Audit of Long-Term Lease Liabilities

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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 A lease is a contract or part of a contract that conveys the right to control the use the
Accounting underlying asset for a period of time in exchange for consideration.
(PFRS 16 -
Leases) 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) aguilar
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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 3,890,000

Lease Liability 3,790,000
Cash 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. Depn. 778,000
At the end of the least term, the entry will be:
Accum. Depn. 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.

Cash 100,000
Fixed payment 1,000,000 x 4.17 = 4,170,000

Guaranteed Res. Value 300,000 x 0.62 = 186,000

4,356,000 1/1/2017
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1,000,000 - 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 - 1/1/2022
Lease liability 1,000,000

Cash 1,000,000
4,456,000 300,000 / 5 yrs = 831, 200

Accrued interest 335,600
2018
Lease liability 664,400
Cash 1,000,000

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:

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:

Loss on finance lease 100,000

Cash 100,000
As long as there is a residual value guarantee, there is not 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.

Cash 100,000
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PV of payment 1,000,000 x 3.79 = 3,790,000

PV of purchase option 500,000 x 0.62 = 310,000
Cost of the Right of Use Asset = 4,200,000

4,100,000 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

Cash 1,000,000
Acccum. Depn. 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:

Cash 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:

Loss on finance lease 2,650,000
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 1,200,000
New implicit rate 8%
2017
Cash 100,000
Fixed payment 1,000,000 x 3.79 = 3,790,000


3,790,000 1/1/2017
1,000,000 379,000 621,000 3,169,000 12/31/2017
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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

Cash 1,000,000
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, 2022 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 = 1,780,000

PV of extended lease term = 4,117,680
Total PV as of Jan. 1, 2020 = 5,897,680
Less: Amortized cost as of 12/31/2019 = 1,734,490
Increase in lease liability as of 1/1/2020 = 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 - 12/31/2026

Cash 1,000,000
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.
Terminal and Freight Storage 4,821,510

Accum. Depreciation 2,334,000
Cash 5,000,000
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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 200,000
Annual rental for the next three years payable at the end of each year 300,000
Initial direct cost paid by the lessee 100,000
Leasehold improvements 250,000
Estimated cost of restoration required at the end of the lease contract 50,000
Useful life of the building 20 years
Implicit interest rate 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
Estimated cost of restoration = 50,000
Cost of the Right to Use Asset = 1,171,640

Cash 100,000
Est. liability for restoration 50,000
Leasehold improvement 250,000

Cash 250,000
Lessor IFRS 16 provides that a lessor shall classify leases as either an operating lease or a finance
Accounting 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.
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.
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- If the lessee can cancel the lease, the lessors 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.
- 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 500,000

Lease bonus 200,000
Initial direct costs incurred by Sablay Company 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 = 5,000,000

Depreciation 2017 5M / 10 yrs = ( 500,000)
Deferred Initial direct costs
300,000 [300,000 / 4 x 10/12] = 237,500
Carrying value of the machine 12/31/2017 = 4,737,500
Unearned rent income [200,000 41,667] = 158,333
Machinery 5,000,000
Cash 5,000,000
Rent Receivable/Cash 1,000,000

Rent income 1,000,000
Cash 500,000
Liability for security deposit 500,0000
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Cash 200,000
Unearned rent income 200,000
Deferred initial direct costs 300,000

Cash 300,000
Repairs and maintenance 25,000

Cash 25,000
Accum. Depreciation 500,000
5M / 10 x = 500,000
Amortization of lease bonus and deferred initial direct costs:
Unearned rent income 41,667

Rent income 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 rent-
free.
Required: Prepare the necessary journal entries.
Total rent for the lease

1st year 1,200,000 x 6/12 = 600,000
2nd year 1,000 x 3,000 = 3,000,000
3rd year 1,000 x 3,000 = 3,000,000
Total rental for 3 years = 6,600,000
1st year
Cash 600,000
Rent receivable 1,600,000
2nd year
Cash 3,000,000
Rent receivable 800,000
3rd year
Cash 3,000,000
Rent receivable 800,000
Finance Finance lease is either:

Lease - Direct financing lease recognizes only interest income
- Sales type lease recognizes both interest income and gross profit on sale.
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(Lessor
Accounting) 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 5,000,000

Residual value unguaranteed 600,000
Annual rental payable in advance 900,000
Initial direct cost incurred by the lessor 250,000
Useful life and least term 8 years
First lease payment 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 = 5,000,000

Net investment = 5,250,000
Gross investment = 7,800,000

Less: Net investment = 5,250,000
Unearned interest income
Total financial revenue = 2,550,000
Payment Interest Principal Amortized cost

5,250,000 1/1/2017
900,000 900,000 4,350,000 1/1/2017
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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 5,000,000
Cash 5,000,000
Equipment 250,000
Cash 250,000
Lease receivable 7,800,000

Equipment 5,250,000
Unearned interest income 2,550,000
Cash 900,000
Lease receivable 900,000
Unearned interest income 522,000

Interest income 522,000
At the end of the lease term, the entry to revert the machine to the lessor would be:
Equipment 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
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
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 4,361,200

Unguaranteed residual value 200,000
Useful life and lease term 8 years
PV of an ordinary annuity of 1 for 8 periods at 10% 5.335
PV of 1 for 8 periods at 10% 0.466
The annual rental is payable at the end of each year. The equipment will revert to the lessor
upon the lease expiration.
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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

4,361,200
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.

4,361,200
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
200,000 200,000 - year 8
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 4,361,200

Divided by PV of an ordinary annuity 5.335
Annual rental 817,470
Note: residual value is completely ignored in the computation since the equipment will not revert to
lessor.
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4,361,200
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 manufacturers 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 entitys 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.
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

Lease receivable gross investment 17,143,550
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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

Total present value 12,283,500
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 12,000,000
Cost of goods sold 7,916,500
Gross profit 4,083,500

[(8,000,000 283,500) + 200,000]
Sales 12,000,000
Inventory 8,000,000
Cash 200,000
Cash 3,328,710

Interest income 1,474,020

12,283,500
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 400,000
Case in Point 17:

Using the same information in CIP#16, except that the residual value is guaranteed.
Required:
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

PV of rentals (3,328,710 x 3.605) 12,000,000

PV of unguaranteed residual value (500,000 x 0.567) 283,500
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Total COS 8,200,000
Sales 12,283,500

Sales 12,283,500
Inventory 8,000,000
Cash 200,000
Entry to revert the helicopter to lessor:
Inventory 400,000
Cash 100,000
Case in Point 18:

Using the same information in CIP#16, except that the asset will not revert to the lessor.
Required:
- 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) 16,643,550

PV of rentals (3,328,710 x 3.605) 12,000,000

Total COS 8,200,000
Sales 12,000,000

Sales 12,000,000
Inventory 8,000,000
Cash 200,000
15
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:
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
PV of rentals (3,328,710 x 3.605) 12,000,000

PV of purchase option (500,000 x 0.567) 283,500


Total COS 8,200,000
Sales 12,283,500

Sales 12,283,500
Inventory 8,000,000
Cash 200,000

12,283,500
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 500,000
Nonexercise of the option:
Inventory 400,000
Case in Point 20:
16
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) 2,500,000

PV of gross rentals (500,000 x 3.60) 1,800,000

Sales 1,800,000

1,800,000 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 1,200,000

CV of lease receivable:
Unearned int. receiv. (700,000 469,795) 230,205 1,269,795
Loss on sale of leased equipment 69,795
Cash 1,200,000
Loss on sale 69,795
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.
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.
17
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 600,000

Lease term 5 years
Useful life of building 20 years
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 500,000

Lease term 8 years
Useful life of equipment 10 years
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?
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
18
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

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.
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.
19
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 c. P 480,000 d. P 522,053
2. What is the total annual lease payment?

a. P 420,000 b. P 455,044 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 1,500,000

Lease term and useful life of machinery 5 years
Cost of equipment 4,000,000
Residual value unguaranteed 500,000
PV of an ordinary annuity of 1 at 12% for 5 periods 3.60
PV of 1 at 12% for 5 periods 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:
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
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 entitys 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:
20
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

a. P 1,732,500 b. P 1,956,500 c. P 2,082,500 d. P 2,306,500
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 5,850,000

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:

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

Dont become overwhelmed by all the possible choices. Consider the options, pick one,
and go with it.
The possibilities do not create their own fulfillment. Thats your job, and its a great
one, though necessarily difficult at times.
When the challenges come, dont slide into the trap of wishing you had chosen
differently. Push on ahead, stick to the road youre on, and build the value youve 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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1

College of Accounting Education

Auditing Problems L. Eddie I. Aguilar, CPA, MBA

Audit of Long-Term Liability

Exemption in Using Finance Lease (this is discretionary)

Initial Measurement of Right of Use Asset

Components of Lease Payments

Required: Prepare the necessary journal entry.

Right of Use Asset 3,890,000

Fixed payment 1,000,000 x 3.79 = 3,790,000

Payment Interest Principal Amort. Cost

Lease Liability 621,000

At the end of the least term, the entry will be:

Accum. Depn. 3,890,000

Required: Prepare the necessary journal entry.

Right of Use Asset 4,456,000

Fixed payment 1,000,000 x 4.17 = 4,170,000

Payment Interest Principal Amort. Cost

1,000,000 - 1,000,000 3,356,000 1/1/2017

Lease liability 1,000,000

Interest expense 335,600

Interest expense 269,160

Accum. Depn. 4,156,000

Accum. Depn. 4,156,000

Loss on finance lease 100,000

Required: Prepare the necessary journal entry.

Right of Use Asset 4,200,000

PV of payment 1,000,000 x 3.79 = 3,790,000

Payment Interest Principal Amort. Cost

Interest expense 410,000

Lease liability 500,000

Accum. Depn. 1,050,000

Additional relevant information:

Required: Prepare the necessary journal entry.

Fixed payment 1,000,000 x 3.79 = 3,790,000

Payment Interest Principal Amort. Cost

1,000,000 316,900 683,100 2,485,900 12/31/2018

Lease Liability 621,000

PV of the remaining 2 years of old lease = 1,780,000

Right of Use Asset 4,163,190

New amortization table:

Lease liability 528,186

CV 12/31/19 (3,890,000 2,334,000) 1,556,000

Required: Prepare the necessary journal entry.

Terminal and Freight Storage 4,821,510

Compute the following:

PV of annual rental for the first two years = 356,000

Right of Use Asset 1,171,640

Leasehold improvement 250,000

Security deposit received from Sacramento 500,000

Required: Compute the following:

Rent income 3/1/2017 to 12/31/17 = 1,000,000

Cost of the machine = 5,000,000

Unearned rent income [200,000 41,667] = 158,333

Rent Receivable/Cash 1,000,000

Deferred initial direct costs 300,000

Repairs and maintenance 25,000

Amortization of lease bonus and deferred initial direct costs:

Unearned rent income 41,667

Amortization initial direct costs 62,500

- Unequal Rental Payments

Required: Prepare the necessary journal entries.