Leases (PFRS 16)

Leases score because PFRS 16 rewired how the lessee reports, and the board loves testing the gap between the old and new worlds. Almost every lease now lands on the lessee's statement of financial position through a right-of-use asset and a lease liability, while the lessor keeps a two-model split. Master the single lessee model and the lessor classification and you can handle the whole topic from one page of rules.

The lessee right-of-use model

At the commencement date the lessee recognizes a lease liability and a right-of-use (ROU) asset for nearly all leases. Two optional exemptions let the lessee simply expense payments on a straight-line basis instead: short-term leases (a term of 12 months or less with no purchase option) and leases of low-value assets (such as tablets or small office items assessed when new).

The lease liability is the present value of the lease payments not yet paid, discounted at the interest rate implicit in the lease, or, if that rate is not readily determinable, the lessee's incremental borrowing rate. The payments included are fixed payments (less any lease incentives receivable), variable payments that depend on an index or rate, the exercise price of a purchase option if the lessee is reasonably certain to exercise, amounts expected to be payable under residual value guarantees, and termination penalties if the term reflects early termination.

The ROU asset starts at the amount of the lease liability, plus any payments made at or before commencement (less incentives received), plus initial direct costs, plus the estimated cost of dismantling or restoring the asset.

After commencement the two lines move differently. The lease liability accretes interest using the effective interest method and is reduced by payments. The ROU asset is depreciated, normally straight-line, over the shorter of the lease term and the asset's useful life, unless ownership transfers or a purchase option is reasonably certain, in which case depreciation runs over the full useful life. Because straight-line depreciation sits on top of front-loaded interest, the total expense is higher in the early years than the cash rent.

Worked example: measuring and unwinding a lease

Imus Logistics leases a warehouse for 5 years with payments of P200,000 due at the end of each year. The interest rate implicit in the lease is 10 percent, and the present value of an ordinary annuity factor for 5 years at 10 percent is 3.7908. Ownership does not transfer and there is no purchase option.

Initial lease liability and ROU asset: 200,000 x 3.7908 equals P758,157 (assume no initial direct costs, so the ROU asset equals the liability).

Year 1 interest: 758,157 x 10 percent equals P75,816.

Year 1 principal reduction: 200,000 payment less 75,816 interest equals P124,184, leaving a liability of 758,157 less 124,184 equals P633,973.

Year 1 depreciation: 758,157 spread over the 5-year term equals P151,631.

Total year 1 expense is 75,816 plus 151,631 equals P227,447, above the P200,000 cash payment. That front-loading is the signature of the lessee model.

Lessor accounting: the two-model split

The lessor still classifies each lease as finance or operating based on whether it transfers substantially all the risks and rewards of ownership.

	Finance lease	Operating lease
Test	Transfers substantially all risks and rewards	Retains them
Lessor's asset	Derecognized; a net investment in the lease (a receivable) is recognized	Kept on the books and depreciated
Income	Interest income on the net investment	Lease income, usually straight-line

Indicators that point to a finance lease include: ownership transfers by the end of the term; a purchase option the lessee is reasonably certain to exercise; the lease term covers the major part of the asset's economic life; the present value of the lease payments amounts to substantially all of the asset's fair value; and the asset is so specialized that only the lessee can use it without major modification. Meet one or more and the substance is a financed sale, not a rental.

Common traps

• Leaving an operating-type lease off the lessee's statement of financial position; PFRS 16 puts nearly every lease on, except short-term and low-value leases.
• Depreciating the ROU asset over the useful life when ownership does not transfer; use the shorter of the term and useful life.
• Discounting at the lessee's borrowing rate when the rate implicit in the lease is actually determinable; the implicit rate comes first.
• Applying the lessee's single model to the lessor; the lessor still splits leases into finance and operating.
• Expecting a level total expense; depreciation plus front-loaded interest makes the early years cost more than the cash rent.

Exam-day strategy

• For a lessee, build the liability first as the present value of unpaid payments, then set the ROU asset to that liability plus prepayments, direct costs, and restoration.
• Choose the discount rate in order: the interest rate implicit in the lease, then the incremental borrowing rate only if the implicit rate is not readily determinable.
• Roll the liability with an interest-then-principal schedule, and depreciate the ROU asset straight-line over the shorter of term and useful life unless ownership passes.
• For a lessor, decide finance versus operating from the risks-and-rewards indicators before you compute anything.
• Remember the two exemptions (short-term and low-value) let the lessee skip the ROU model and just expense the payments.