ownership at the end of the lease term.
It also includes a purchase option not reasonably expected to be exercised. The leased asset has (1) a 6-year
economic life, (2) no residual value, and (3) a present value of the annual lease payments equal to 75% of the
leased asset’s fair value. If the leased asset has no alternative use to the lessor at the end of the lease term, how
should Lessee classify the lease?
a. Operating
b. Sales-type
c. Short-term
d. Finance

Solution: A lessee classifies a lease as a finance lease or an operating lease. A finance lease meets at least one of
five classification criteria. The lease does not (1) transfer ownership of the leased asset to the lessee or (2) contain a
purchase option the lessee is reasonably certain to exercise. (3) The lease term also is for 67% (4 years ÷ 6 years) of
the leased asset’s remaining economic life, not a major part (at least 75%). (4) Furthermore, the present value of
the sum of the lease payments is 75% of the leased asset’s fair value, not substantially all (at least 90%). However,
(5) the leased asset is so specialized that it is expected to have no alternative use to the lessor at the end of the lease
term. Consequently, a criterion for classification of the lease as a finance lease is met.

17. The amount recorded initially by the lessee as a lease liability should normally
a. Exceed the total of the lease payments.
b. Exceed the present value of the lease payments at the beginning of the lease.
c. Equal the total of the lease payments.
d. Equal the present value of the lease payments at the beginning of the lease.

Solution: The lessee records a lease as an asset and a liability at the present value of the lease payments. The
discount rate is the lessor’s implicit interest rate (if known) or the lessee’s incremental borrowing rate
of interest. Lease payments include the rental payments required during the lease term and the amount
of a purchase option if the lessee is reasonably certain to exercise it. If no such option exists, the lease
payments equal the sum of (1) the rental payments, (2) the amount of residual value guaranteed by the
lessee, and (3) any nonrenewal penalty imposed.

18. In a lease that is recorded as a sales-type lease by the lessor, interest revenue
a. Should be recognized in full as revenue at the lease’s inception.
b. Should be recognized over the period of the lease using the straight-line method.
c. Should be recognized over the period of the lease using the effective-interest method.
d. Does not arise.

Solution: In a sales-type lease, each periodic lease payment received has two components: interest income and
the reduction of the net investment in the lease. Interest income is calculated using the effective
interest method. It equals the carrying amount of the net investment in the lease at the beginning of the
period times the discount rate implicit in the lease.

19. Glade Co. leases computer equipment to customers under sales-type leases. The equipment has no
residual value at the end of the lease, and the lease does not contain purchase options. At lease inception, the fair
value of the leased computer equipment equals its carrying amount. Glade wishes to earn 8% interest on a 5-year
lease of equipment with a fair value of P323,400. The present value of an annuity due of P1 at 8% for 5 years is
4.312. What is the total amount of interest revenue that Glade will earn over the life of the lease?
a. P51,600
b. P75,000
c. P129,360
d. P139,450

Solution: To earn 8% interest over the lease term, the annual payment must be P75,000 (P323,400 fair value at
the inception of the lease ÷ 4.312 annuity factor). Given no residual value and no purchase option, total
lease payments over the lease term will be P375,000 (P75,000 payment × 5 years). The entire
difference between the gross lease payments received (P375,000) and their present value (P323,400 net
investment in the lease) is the interest revenue recognized over the entire lease term (P375,000 –
P323,400 = P51,600).

20. Wall Co. leased office premises to Fox, Inc., for a 5-year term beginning January 2, Year 4. Under the terms of
the operating lease, rent for the first year is P8,000 and rent for Years 2 through 5 is P12,500 per annum.
a. P12,000
b. P11,600
 c. P10,800
d. P8,000

Solution: For an operating lease, lease payments are recognized as rental income by the lessor. If rental
payments vary from a straight-line basis, rental income should be recognized over the full lease term
on a straight-line basis. Thus, an equal amount of rental income is recognized each period over the
lease term. Wall therefore should report rental revenue of P10,800 {[P8,000 – (P8,000 × .5) + (P12,500
× 4)] ÷ 5 years}.

21. On January 1, Year 1, Jims Co. entered into a 2-year lease agreement with Gab Co. to lease a new computer. The
lease term begins on January 1, Year 1, and ends on December 31, Year 2. The lease agreement requires Jims
Co. to pay Gab Co. two annual lease payments of P8,000. The present value of the minimum lease payments is
P13,000. Which of the following circumstances would require Jims Co. to classify and account for the
arrangement as a finance lease?
a. The economic life of the computer is 3 years.
b. The fair value of the computer on January 1, Year 1, is P14,000.
c. Jims Co. does not have the option of purchasing the computer at the end of the lease term.
d. Ownership of the computer remains with Gab Co. throughout the lease term and after the lease ends.

Solution: A lease is classified as a finance lease by the lessee if, at lease commencement date, any one of five
criteria is satisfied. One criterion is that the present value of the sum of the lease payments and any
residual value guaranteed by the lessee equals or exceeds substantially all (generally considered to be
at least 90%) of the fair value of the leased asset. Consequently, if the fair value of the computer on
January 1, Year 1, is P14,000, the lease is a finance lease because the present value of the lease
payments is 93% (P13,000 ÷ P14,000) of the fair value of the computer.

22. Star Company has entered into a 3-year lease agreement with Bell Corp. (lessor) for the use of 10 new
commercial copy machines. The present value (PV) of the sum of the lease payments is P72,000. The total fair
value of the machines on the lease commencement date is P120,000. An option to purchase the machines is not
part of the lease agreement, and the copy machines will be returned to Bell at the end of the lease period. The
machines are not specialized, and Bell will be able to lease or sell the leased machines after they are returned.
The estimated useful life is 7 years. The residual value of P6,500 per machine is not guaranteed by Star or by a
third party. It is probable that all lease payments will be collected. How should the lease be classified by the
lessor?
a. Operating lease.
b. Sales-type lease.
c. Finance lease.
d. Direct financing lease.

Solution: A lease is classified as a sales-type lease by the lessor and as a finance lease by the lessee if, at lease
commencement, at least one of five criteria is met: (1) the lease transfers ownership of the leased asset
to the lessee by the end of the lease term, (2) the lease includes an option to purchase the leased asset
that the lessee is reasonably certain to exercise, (3) the lease term is for the major part of the remaining
economic life of the leased asset (generally considered to be 75% or more), (4) the PV of the sum of
(a) the lease payments and (b) any residual value guaranteed by the lessee equals or exceeds
substantially all of the fair value of the leased asset (generally considered to be 90% or more), and (5)
the leased asset is so specialized that it is expected to have no alternative use to the lessor at the end of
the lease term. The lease therefore must be classified as an operating lease or a direct financing lease
by the lessor because, at lease commencement, none of the five criteria are met. The lease also does not
meet the fair value criterion classification for a direct financing lease. Accordingly, the lease is
classified as an operating lease.

23. On January 1, Emerald Co. entered into a 10-year noncancelable lease requiring year-end payments of P90,000.
Emerald’s incremental borrowing rate is 12%, while the lessor’s implicit interest rate, known to Emerald, is 10%.
Present value factors for an ordinary annuity for 10 periods are 6.145 at 10% and 5.650 at 12%. Ownership of the
property remains with the lessor at expiration of the lease. There is no option to purchase the leased property.
The leased property has an estimated economic life of 15 years. The fair value of the leased property is P1.2
million. What amount should Emerald recognize for the right-of-use asset on January 1?
a. P900,000
b. P553,050
c. P508,500
d. P0

Solution: Under both finance and operating leases, at the lease commencement date, a lessee must recognize a
lease liability and a right-of-use asset. At the lease commencement date, a right-of-use asset is
measured at the amount at which the lease liability was recognized (i.e., the present value of the lease
payments to be made over the lease term) plus initial direct costs incurred by the lessee. The rate
implicit in the lease, if it is known to the lessee, of 10% is the discount rate for the lease. Thus, on
 January 1, the right-of-use asset recognized by Emerald is P553,050 (P90,000 × 6.145).

24. Cott, Inc., prepared an interest amortization table for a 5-year lease payable with a purchase option
having an exercise price of P2,000, effective at the end of the lease. At the end of the 5 years, the balance in the
leases payable column of the spreadsheet was zero. Cott has asked Grant, CPA, to review the spreadsheet to
determine the error. Only one error was made on the spreadsheet. Which of the following statements represents the
best explanation for this error?
a. The beginning present value of the lease did not include the present value of the payment called
for by the purchase option.
b. Cott subtracted the annual interest amount from the lease payable balance instead of adding it.
c. The present value of the payment called for by the purchase option was subtracted from the present
value of the annual payments.
d. Cott discounted the annual payments as an ordinary annuity, when the payments actually occurred at the
beginning of each period.

Solution: Cott (the lessee) initially must record a finance lease by debiting a right-of-use asset and crediting a
lease liability equal to the present value of the lease payments, which consist of (1) the rental payments
and (2) the amount of the exercise price of the option to purchase the leased asset that the lessee is
reasonably certain to exercise. The effect of including the present value of the purchase option is that,
at the end of the 5-year amortization period, the lease liability should equal that amount.

25. On December 29, 2020, Action Corp. signed a 7-year lease for an airplane to transport its professional sports
team around the country. The airplane’s fair value was P841,500. Action made the first annual lease payment of
P153,000 on December 31, 2020. Action’s incremental borrowing rate was 12%, and the interest rate implicit in
the lease, which was known by Action, was 9%. The following are the rounded present value factors for an
annuity due:
9% for 7 years 5.5
12% for 7 years 5.1

What amount should Action report as a lease liability in its December 31, 2020, balance sheet?
a. P841,500
b. P780,300
c. P688,500
d. P627,300

Solution: The lease liability is recorded at the present value of the lease payments. The lease should be recorded
at the present value of lease payments discounted at the implicit rate of 9% because this rate is known
by the lessee. The amount is P841,500 (P153,000 × 5.5), which then must be reduced by the payment
made at the inception of the lease of P153,000. The lease liability therefore should be P688,500
(P841,500 – P153,000) in the December 31, 2020, balance sheet.

26. Quick Company’s lease payments are made at the end of each period. Quick’s liability for a finance lease will be
reduced periodically by the
a. Lease payment minus the portion of the lease payment allocable to interest.
b. Lease payment plus the amortization of the related asset.
c. Lease payment minus the amortization of the related asset.
d. Lease payment.

Solution: The lease liability consists of the present value of the lease payments. The lease liability is reduced by
the portion of the lease payment attributable to the lease liability. This amount is the lease payment
minus the interest component of the payment. Thus, the liability is decreased by the lease payment
each period minus the portion of the payment allocable to interest.

27. On January 1, Year 4, Babson, Inc., leased two automobiles for executive use. The lease requires Babson to
make 5 annual payments of P13,000 beginning January 1, Year 4. At the end of the lease term, December 31,
Year 8, Babson guarantees the residual value of the automobiles will total P30,000. Babson estimates that it will
probably owe only P10,000 at the end of the lease term under the residual value guarantee. The interest rate
implicit in the lease is 9%. Present value factors for the 9% rate implicit in the lease are as follows:

For an annuity due with 5 payments 4.240

For an ordinary annuity with 5 payments 3.890
Present value of P1 for 5 periods 0.650

Babson’s recorded lease liability immediately after the first required payment should be
a. P48,620
b. P44,070
c. P35,620
d. P61,620
 Solution: The lessee records a lease as an asset and a liability at the present value of the lease payments. If no
purchase option exists, the lease payments equal the sum of (1) the rental payments, (2) the amount
probable of being owed by the lessee under the residual value guarantee, and (3) any nonrenewal
penalty imposed. Accordingly, the lease liability recorded at the inception of the lease was P61,620
[(P13,000 annual payment × 4.240 PV of an annuity due at 9% for 5 periods) + (P10,000 amount
probable of being owed under the residual value guarantee × .650 PV of P1 at 9% for 5 periods)]. The
first required payment reduced this amount to P48,620 (P61,620 - P13,000).

28. On January 2, Cole Co. signed an 8-year noncancelable lease for a new machine, requiring P15,000 annual
payments at the beginning of each year. The machine has a useful life of 12 years with no salvage value. Title
passes to Cole at the lease expiration date. Cole uses straight-line amortization for all of its plant assets.
Aggregate lease payments have a present value on January 2 of P108,000, based on an appropriate rate of
interest. For the current year, Cole should record amortization expense for the right-of-use asset at
a. P0
b. P9,000
c. P13,500
d. P15,000

Solution: This lease is classified as a finance lease because the leased machine is transferred to Cole at the end of
the lease term. The lease liability and right-of-use (ROU) asset are initially recognized at the present
value of the lease payments of P108,000. The lessee amortizes the ROU on a straight-line basis. When,
at the end of the lease term, the ownership of the leased asset is transferred to the lessee or the lessee is
reasonably certain to exercise the purchase option, the amortization period is the useful life of the
leased asset. Thus, current amortization expense is P9,000 [(P108,000 right-of-use asset – P0 salvage
value) ÷ 12-year economic life].

29. On January 1, Year 4, Mollat Co. signed a 6-year lease for equipment having a 10-year economic life. The
present value of the monthly equal lease payments equaled 80% of the equipment’s fair value. The lease
agreement provides for neither a transfer of title to Mollat nor a purchase option. In its Year 4 income statement,
Mollat should report
a. Lease expense equal to the Year 4 lease payments.
b. Lease expense equal to the Year 4 lease payments less interest expense.
c. Amortization expense equal to one-tenth of the equipment’s fair value.
d. Amortization expense equal to one-seventh of 80% of the equipment’s fair value.

Solution: The lease is classified as an operating lease by Mollat. No criterion for classification as a financial
lease is met: (1) The ownership of the leased asset is transferred to the lessee by the end of the lease
term, (2) the lease includes an option to purchase the leased asset that the lessee is reasonably certain
to exercise, (3) the lease term is for the major part (generally considered as 75%) of the remaining
economic life of the leased asset, (4) the present value of the sum of the lease payments and any
residual value guaranteed by the lessee equals or exceeds substantially all of the fair value (generally
considered as 90%) of the leased asset, and (5) the leased asset is so specialized that it is expected to
have no alternative use to the lessor at the end of the lease term. In an operating lease, a lessee
recognizes for each period a single lease expense. It is calculated so that the total undiscounted lease
payments are allocated over the lease term on a straight-line basis. Because Mollat makes equal
monthly lease payments throughout the entire lease term, annual lease expense equals the annual lease
payments.

30. Manning Co. (lessee) has the following current lease liabilities at the end of Year 7:
Lease A – finance lease, 5 years, lease liability P125,000
Lease B – operating lease, 3 years, lease liability P65,000

How should Manning present the lease liabilities on its balance sheet?
a. Finance and operating lease liabilities may be presented together in the same line item on the balance
sheet.
b. Finance and operating lease liabilities may be presented with other liabilities on the balance sheet.
c. Finance and operating lease liabilities must be presented separately from each other and other
liabilities on the balance sheet.
d. The finance lease liability, not the operating lease liability, must be presented separately from other
liabilities on the balance sheet.

Solution: In the balance sheet, a lessee must not present (1) finance lease right-of-use assets in the same line item
as operating lease right-of-use assets or (2) finance lease liabilities in the same line item as operating
lease liabilities. Moreover, they must be presented separately from other assets or liabilities,
respectively.
31. On January 1, Year 1, JCK Co. signed a contract for an 8-year lease of its equipment with a 10-year life. The
present value of the 16 equal semiannual payments in advance equaled 85% of the equipment’s fair value. The
contract had no provision for JCK, the lessor, to give up legal ownership of the equipment. Should JCK
recognize rent or interest revenue in Year 3, and should the revenue recognized in Year 3 be the same or smaller
than the revenue recognized in Year 2?

Year 3 Revenues Year 3 Amount Recognized

Recognized Compared with Year 2

a. Rent The same

b. Rent Smaller
c. Interest The same
d. Interest Smaller

Solution: JCK classifies the lease as a sales-type lease because the lease term is for the major part (80% = 8
years ÷ 10 years) of the remaining economic life of the leased equipment. A lease term of 75% or more
of the remaining economic life of the leased asset generally is considered to be a major part of its
remaining economic life. In a sale-type lease, each periodic lease payment received has two
components: interest income and the reduction of the net investment in the lease. Interest income is
calculated using the effective interest method. It equals the carrying amount of the net investment in
the lease at the beginning of the period times the discount rate implicit in the lease. The amount of
interest income declines over the lease term. As the carrying amount of the investment in the lease
decreases, the interest component of the periodic lease payment also decreases.

32. Able Co. leased equipment to Baker under a noncancelable lease with a transfer of title. After recognition of the
lease, will Able record any depreciation expense on the leased asset and interest revenue related to the lease?

Depreciation Expense Interest Expense

a. Yes Yes
b. Yes No
c. No No
d. No Yes

Solution: The lease transfers ownership. Accordingly, the lease is recognized as a sales-type lease by the lessor.
The leased equipment is derecognized at the lease commencement date. Thus, no depreciation expense
on the leased equipment is recognized by Able. In a sales-type lease, subsequent to the lease
commencement date, each periodic lease payment received by the lessor includes both interest income
and a reduction of the net investment in the lease.

33. On the first day of its fiscal year, Lessor, Inc., leased certain property at an annual rental of P100,000 receivable
at the beginning of each year for 10 years. The first payment was received immediately. The leased property is
new, had cost P650,000, and has an estimated useful life of 13 years with no salvage value. The rate implicit in
the lease is 8%. The present value of an annuity of P1 payable at the beginning of the period at 8% for 10 years is
7.247. Lessor had no other costs associated with this lease. Lessor should have accounted for this lease as a sales-
type lease but mistakenly treated the lease as an operating lease. Lessor depreciates all of its properties using the
straight-line depreciation method. Ignoring tax effects, what was the effect on net earnings during the first year
of treating this lease as an operating lease rather than as a sale?
a. Overstatement of P25,300.
b. Understatement of P74,676.
c. Understatement of P24,676.
d. Understatement of P24,700.

Solution: Accounting for the lease as an operating lease during the first year generated P50,000 of income, the
P100,000 lease payment minus P50,000 of depreciation (P650,000 ÷ 13). In a sales-type lease, the
lessor recognizes two income components: profit on the sale and interest income. Total income from
accounting for the lease as a sale would have been P124,676 (P74,700 + P49,976). The effect of the
error on net earnings was therefore an understatement of P74,676 (P124,676 – P50,000).

Net investment (P100,000 × 7.247) P724,700 Net investment (P100,000 × 7.247) P724,700
Carrying amount (650,000) First lease payment (100,000)
Profit on sale P 74,700 Lease balance P624,700
Interest rate × .08___
Interest income P 49,976
34. Rent should be reported by the lessor as revenue over the lease term as it becomes receivable according to the
provisions of the lease for a(n)

Direct-Financing Lease Operating Lease Sales-Type Lease

a. Yes Yes Yes
b. Yes No No
c. No Yes No
d. No No Yes

Solution: In sales-type and direct financing leases, subsequent to the lease commencement date, each periodic
cash payment received by the lessor includes both interest income and a reduction of the net
investment in the lease. In an operating lease, lease payments are recognized as lease (rental) income
by the lessor. If rental payments vary from a straight-line basis, rental income should be recognized
over the full lease term on the straight-line basis. In a sales-type lease, selling profit or loss on the lease
is calculated on the lease commencement date. In a direct-financing lease, no selling profit is
recognized on the lease commencement date. Any selling profit is deferred and reduces the initial
amount of the net investment in the lease.

35. Neary Company has entered into a contract to lease computers from Baldwin Company starting on January 1,
2020. Relevant information pertaining to the lease is provided below.
Lease term 4 Years
Useful life of computers 5 Years
Present value of future lease payments P100,000
Fair value of leased asset on date of lease 105,000
Baldwin’s implicit rate (known to Neary) 10%

At the end of the lease term, ownership of the asset transfers from Baldwin to Neary. Neary has
properly classified this lease as a capital lease on its financial statements and uses straight-line
depreciation on comparable assets.

At January 1, 2020, the lease would be reported on Neary’s books as a(n)

a. Asset only.
b. Asset and a liability
c. Liability only
d. Expense and a liability

Solution: The lease is classified as a finance lease by the lessee because the ownership of the leased asset is
transferred to the lessee at the end of the lease term. The lessee must record a finance lease by debiting
a right-of-use asset and crediting a lease liability.

36. Neary Company has entered into a contract to lease computers from Baldwin Company starting on January 1,
2020. Relevant information pertaining to the lease is provided below.
Lease term 4 Years
Useful life of computers 5 Years
Present value of future lease payments P100,000
Fair value of leased asset on date of lease 105,000
Baldwin’s implicit rate (known to Neary) 10%

At the end of the lease term, ownership of the asset transfers from Baldwin to Neary. Neary has
properly classified this lease as a capital lease on its financial statements and uses straight-line
depreciation on comparable assets.

What is the annual amortization expense that Neary will record on the leased computers?
a. P20,000
b. P21,000
c. P25,000
d. P26,250

Solution: Under a finance lease, the lessee recognizes a right-of-use asset and lease liability at an amount equal
to the present value of the lease payments (P100,000) given no initial direct costs. Because the lease
provides for the transfer of ownership, the lease is a finance lease, and the lessee should amortize the
right-of-use asset using the straight-line method over the estimated useful life (5 years). Annual
expense is P20,000 (P100,000 ÷ 5 years).
37. If a lessee uses off-balance-sheet financing, assets have been acquired
a. For cash
b. With short-term leases
c. With finance leases
d. With a line of credit

Solution: A short-term lease has a term of 12 or fewer months and does not include a purchase option reasonably
expected to be exercised. For this type of lease, the lessee may elect not to recognize the right-of-use
asset and lease liability.

38. Which of the following meets a criterion for a lessee to account for a lease as a finance lease?
a. The lease is for unspecialized equipment
b. A third party has guaranteed the residual value of the leased asset.
c. The present value of the lease payments is 75% of the fair value of the leased asset.
d. The lessee is reasonably certain to exercise the option to purchase the leased asset.

Solution: A lease is classified as a sales-type lease by the lessor and as a finance lease by the lessee if, at lease
commencement, the lease includes an option to purchase the leased asset that the lessee is reasonably
certain to exercise.

39. Which of the following is a criterion for a lease to be classified as a finance lease in the books of a lessee?
a. The lease contains a purchase option that the lessee is reasonably certain to exercise.
b. The lease does not transfer ownership of the property to the lessee.
c. The lease term is equal to 65% or more of the estimated useful life of the leased property.
d. The present value of the minimum lease payments is 70% or more of the fair market value of the leased
property.

Solution: A lease is classified as a finance lease by the lessee if, at lease commencement date, any of the
following five criteria is satisfied: (1) the lease transfers ownership of the leased asset to the lessee by
the end of the lease term, (2) the lease includes an option to purchase the leased asset that the lessee is
reasonably certain to exercise, (3) the lease term is for the major part (generally is considered to be at
least 75%) of the remaining economic life of the leased asset, (4) the present value of the sum of the
lease payments and any residual value guaranteed by the lessee equals or exceeds substantially all
(generally, is considered to be at least 90%) of the fair value of the leased asset, or (5) the leased asset
is of such a specialized nature that it is expected to have no alternative use to the lessor at the end of
the lease term.

40. Which of the following statements about a lease is false if a lease classification criterion is met?
a. The lessor capitalizes the net investment in the lease.
b. The lessor records a leased asset.
c. The lessee amortizes right-of-use asset.
d. A sales-type lease is a form of financing.

Solution: If at least one of five classification criteria is met, the lessor recognizes a sales-type lease and
derecognizes the leased asset.

41. A corporation signed a 3-year lease for an automobile on December 1. The automobile had a list price of
P17,000 and an estimated useful life of 8 years. The lease called for payments of P500 per month for 36 months.
The present value of the P500 payments was P15,054 at the corporation’s incremental borrowing rate and
P15,496 at the lessor’s implicit rate, which is known to the lessee. Based on the above information, the
corporation should record the lease as a(n)
a. Finance lease
b. Operating lease
c. Sale-leaseback
d. Sales-type lease

Solution: A lessee must report a lease as a finance lease if the present value of the lease payments and any
residual value guaranteed by the lessee is 90% or more of the fair value of the leased asset. If the
lessor’s implicit rate is known to the lessee, that is the appropriate discount rate. Dividing the present
value by the list price of the automobile yields a result > 90% (P15,496 ÷ P17,000 = 91.2%). Thus, this
lease must be classified by the corporation as a finance lease.