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UNIT 6

AUDIT OF LEASES
Estimated Time: 3.0 HOURS

Discussion Questions:
1. Discuss the following terms:
a. Operating lease
b. Finance lease
c. Sale and leaseback
d. Direct financing lease
e. Sales type lease
2. Discuss the requirements before an arrangement could be classified as finance
lease.
3. What are the instances for which a cancellable lease could be accounted for
under finance lease?
4. Discuss the disclosure requirements for the following:
a. Operating lease
b. Finance lease

Problem 6-1: Operating Lease


On January 1, 2016, ABC Company leased a building from DEF Company under an
operating lease for five years. The lease agreement provides for monthly payments of
P30,000 for the first three years and P50,000 for the last two years. A lease bonus of
P120,000 was paid by ABC Company. DEF Company provided six months free rent
to ABC. Annual depreciation of the building amounted to P150,000. Property taxes
and insurances paid during 2016 totaled P50,000.

Required:
1. How much is the rent expense for the year?
2. How much is the net income to be reported by DEF for the year with regard to the
lease transaction above?
3. Assume that the lease contract provides for a contingent rent of 5% of net sales
above P1,000,000. Estimated net sales by ABC during the lease term was
P8,500,000. ABC reported net sales of P1,250,000 during 2016. How much is the
rent expense for the year?
Problem 6-2: Finance Lease
Spicy Co. leased a machine from Bitter Co. The lease qualifies as finance lease and
requires 10 annual payments of P 100,000 beginning immediately. The lease
specifies an interest rate of 12% and a purchase option of P 10,000 at the end of the
lease term, even though the machines estimated value on that date is P 20,000.
Spicy Co.s incremental borrowing rate is 14%. The machine is estimated to have a
fair value of P5,000 at the end of its 12-year useful life.

Required:
1. How much should be recognized as lease liability immediately at the beginning of
the lease term?
2. How much should be recognized as interest expense for the first year of the lease
term?
3. How much should be recognized as depreciation expense for the first year of the
lease term?

Auditing Practice II
Workbook

Third Term, AY 2015-2016


Page 1-1

Problem 6-3: Finance Lease


On January 1, 2016, Kaa Sir, Corp. (KSC) entered into a 5-year non-cancelable lease
of a warehouse. The following are the agreement:
i. Annual rental payments of P750,000 are payable starting January 1, 2016.
ii. Fair value of the warehouse is P2.8 million as of January 1, 2016.
iii. The building has an estimated economic life of five years.
iv. At the termination of the lease, ownership of the warehouse reverts back to
the lessor.
v. KSCs incremental borrowing rate is 12% per year.
vi. The annual rental payment includes P54,705 of executory costs related to
taxes on the property.

Required:
1. How much is the cost of the warehouse?
2. How much should be reported as current liabilities as of December 31, 2016?
3. How much should be reported as non-current liabilities as of December 31, 2016?
4. How much is the total lease-related expense for the year ended December 31,
2016?
Problem 6-4: Direct Financing Lease
On December 31, 2015, Sir Kit, Inc. (SKI) purchased machinery for P1.5 million and
delivered the same to So Sir, Inc. (SSI), the lessee. The following are the related
information for the lease:
i. SKIs implicit rate is 11%, which is known to SSI. SSIs incremental borrowing
rate is 14% as of December 31, 2015.
ii. The machinery has an estimated useful life of eight years, which is also the
lease term.
iii. A non-guaranteed residual value of P150,000 will revert to SKI.
iv. Lease rentals consist of eight equal annual payments starting December 31,
2015.

Required:
1. How much is the annual lease payment?
2. How much is SSIs depreciation expense in 2016?
3. How much is SSIs interest expense in 2016?
4. How much is the unearned interest income by SKI at the start of the lease?
5. Assuming that the residual value is guaranteed by SSI, recomputed requirements
1 to 4.

Auditing Practice II
Workbook

Third Term, AY 2015-2016


Page 1-2

Problem 6-5: Sales Type


Gryffindor, Inc. leases equipment to its customers under non-cancelable leases. On
January 1, 2016, Gryffindor leased equipment costing P3,900,000 to Snape Co., for
nine years. The rental cost was P440,000 payable in advance semiannually (January
1 and July 1), plus P30,000 semiannually for executory costs. The equipment had an
estimated life of 15 years and sold for P5,312,740 with an estimated unguaranteed
residual value of P750,000. The implicit interest rate is 12%.

Required:
1. How much is the total interest income from lease that will be earned by
Gryffindor?
2. How much should Gryffindor report as profit on the sale?
3. How much should be reported by Snape as liability under finance lease as of
December 31, 2016?
4. How much should Snape report under current liabilities as liability under finance
lease as of December 31, 2016?
5. How much interest expense should be reported by Snape in relation to the lease
for the year ended December 31, 2016?

Problem 6-6: Sale-Lease Back


ABC Company sold a machinery for P5,500,000 on January 1, 2016 and immediately
leased the machine back for a period of five years. The fair value of the machinery on
date of sale was P5,200,000. The machinery was carried by ABC Company at
P5,000,000 immediately before the sale.

Required:
1. Assuming that the sale qualifies as an operating lease, how much should be
reported as gain on 2016?
2. Assuming that the sale qualifies as a finance lease, how much should be reported
as gain on 2016?
3. Assuming that the sale qualifies as an operating lease and that the fair value of
the machinery was P5,700,000, how much should be reported as gain on 2016?

Auditing Practice II
Workbook

Third Term, AY 2015-2016


Page 1-3

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