AC3202 Corporate Accounting I

Leases
Week 9
Spring 2024

Wiley: Chapter 21
In the previous class

• Impairment test for assets

• Accounting for an impairment loss and reversal of impairment loss

• Please form a group of four to five by the end of this week

(Sunday, 17 March 2024, 11:59 pm)
• https://docs.google.com/spreadsheets/d/1PkOxBVne0xkxiROQi3bzfwqZP
KuSvF8N1beUTfwqyE8/edit?usp=sharing
• Please find your groupmate online if you cannot find one in class
• Please be respectful to others - allow your classmates to join your group on
Google Spreadsheet if you have a vacancy in your group
• Group project instructions will be available soon
Relevant Standard

• Hong Kong Financial Reporting Standard (HKFRS) 16

• Leases

• https://www.hkicpa.org.hk/-/media/HKICPA-Website/Members-
Handbook/volumeII/hkfrs16.pdf

3
Learning Objectives

1. Identify the type of leases that are within the scope of

HKFRS 16 and define the terminologies used in relation to
leases.
2. Classify leases into operating and finance leases by looking
into the substance of the transactions and applying HKFRS 16.
3. Account for operating leases from the perspective of a lessee
and a lessor, respectively.
4. Account for finance leases from the perspective of a lessee
and a lessor, respectively.
5. Prepare disclosures for lessees and lessors in respect of
finance leases.

4
Contents

1. Introduction - What is a lease?

2. Classification of leases
• Operating lease vs Finance lease
3. Accounting for low-value and short-term leases
• Lessee and Lessor
4. Accounting for finance lease - Lessee
5. Accounting for finance lease - Lessor
6. Disclosures

5
What is a lease?
• Capital investment can be prohibitively expensive
• e.g., airline industry
• Thus, companies may not be able/willing to purchase the
asset with one single payment
• Decrease company’s cash reserve
• For smaller/high growth firms, may not be able to borrow from a bank

6
What is a lease?

• That’s why we have lease:

• HKFRS 16 defines a lease as an agreement whereby the lessor (the
owner of an asset) conveys to the lessee (renter) the right to use an
asset for an agreed period of time, in return for a payment or series of
payments
• A lease conveys the use of an asset from lessor to lessee without
transferring ownership

7
Contents

1. Introduction - What is a lease?

2. Classification of leases
• Operating lease vs Finance lease
3. Accounting for low-value and short-term leases
• Lessee and Lessor
4. Accounting for finance lease - Lessee
5. Accounting for finance lease - Lessor
6. Disclosures

8
2. Classification of Leases

• Classification of lease based on substance of the transaction,

rather than merely the legal form of the contract.
• Rationale for the accounting treatment: substance over form
• i.e., transactions and other events are accounted for and presented in
accordance with their substance and financial reality and not merely with
legal form

• Assets are defined as “a resource controlled (the risk and benefits) by

the enterprise as a result of past events and from which future
economic benefits are expected to flow to the enterprise”

• Thus, it is “control” not “ownership” that is essential in determining

whether a lease fits the description of assets
• Lessee has substantial control over the asset  finance lease
• If not  operating lease

9
2.1 Classification of Leases ‐ Lessee

 HKFRS 16 requires a lessee to classify a lease as finance lease

for all leases with a term of more than 12 months, unless the
underlying asset is of low value
 Exemption for a short-term lease (if lease term shorter than 12
months) or underlying asset is of low value (US$5,000 or less)
no journey entry, if the leases is less than a
year, we dun classified it as a lessee
 A lessee is required to recognize a right-of-use asset
representing its right to use the underlying leased asset and a
lease liability representing its obligation to make lease
payments

10
 2.2 Classification of Leases ‐ Lessor
• A lessor shall classify each of its leases as either an operating
lease or a finance lease
• A lease is classified as a finance lease if it transfers substantially all
the risks and rewards incidental to ownership of an underlying asset

• A lease is classified as an operating lease if it does not transfer

substantially all the risks and rewards incidental to ownership of an
underlying asset

Risks: technological obsolescence, idle capacity, unsatisfactory performance,

variations in return due to changing economic conditions, etc.

Rewards: profits gained from using the asset over its economic life, gain from
appreciation in value or realization of a residual value.

11
 2.2 Classification of Leases ‐ Lessor
• Conditions/situations that individually or in combination would normally
lead to a lease transaction being classified as a finance lease as risks and
benefits are considered to be substantially transferred:

1. The ownership is transferred to the lessee at the end of the lease term;
2. The lease contains a bargain purchase option;
3. The lease term is for the major part of the economic life of the asset even
if title is not transferred (e.g., >=75%);
4. At the inception of the lease, the present value of the minimum lease
payments amounts to at least substantially all of the fair value of the
leased asset (e.g., >=90%); and
5. The leased assets are of a specialized nature such that only the lessee can
use them without major modifications being made [no alternative use].
The company cannot resell
it, for other alternative use

12
Leased Asset/ Lease Liability
Example ‐ Classification of Leases
 Lease term test
The economic life of the equipment is 12 years. The lease term is 10 years.

Finance lease
10/12 = 83.3% > 75%

Yes, it is a finance leases

 Transfer of ownership test

Ownership of the property automatically passes to Westside (lessee) at the end
of the lease term.

Finance lease
Transfer of title at the end of the lease term

Yes, it is a finance
leases 13
 Example ‐ Classification of Leases
 Present value test
• The market value of the equipment is $75,000. The present value of
the lease payment is $71,000.

Finance lease
71,000/75,000 = 94.7% > 90% Yes, it is a finance
leases

• The lease requires payments of $9,000 per year in advance per year.
The lease period is three years, and implicit interest rate is 12%.
The fair market value of the equipment is $28,000.
Operating lease (lessor)
$9,000 + 9,000 x PVIFA (12%, 2)
= $9,000 + 9,000 x 1.6901 = $24,211
No, it is <=90%, it is not a
$24,211/$28,000 = 86.5% < 90% finance leases

Less than 90%, probably would not be considered

to be “substantially all” of the fair value
14
 Example ‐ Classification of Leases
 Present value test

15
 Example ‐ Classification of Leases
 Present value test
• The lease requires payments of $6,000 per year in advance, which
includes executory costs of $500 per year. The lease period is three
years, and the implicit interest rate is 10%. The market value of the
equipment is $16,650.

Finance lease

$5,500 + 5,500 x PVIFA (10%, 2)

= $5,500+5,500 x 1.7355 = $15,045
15,045/16,650 = 90.4% > 90% Yes, it is a finance leases

• Executory costs refers to the normal expenses associated with a leased

asset, including insurance, maintenance, and taxes
• Excluded when calculating the present value of minimum lease payments
16
 Example ‐ Classification of Leases
 Present value test

17
Contents

1. Introduction - What is a lease?

2. Classification of leases
• Operating lease vs Finance lease
3. Accounting for low-value and short-term leases
• Lessee and Lessor
4. Accounting for finance lease - Lessee
5. Accounting for finance lease - Lessor
6. Disclosures

18
 3. Accounting For Low‐Value & Short‐Term Leases

• Lease payments (income) under a low-value or short-term lease

could be recognized as an expense (income) in the Statement of
Comprehensive Income (Income Statement) on a straight-line
basis over the lease term, unless another systematic basis is more
representative of the time pattern of the user’s benefit

• Journal Entry

Lessee Lessor
Dr. Rent expense Dr. Cash
Cr. Cash Cr. Rent revenue
除了，short lease or low value lease

Rent Exp/Cash(Lessor)
-->no liability,no need to care about the interest, no interest expense
19
-->short term, no depreciation expense

Cash/Rent revenue(Lessee)
3.1 Accounting For Low‐Value & Short‐Term Leases
‐ Lessee
Straight-line basis means rent expense stays the same over the
lease period, irrespective of actual cash payment

Uniform periodic payments (lease pmt. remains the same)

Dr. Rent Expense

Cr. Cash

20
3.1 Accounting For Low‐Value & Short‐Term Leases
‐ Lessee
• Variable Payment
Rent expense = average payment
Cash = actual payment

Varying periodic payments (early payments > late payments)

• In early periods (when actual payment > average payment)
Dr. Rent Expense
Dr. Prepaid Rent Expense pay more in the
Cr. Cash early period

• In later periods (when actual payment < average payment)

Dr. Rent Expense
Cr. Cash
Cr. Prepaid Rent Expense
21
3.1 Accounting For Low‐Value & Short‐Term Leases
‐ Lessee
• Variable Payment
Rent expense = average payment
Cash = actual payment

Varying periodic payments (early payments < late payments)

• In early periods (when actual payment < average payment)
Dr. Rent Expense
Cr. Rent Payable
Cr. Cash

• In later periods (when actual payment > average payment)

Dr. Rent Expense
Dr. Rent Payable (plug-in)
Cr. Cash
22
Low‐Value & Short‐Term Lease Example ‐ Lessee

Marks and Spencer plc leased a compactor from Asia Leasing Ltd. for
five months. Assume that the terms of the lease provide for payments of
It is a short term lease
(i) five monthly payments of $20,000 each or
(ii) $15,000 a month for the first two months of the lease and $25,000
for the next three months.

Required:

Provide necessary journal entries under the two alternative assumptions

for Marks and Spencer plc.

23
Low‐Value & Short‐Term Lease Example ‐ Lessee
Lessee’s book:

(i) Uniform periodic cash payments:

Dr. Rent Expense $20,000

Cr. Cash $20,000

24
Low‐Value & Short‐Term Lease Example ‐ Lessee
Lessee’s book:
(i)z
(ii) Varying periodic cash payments
Average payments = ($15,000*2 + $25,000*3)/5 = $21,000

For months 1 and 2:

Dr. Rent Expense $ 21,000
Cr. Rent Payable $ 6,000
Cr. Cash $15,000

For months 3 to 5:
Dr. Rent Expense $21,000
Dr. Rent Payable $ 4,000
Cr. Cash $25,000
25
3.2 Accounting For Low‐Value & Short‐Term Leases
‐ Lessor
Lease income under a low-value or short-term lease could be
recognized as income in the Income Statement on a straight-
line basis over the lease term
• Rent revenue stays the same over the lease period, irrespective
of actual cash receipt

Uniform periodic payments (lease pmt. remains the same)

Dr. Cash
Cr. Rent Revenue

26
3.2 Accounting For Low‐Value & Short‐Term Leases
‐ Lessor
• Variable Payment
Rent revenue = average receipt
Cash = actual receipt

Varying periodic payments (early payments > late payments)

• In early periods (when actual receipt > average receipt)
Dr. Cash
Cr. Rent revenue
Cr. Unearned rent revenue

• In later periods (when actual receipt < average receipt)

Dr. Cash
Dr. Unearned rent revenue
Cr. Rent revenue 27
3.2 Accounting For Low‐Value & Short‐Term Leases
‐ Lessor
• Variable Payment
Rent revenue = average receipt
Cash = actual receipt

Varying periodic payments (early payments < late payments)

• In early periods (when actual receipt < average receipt)
Dr. Cash
Dr. Rent receivable
Cr. Rent revenue

• In later periods (when actual receipt > average receipt)

Dr. Cash
Cr. Rent receivable
Cr. Rent revenue 28
3.2 Accounting For Low‐Value & Short‐Term Leases
‐ Lessor
• As the risks and rewards incidental to ownership of an asset
remain with the lessor, this requires the lessor to recognize the
leased asset as its own asset. Thus,

• The lessor shall present the assets in the Statement of

Financial Position (Balance Sheet) according to the nature of
the asset

• The lessor recognizes the depreciation expense of the assets in

the Statement of Profit or Loss (Income Statement)

29
3.2 Accounting For Low‐Value & Short‐Term Leases
‐ Lessor
• Initial direct costs incurred by lessor Initial direct costs/Cash
-->Rent exp/IDC

• Incremental costs of a lease that would not have been incurred had
the lease not been executed

• E.g., commissions and legal fees incurred by the lessor in

negotiating and arranging a lease

• To be added to (capitalized) the carrying value of the leased asset

and recognized as an expense (“lease expense”) over the lease term

30
3.2 Accounting For Low‐Value & Short‐Term Leases
‐ Lessor
Example: On 1/1/2020, lessor acquired a building with $10,000
cost. Expected life is 10 years with 0 residual value. On 1/1/2021,
the building was leased to the lessee for 2 years. Initial direct
cost associated with arranging the lease was $2,000.
1/1/2021 (Lessor):
Dr. Initial direct cost - Building 2,000
Cr. Cash 2,000
12/31/2021 (Lessor):
Dr. Lease expense 1,000 (=2,000/2)
Cr. Initial direct cost - Building 1,000
Dr. Depreciation expense - Building 1,000 (=10,000/10)
Cr. Accumulated depreciation - Building 1,000
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Contents

1. Introduction - What is a lease?

2. Classification of leases
• Operating lease vs Finance lease
3. Accounting for low-value and short-term leases
• Lessee and Lessor
4. Accounting for finance lease - Lessee
5. Accounting for finance lease - Lessor
6. Disclosures

32
 Terminology Associated With Finance Lease
Point 2

• Bargain purchase option (BPO): the option for the lessee to

purchase the leased asset in the future at a price substantially
below the fair market value.
how much it left at the period end of its
useful life

• Residual value: the fair value of the leased asset at the end of the
lease term. A residual value can be guaranteed or unguaranteed.

33
 Terminology Associated With Finance Lease

• Guaranteed residual value (GRV)

• The lessee has an obligation to not only return the leased asset
at the end of the lease term but also to guarantee that the
residual value will be a certain amount.

• Example: At the start of the lease

• Lessee has a GRV of $100, while expected RV is $90.

 Lessee should pay ($100 - $90) to lessor at end of lease,
in addition to returning asset to lessor.

34
 Terminology Associated With Finance Lease

• Unguaranteed residual value (URV) is that portion of the residual

value of the leased asset, the realization of which by the lessor is
not assured or is guaranteed solely by a party related to the lessor.

35
 Terminology Associated With Finance Lease
• Minimum Lease Payments (MLPs) used to calculate lease liability
by lessee
Year 1 Year 2 Year 3

Purchase at a very
low price at the end
During the lease: End of lease:
MLP = Periodic lease payments + Bargain Purchase Option
or return it assets back to the
Lessor
(Guaranteed RV – Expected RV at lease commencement)
if RV is guaranteed,
and Guaranteed RV > Expected RV
at lease commencement
excluding contingent rent, executory costs (such as cost for services and taxes)
to be paid by and reimbursed to the lessor
36
 Terminology Associated With Finance Lease

• Right-of-use asset Leased Assets

• An asset that represents a lessee’s right to use an underlying asset for
the lease term

• Short-term lease
• A lease that, at the commencement date, has a lease term of 12 months
or less

• Contingent rent: the amount of the lease payment that is not fixed but is
based on the future amount of a factor that changes other than with the
passage of time (e.g., % of future sales, future interest rates)
• E.g., lease payment in year t = fixed payment + 3% of sales in t

37
Initial Recognition ‐ Finance Lease
Lessee
• At the commencement of the lease term, lessees shall recognize finance
leases as leased assets and lease liabilities in Statement of Financial
Position (Balance Sheet) at the present value of the minimum lease
payments (PVMLP) at the inception of the lease

To record the leased asset and liabilities:

Dr. Leased asset
Cr. Lease liability (Obligation under Finance Leases)

38
 Initial Recognition ‐ Finance Lease
Lessee
At the commencement date, a lessee shall measure the lease liability at the
present value of the lease payments.

PVMLP = PV (periodic lease payments*) Cash pmt. during the lease

+ PV (BPO or (GRV – expected RV)) Cash pmt. @ end of lease

*excluding contingent rent, executory costs to be paid and

reimbursed to the lessor: cost for services and taxes
(e.g., insurance expense)

39
Initial Recognition ‐ Finance Lease
Lessee
How to calculate the Present Value of MLP?
(i.e., how to discount the MLP into present value?)
get the discount
rate for the PV

PVMLP’s discount factor (interest rate) is

 the implicit interest rate to the lessor,

if known to the lessee, if not;

 the lessee’s incremental borrowing rate should be used.

40
Terminology Associated With Finance Lease

• If the implicit rate of interest in a lease is not determinable,

then the lessee’s incremental borrowing rate should be used.

• Lessee’s incremental borrowing rate of interest: the rate of

interest the lessee would have to pay on a similar lease or at the
inception of the lease, the lessee would incur to borrow over a
similar term, and with a similar security, the funds necessary to
purchase the asset.

41
 Terminology Associated With Finance Lease
• Implicit interest rate: It is a discount rate that, at the inception of the lease, causes
the aggregate present value of (a) the minimum lease payments (b) plus expected RV and (c)
any additional residual value (unguaranteed) to the lessor to be equal to the sum of (i) the
fair value of the leased asset and (ii) any initial direct costs of the lessor.

Value that lessor will receive Value that lessor gave up at

throughout the lease inception of lease
(a) Cash pmt from lessee
MLP = periodic cash pmt
+ BPO or (GRV – expected RV)
(i) FV of asset
if GRV > expected RV)

(b) Expected value of asset when

(ii) Initial direct cost by lessor
Expected RV returned to lessor

(c) Any additional RV that lessor can

they want to
Additional enjoy beyond the expected RV recover from u
RV to lessor • This amount is usually known
only to the lessor, but not the
lessee.
• Thus, it is always unguaranteed.
42
 Terminology Associated With Finance Lease

• How does lessor calculate desired periodic lease payment?

• Determining periodic cash payment:

PV(lessee’s MLP + expected RV, if asset to be returned to lessor

+ any additional RV to the lessor),
discounted at the implicit interest rate
=
FV of leased asset at inception of lease
+ any initial direct costs to the lessor

43
 Terminology Associated With Finance Lease

• Example: When negotiating the lease, the lessor and lessee agreed that the
expected RV of the asset is $100, and the guaranteed RV is $150.
• However, in private, to the lessor can get additional residual value of $10 from
the returned asset.

• Expected RV ($100) < GRV ($150): Lessee expected to make $50 payment
to lessor at the end of the lease (included in MLP), in addition to returning
the asset expected to be worth $100.

• Additional RV to lessor beyond expected RV: $10

• When determining desired cash payment by lessee, the lessor will first set
an interest rate that it wants to charge the lessee. Then calculating periodic
cash payment as:
PV( periodic cash payment + $50 + $100 + $10) = FV of asset + IDC

MLP
44
Initial Recognition ‐ Finance Lease
Lessee
Any Initial direct costs (e.g., costs directly attributable to negotiating
and arranging a lease – commissions and legal fees for new leases)
of the lessee are added to the amount recognized as leased asset.
• Initial direct costs by lessee will NOT increase its lease liability
• Does not affect interest expense

To record any initial direct costs of the lessee:

Dr. Leased asset

Cr. Cash

Leased asset = Lease liability + Initial Direct Costs

45
46
 Subsequent Measurement ‐ Finance Lease
Lessee

• A finance lease gives rise to depreciation expense for depreciable

assets as well as finance expense for each accounting period.

• Contingent rents shall be charged as expenses in the periods in

which they are incurred.

47
 4.3.2 Lease Liabilities and Finance Charges
Finance Lease ‐ Lessee

• Contingent rents shall be charged as expenses in the periods in which they

are incurred.

• The amount of the lease payment that is not fixed but is based on the
future amount of a factor that changes other than with the passage of
time (e.g., % of future sales, future interest rates).

Dr. Lease Expense

Cr. Cash

48
 Depreciation of Leased Asset
Finance Lease ‐ Lessee
• Depreciation/amortization policy for depreciable leased assets
 Consistent with that for depreciable assets which are owned;

• Depreciation period:
1. If reasonably assured that the lessee will obtain ownership by the end of the
lease term or contractual right to use the asset for any secondary period at the
end of the lease, depreciate the leased asset over the useful life (e.g., BPO,
title automatically transferred to the lessee);

2. If there is no reasonable certainty that the lessee will obtain ownership by the
end of the lease term, the asset should be fully depreciated over the shorter of
the lease term OR its useful life.

49
 Depreciation of Leased Asset
Finance Lease ‐ Lessee

• Depreciable base: Original amount capitalized as leased asset

• If ownership of asset reverts to lessor at end of lease: “Leased asset” account should
be fully depreciated.

• If lessee retains ownership of asset (e.g., BPO), lessee will transfer the remaining
balance of “Leased Asset” to “Asset” account, and recalculate depreciation expense
based on re-estimated useful life and residual value at the end of the asset’s useful
life.

Dr. Depreciation expense on leased asset

Cr. Accumulated depreciation on leased asset

50
 4.3.2 Lease Liabilities and Finance Charges
Finance Lease ‐ Lessee
• Periodic MLP is apportioned between the finance charge (interest expense) and
the reduction of the outstanding liability.

 To record the first prepayment on the date of lease commencement:

Dr. Lease Liabilities (Obligation under finance leases)
Cr. Cash

 To record the following periodic payments of interest expenses and principals

Dr. Interest Expense
Dr. Lease Liabilities (Obligation under finance leases)
Cr. Cash

Split cash payment at beginning of period t or end of t-1 into:

 Interest Expense over t-1= Interest rate ൈ Book Value of “Lease liabilities” @ beg. of t-1
 Principal repayment = lease payment – interest expense

51
Example 3 ‐ Finance Lease
Implicit Interest Rate Method
A lease with the following terms:
• Lease period: 5 years, beginning 1 Jan 2021, non-cancelable
• Rental amount: $65,000 payable annually in advance includes $5,000 executory
costs
• The first lease payment is made on 1 Jan 2021 & four subsequent lease
payments are made on each reporting date (i.e., reporting date, 31 Dec)
• Estimated economic life of equipment: 5 years
• Expected residual value: 0
• Both implicit and incremental rates: 10%

Required:
Prepare the lease payment schedule to show the lease liability and interest expense
over the lease period.

52
 Example 3 ‐ Finance Lease
Implicit Interest Rate Method
What is the PVMLP?
60,000 60,000 60,000 60,000
60,000    
(1  10 %) (1  10 %) 2
(1  10 %) 3
(1  10 %) 4
= 60,000 + 60,000 (PVIFA 10%, 4)
= 60,000 + 60,000 x 3.16986 = 250,192

PVMLP: $250,192
An annuity of $60,000/year, for
4 years, at 10% discount rate

1/1/2021 12/31/2021 12/31/2022 12/31/2023 12/31/2024 12/31/2025

60,000 60,000 60,000 60,000 60,000

 How to calculate present value of future cash
flow?
Present Value of $1 Discounted at k Percent for n Periods:
PVIF = 1 / (1 + k) n

Period 1% 2% 3% 4% 5% 6% 7% 8% 9% 10% 11% 12%

1 0.9901 0.9804 0.9709 0.9615 0.9524 0.9434 0.9346 0.9259 0.9174 0.9091 0.9009 0.8929
2 0.9803 0.9612 0.9426 0.9246 0.9070 0.8900 0.8734 0.8573 0.8417 0.8264 0.8116 0.7972
3 0.9706 0.9423 0.9151 0.88 90 0.8638 0.8396 0.8163 0.7938 0.7722 0.7513 0.7312 0.7118
4 0.9610 0.9238 0.8885 0.8548 0.8227 0.7921 0.7629 0.7350 0.7084 0.6830 0.6587 0.6355
5 0.9515 0.9057 0.8626 0.8219 0.7835 0.7473 0.7130 0.6806 0.6499 0.6209 0.5935 0.5674

Present Value Interest of an Annuity of $1 per Period for n Periods Discounted at k Percent:
PVIFA = [1 - 1/(1 + k)n] / k

Period 1% 2% 3% 4% 5% 6% 7% 8% 9% 10% 11% 12%

1 0.9901 0.9804 0.9709 0.9615 0.9524 0.9434 0.9346 0.9259 0.9174 0.9091 0.9009 0.8929
2 1.9704 1.9416 1.9135 1.8861 1.8594 1.8334 1.808 1.7833 1.7591 1.7355 1.7125 1.6901
3 2.941 2.8839 2.8286 2.7751 2.7232 2.673 2.6243 2.5771 2.5313 2.4869 2.4437 2.4018
4 3.902 3.8077 3.7171 3.6299 3.546 3.4651 3.3872 3.3121 3.2397 3.1699 3.1024 3.0373
5 4.8534 4.7135 4.5797 4.4518 4.3295 4.2124 4.1002 3.9927 3.8897 3.7908 3.6959 3.6048

54
 Example 3 ‐ Finance Lease
Implicit Interest Rate Method
(a) (b) (c) (d)
Periodic Interest Expense Reduction in Lease Carrying Amount of
Date Payment 10% Liabilities Lease Liabilities
$ $ $ $
10% x carrying
(a) – (b)
amount of (d)

1.1.2021 250,192
250,192 – 60,000
1.1.2021 60,000 --- 60,000
= 190,192
190,192*10% 60,000 - 19,019 190,192 – 40,981
31.12.2021 60,000
=19,019 =40,981 = 149,211
31.12.2022 60,000 14,921 45,079 104,132

31.12.2023 60,000 ? ? ?

31.12.2024 60,000 5,455 54,545 0

TOTAL 300,000 49,808 250,192
55
 Example 3 ‐ Finance Lease
Implicit Interest Rate Method
(a) (b) (c) (d)
Periodic Interest Expense Reduction in Lease Carrying Amount of
Date Payment 10% Liabilities Lease Liabilities
$ $ $ $
10% x beginning
(a) – (b)
balance of (d)

1.1.2021 250,192
250,192 – 60,000
1.1.2021 60,000 --- 60,000
=190,192
190,192*10% 60,000 - 19,019 190,192 – 40,981
31.12.2021 60,000
=19,019 =40,981 = 149,211
31.12.2022 60,000 14,921 45,079 104,132

31.12.2023 60,000 10,413 49,587 54,545

31.12.2024 60,000 5,455 54,545 0

TOTAL 300,000 49,808 250,192
56
 4.4.1 Accounting for
Guaranteed Residual Value (GRV)

• To record the guaranteed residual value

• At the beginning of the lease:

• If expected RV > GRV, lessee is expected to return the leased asset to lessor.
No final payment regarding RV is required

• If expected RV < GRV, lessee is not only expected to return the leased asset
to lessor, but also make a payment to make up for the difference between
GRV and expected RV

 PV of (GRV – expected RV) included in lease liability at the beg. of lease.

57
 Example Question
Finance Lease with GRV ‐ Lessee
The Man Po Automobile Company leases automobiles under the following terms.
• A three-year lease agreement is signed on 1 May 2020.
• The lessor receives annual rental of $4,000 in advance.
• The guaranteed residual value is $5,000. The expected residual value is $1,500 at
the end of lease term.
• The price of the automobile is $14,500.
• The implicit interest rate (used by the lessor) is 12%, which is known to the
lessee, and the lessee’s incremental borrowing rate is 14%.
• The lessee depreciates its automobiles on a straight-line basis.
• The useful life of the automobile is 5 years.
• 1st payment on 1 May 2020 and subsequent payments on 30 Apr each year
(reporting date).

Required: Prepare the entries on the lessee’s books for the above lease transactions in
the year of 2020, 2021, 2022 and 2023.

58
Example 4
Calculation of Lease Liability
Year 1 Year 2 Year 3

1/5/2020 30/4/2021 30/4/2022 30/4/2023

Cash price
$14,500
1st 2nd 3rd Pay $3,500 ($5,000 - $1,500) to
Payment Payment Payment lessor to make up for the diff. b/w
$4,000 $4,000 $4,000 expected RV and GRV

59
Example 4 Exercise
Finance Lease with GRV ‐ Lessee
Construct the lease payment schedule

Lease Interest Expense Decrease in Lease

Date Payment $ 12% $ Lease Liabilities $ Liabilities $
1/5/2020
1/5/2020 4,000
30/4/2021 4,000
30/4/2022 4,000
30/4/2023 3,500

*adjusted for $1 rounding difference At end of lease, lease liabilities fully paid off.

60
Example 4
Calculation of Lease Liability
Year 1 Year 2 Year 3

1/5/2020 30/4/2021 30/4/2022 30/4/2023

Cash price
$14,500
1st 2nd 3rd Pay $3,500 ($5,000 - $1,500) to
Payment Payment Payment lessor to make up for the diff. b/w
$4,000 $4,000 $4,000 expected RV and GRV

1st payment: 4,000

2nd & 3rd payment: 4,000 x 1.6901 (PVIFA (12%,2)) 6,760
GRV – Expected RV: 3,500 x 0.7118 (PVIF(12%,3)) 2,491
PVMLP $13,251
61
How to calculate present value of future cash flow?
Present Value of $1 Discounted at k Percent for n Periods:
PVIF = 1 / (1 + k) n

Period 1% 2% 3% 4% 5% 6% 7% 8% 9% 10% 11% 12%

1 0.9901 0.9804 0.9709 0.9615 0.9524 0.9434 0.9346 0.9259 0.9174 0.9091 0.9009 0.8929
2 0.9803 0.9612 0.9426 0.9246 0.9070 0.8900 0.8734 0.8573 0.8417 0.8264 0.8116 0.7972
3 0.9706 0.9423 0.9151 0.88 90 0.8638 0.8396 0.8163 0.7938 0.7722 0.7513 0.7312 0.7118
4 0.9610 0.9238 0.8885 0.8548 0.8227 0.7921 0.7629 0.7350 0.7084 0.6830 0.6587 0.6355
5 0.9515 0.9057 0.8626 0.8219 0.7835 0.7473 0.7130 0.6806 0.6499 0.6209 0.5935 0.5674

Present Value Interest of an Annuity of $1 per Period for n Periods Discounted at k Percent:
PVIFA = [1 - 1/(1 + k)n] / k

Period 1% 2% 3% 4% 5% 6% 7% 8% 9% 10% 11% 12%

1 0.9901 0.9804 0.9709 0.9615 0.9524 0.9434 0.9346 0.9259 0.9174 0.9091 0.9009 0.8929
2 1.9704 1.9416 1.9135 1.8861 1.8594 1.8334 1.808 1.7833 1.7591 1.7355 1.7125 1.6901
3 2.941 2.8839 2.8286 2.7751 2.7232 2.673 2.6243 2.5771 2.5313 2.4869 2.4437 2.4018
4 3.902 3.8077 3.7171 3.6299 3.546 3.4651 3.3872 3.3121 3.2397 3.1699 3.1024 3.0373
5 4.8534 4.7135 4.5797 4.4518 4.3295 4.2124 4.1002 3.9927 3.8897 3.7908 3.6959 3.6048

62
 Example 4
Depreciation
Year 1 Year 2 Year 3

1/5/2020 30/4/2021 30/4/2022 30/4/2023

Cash price
$14,500
1st 2nd 3rd Pay $3,500 ($5,000 - $1,500) to
Payment Payment Payment lessor to make up for the diff. b/w
$4,000 $4,000 $4,000 expected RV and GRV

Depreciation Depreciation Depreciation

$13,251/3=4,417 $13,251/3=4,417 $13,251/3=4,417
Accumulated Accumulated Accumulated At end of lease,
Depreciation Depreciation Depreciation leased asset should
$4,417 $8,834 $13,251 be fully depreciated.
63
 Example 4
Finance Lease with GRV ‐ Lessee
Year 1 Year 2 Year 3

1/5/2020 30/4/2021 30/4/2022 30/4/2023

Cash price
$14,500

1st Payment 2nd Payment 3rd Payment Pay $3,500 ($5,000 - $1,500) to lessor to make up for
$4,000 $4,000 $4,000 the diff. b/w expected RV and GRV.
Depreciation Depreciation Depreciation
$13,251/3=4,417 $13,251/3=4,417 $13,251/3=4,417
Accumulated Accumulated Accumulated At end of lease,
Depreciation Depreciation Depreciation leased asset should
$4,417 $8,834 $13,251 be fully depreciated.
1st payment: 4,000
nd rd
2 & 3 payment: 4,000 x 1.6901 (PVIFA (12%,2)) 6,760
GRV – Expected RV: 3,500 x 0.7118 (PVIF (12%,3)) 2,491
64
PVMLP $13,251
Example 4 Exercise
Finance Lease with GRV ‐ Lessee
Construct the lease payment schedule

Lease Interest Expense Decrease in Lease

Date Payment $ 12% $ Lease Liabilities $ Liabilities $
1/5/2020 13,251
1/5/2020 4,000 4,000 9,251
30/4/2021 4,000 9,251ൈ12%=1,110 4,000-1,110=2,890 6,361
30/4/2022 4,000 6,361ൈ12%=763 4,000-763=3,237 3,124
30/4/2023 3,500 3,124ൈ12%=376* 3,500-376=3,124 -0-

At end of lease, lease

*adjusted for $1 rounding difference liabilities fully paid off.

65
Example 4 Exercise
Finance Lease with GRV ‐ Lessee

1 May 2020 $ $

Dr. Leased automobile 13,251

Cr. Lease liability 13,251

Dr. Lease liability 4,000

Cr. Cash 4,000

66
Example 4 Exercise
Finance Lease with GRV ‐ Lessee
Construct the lease payment schedule

Lease Interest Expense Decrease in Lease

Date Payment $ 12% $ Lease Liabilities $ Liabilities $
1/5/2020 13,251
1/5/2020 4,000 4,000 9,251
30/4/2021 4,000 9,251ൈ12%=1,110 4,000-1,110=2,890 6,361
30/4/2022 4,000 6,361ൈ12%=763 4,000-763=3,237 3,124
30/4/2023 3,500 3,124ൈ12%=376* 3,500-376=3,124 -0-

*adjusted for $1 rounding difference At end of lease, lease

liabilities fully paid off.

67
 Example 4 Exercise
Finance Lease with GRV ‐ Lessee

30 Apr 2021 $ $
Dr. Lease liability 2,890
Dr. Interest expense = (13,251-4,000) ൈ 12% 1,110
Cr. Cash 4,000

Dr. Depreciation exp. on leased automobile 4,417

Cr. Accumulated depreciation on leased automobile 4,417

68
 Example 4 Exercise
Finance Lease with GRV ‐ Lessee

30 Apr 2022 $ $

Dr. Lease liability 3,237

Dr. Interest expense 763
Cr. Cash 4,000

Dr. Depreciation exp. on leased automobile 4,417

Cr. Accumulated depreciation on leased automobile 4,417

69
 Example 4 Exercise
Finance Lease with GRV ‐ Lessee

30 Apr 2023 $ $
Dr. Lease liability 3,124
Dr. Interest expense 376
Cr. Cash 3,500

Dr. Depreciation exp. on leased automobile 4,417

Cr. Accumulated depreciation on leased automobile 4,417

Derecognition of the leased asset:

Dr. Accumulated Depreciation on leased automobile 13,251
Cr. Leased automobile 13,251

70
 Example 4 Exercise
Finance Lease with GRV ‐ Lessee
What if, on 30/4/2023, the realized RV of the asset turns out to be $1,000 (rather than
$1,500 as expected)?
 Lessee still need to ensure that the lessor will get $5,000 GRV.
 Actual cash payment on 30/4/23 = $5,000 (GRV) - $1,000 (realized RV) = $4,000

30 Apr 2023 $ $
Dr. Lease liability 3,124
Dr. Interest expense 376
Dr. Loss on lease (P/L) 500
Cr. Cash 4,000

Dr. Depreciation exp. on leased automobile 4,417

Cr. Accumulated depreciation on leased automobile 4,417

Dr. Accum. depreciation on leased automobile 13,251

Cr. Leased automobile 13,251
71
 4.4.2 Accounting for
Bargain Purchase Option (BPO)
• To record the exercising of bargain purchase option
• At beginning of lease, PV of BPO is included in lease liability as
lessee is expected to make this payment to lessor at end of lease
• At the end of lease:
• BPO is the final payment made by lessee to lessor
• Similar to regular periodic payment, BPO is also used to 1) pay interests
accrued, and 2) reduce lease liability
• No gain or loss is recognized when a leased asset is purchased
• As with exchange of similar assets, the fair value of the asset is ignored.
Leased asset is transferred to the regular asset account.

With BPO, depreciation expense is based on

useful life of asset, rather than lease term.

72
 4.4.2 Accounting for
Bargain Purchase Option (BPO)

 The final lease (BPO) payment

Dr. Lease liabilities (plug-in balance)
Dr. Interest expense (interest rate × liabilities beg. balance)
Cr. Cash (the BPO payment)

 Transfer from leased asset to its own asset

Dr. Asset (e.g., Equipment)
Dr. Accumulated depreciation on leased asset
Cr. Leased asset

With BPO, depreciation expense is based on

useful life of asset, rather than lease term.

73
Contents

1. Introduction - What is a lease?

2. Classification of leases
• Operating lease vs Finance lease
3. Accounting for low-value and short-term leases
• Lessee and Lessor
4. Accounting for finance lease - Lessee
5. Accounting for finance lease - Lessor
6. Disclosures

74
 5.1 Direct‐Finance Lease
• Under a finance lease, substantially all the risks and rewards
incidental to ownership are transferred by the lessor to the lessee
in return for a stream of lease payments receipts

• Thus, the lessor shall recognize the asset held under a finance
lease as a receivable in the Statement of Financial Position
(Balance Sheet)
Lease Payments Receivable

• Lease payments receivable are treated by the lessor as repayments

of principal and finance income to reimburse and reward the lessor
for its investment and service

75
5.1.1 Initial Recognition
Finance Lease ‐ Lessor

• To record lease payment receivable,

Dr. Lease payments receivable

Cr. Asset purchased for lease

76
 5.1.2 Subsequent Measurement ‐ Finance Lease
Lessor

• For the lessor, each payment received from the lessee will be
recognized partly as finance income (i.e., interest income), and the
remaining balance will be used to reduce the balance of lease
receivable (the “principal”)

• The lessor’s only source of income from the lease transaction is

interest income over the lease term

• There is no annual depreciation of assets under finance leases on the

lessor’s book, because the leased assets are considered “sold.”

77
5.1.2 Subsequent Measurement ‐ Finance Lease
Lessor
• To record the first periodic prepayment on the date of lease
Dr. Cash
Cr. Lease payments receivable

• To record the following periodic payments and to

recognize interest revenue
Dr. Cash
Cr. Interest revenue*
Cr. Lease payments receivable (plug-in balance)

*Interest revenue
= beginning bal of Lease Payments Receivable × implicit interest rate
78
 Example 5
Finance Lease with Residual Value ‐ Lessor
• A leasing company acquires a specialized packaging machine for
$300,000 cash and leases it for a period of 6 years.
• The machine is returned to the company for disposition.
• The expected unguaranteed residual value of the machine is $20,000.
• The lease terms are arranged so that a return of 12% is earned by the
insurance company.
• The lease start at 1 January 2021.
• Payment is made in advance. The first lease payment is made on 1
January 2021, and subsequent payments are made each December 31
(Balance Sheet date).

79
Example 5
Finance Lease with Residual Value ‐ Lessor
a) Calculate the annual lease payment by lessee to yield the
desired return

b) Prepare entries for the lessor for the first year of the lease
assuming the machine is acquired

80
 Terminology Associated With Finance Lease

• How does lessor calculate desired periodic lease payment?

• Determining periodic cash payment:

PV(lessee’s MLP + expected RV, if asset to be returned to lessor

+ any additional RV to the lessor),
discounted at the implicit interest rate
=
Fair value of leased asset at inception of lease
+ any initial direct costs to the lessor

81
 Example 5
Finance Lease with Residual Value ‐ Lessor

Year 1 Year 2 Year 3 Year 4 Year 5 Year 6

1/1/21 31/12/21 31/12/22 31/12/23 31/12/24 31/12/25 31/12/26

Cash price
$300,000
1st 2nd 3rd 4th 5th 6th URV
Payment Payment Payment Payment Payment Payment $20,000

Lessee makes periodic Lessee

payment (MLP) returns asset

82
Example 5
Finance Lease with Residual Value ‐ Lessor
R=?

The present value of the future cash flows from the lease contract
should equal to $300,000.

Let R be the periodic lease payment by the lessee

$300,000 = [R + R × (PVIFA (12%, 5)) + $20,000 × (PVIF(12%, 6))]

$300,000 = R + 3.6048R + $20,000 × 0.5066

R + 3.6048R = 300,000 - 20,000 × 0.5066
R = (300,000 - 20,000 x 0.5066 ) / 4.6048
R = $62,949
83
How to calculate present value of future cash flow?

84
 Date (a) Periodic (b) Interest (c) Reduction in (d) Lease
Receipts Income 12% lease payment Payments
$ $ receivable $ Receivable $
12% x beginning (a) – (b)
balance of (d)

1-Jan-21 300,000
1-Jan-21 62,949 0 62,949 237,051
31-Dec-21 62,949 28,446 34,503 202,548
31-Dec-22 62,949 ? ? ?
31-Dec-23 62,949 19,669 43,280 120,625
31-Dec-24 62,949 ? ? ?
31-Dec-25 62,949 8,658 54,291 17,860
Balance @
31-Dec-
25 $377,694 $95,554 282,140 17,860
URV (return
asset at
31-Dec-
2026) 20,000 2,140* 17,860 0
Total $397,694 $97,694 300,000
*Adjusted for $3 rounding difference : $2,140 is the balancing figure = $20,000-17,860
 Date (a) Periodic (b) Interest (c) Reduction in (d) Lease
Receipts Income 12% lease payment Payments
$ $ receivable $ Receivable $
12% x beginning (a) – (b)
balance of (d)

1-Jan-21 300,000
1-Jan-21 62,949 0 62,949 237,051
31-Dec-21 62,949 28,446 34,503 202,548
31-Dec-22 62,949 24,306 38,643 163,905
31-Dec-23 62,949 19,669 43,280 120,625
31-Dec-24 62,949 14,475 48,474 72,151
31-Dec-25 62,949 8,658 54,291 17,860
Balance @
31-Dec-
25 $377,694 $95,554 282,140 17,860
URV (return
asset at
31-Dec-
2026) 20,000 2,140* 17,860 0
Total $397,694 $97,694 300,000
*Adjusted for $3 rounding difference : $2,140 is the balancing figure = $20,000-17,860
Example 5
Finance Lease with Residual Value ‐ Lessor
(b)
2021 $ $
1 Jan Dr. Machine Purchased for Lease 300,000
Cr. Cash 300,000

1 Jan Dr. Lease Payments Receivable 300,000

Cr. Machine Purchased for Lease 300,000

1 Jan Dr. Cash 62,949

Cr. Lease Payments Receivable 62,949

31 Dec Dr. Cash 62,949

Cr. Interest Revenue 28,446*
Cr. Lease Payments Receivable 34,503

*($300,000– $62,949) × 12% = $28,446

87
Example 5
Finance Lease with Residual Value ‐ Lessor
(b)
2022
31 Dec Dr. Cash 62,949
Cr. Interest Revenue 24,306
Cr. Lease Payments Receivable 38,643
2023
31 Dec Dr. Cash 62,949
Cr. Interest Revenue 19,669
Cr. Lease Payments Receivable 43,280

2024
31 Dec Dr. Cash 62,949
Cr. Interest Revenue 14,475
Cr. Lease Payments Receivable 48,474

88
Example 5
Finance Lease with Residual Value ‐ Lessor

(b)
2025
31 Dec Dr. Cash 62,949
Cr. Interest Revenue 8,658
Cr. Lease Payments Receivable 54,291

2026
31 Dec Dr. Machine 20,000
Cr. Interest Revenue 2,140
Cr. Lease Payments Receivable 17,860

89
 Example 5
Finance Lease with Residual Value ‐ Lessor
(c) At the end of the 6 years, rather than returning the machine to the
lessor, the packaging machine is sold by the leasing company to the
lessee for $32,000.

How will the journal entry at the end of the lease change?

Journal entries from 2021-2025 remain the same as in (b)

2026 $ $
31 Dec Dr. Cash 32,000
Cr. Lease Payments Receivable 17,860
Cr. Interest Revenue 2,140
Cr. Gain on Sale of Machine (plug-in) 12,000

90
 Initial Recognition ‐ Finance Lease
Initial Direct Costs ‐ Lessor
• Initial direct costs (IDC) are often incurred by lessors and include
amounts such as commissions and legal fees

• Initial direct costs are included in the initial measurement of the

finance lease receivable (i.e., capitalized)
• IDC will be amortized over the course of the lease
• No interest income will accrue from the initially capitalized IDC

To record initial direct cost:

Dr. Lease payments receivable
Cr. Cash

91
 Lessor versus Lessee
• Lease receivable for Lessor may not be the same as Lease liability
by lessee
• The amount to be capitalized is different:
• Lease receivable: PV(MLP from lessee + Expected RV + any
additional RV accruing to the lessor)
• Lease liability: PV(MLP)

• The interest rate used in discounting may be different:

• Lessor: implicit interest rate
• Lessee: lessor’s implicit interest rate if known, if not, use lessee’s
own incremental borrowing rate

• For the same reasons, the lease interest expense (lessee) and lease
interest revenue (lessor) may not be the same

92
 5.2 Manufacturer or Dealer Lessor
• If lessor is manufacturer or dealer, a finance lease can give rise to
two sources of income: [if amount of lease receivable is different
from the lessor’s cost]
• Selling profit or loss resulting from an outright sale of the asset being
leased at the lease inception date
• Manufacturer or dealer lessor's profit
= lease payment receivable - cost of leased asset
• Interest revenue over the lease term
• To record the lease at its commencement
Dr. Lease Payments Receivable
Cr. Sales
Dr. Cost of Goods Sold (lessor’s cost)
Cr. Finished Goods or Asset purchased for lease
• If artificially low discount rates are quoted, selling profit should be
restricted to that would apply if a market rate of interest were charged
93
Contents

1. Introduction - What is a lease?

2. Classification of leases
• Operating lease vs Finance lease
3. Accounting for operating leases
• Lessee and Lessor
4. Accounting for finance lease - Lessee
5. Accounting for finance lease - Lessor
6. Disclosures

94
 6.1 Statement of Financial Position
(Balance Sheet)

• Lessee
• “Lease Liabilities” shall be separately presented as current
liabilities and non-current liabilities on the face of the
statement of financial position (balance sheet)

• Lessor
• “Lease Payments Receivables” shall be separately presented
as current assets and non-current assets on the face of the
statement of financial position (balance sheet)

95
6.1 Statement of Financial Position (B/S)
Disclosures for Finance Lease (Example 3)
(a) (b) (c) (d)
Periodic Interest Reduction in Lease
Date payment $ expense $ lease liabilities $ liabilities $
= 10% x beginning = (a) – (b)
balance of (d)

1-Jan-21 250,192

1-Jan-21 60,000 --- 60,000 190,192

31-Dec-21 60,000 19,019 40,981 149,211

45,079 (N2)
31-Dec-22 60,000 (N1) 14,921 104,132
(amt. due in 1 yr)
31-Dec-23 60,000 (N3) 10,413 49,587 (N4) 54,545

31-Dec-24 60,000 (N3) 5,455 54,545 (N4) ---

TOTAL 300,000 49,808 250,192

96
 Example 3 ‐ Finance Lease
Implicit Interest Rate Method
(a) (b) (c) (d)
Periodic Interest Expense Reduction in Lease Carrying Amount of
Date Payment 10% Liabilities Lease Liabilities
$ $ $ $
10% x beginning
1.1.2021 balance of (d)
(a) – (b) 250,192
250,192 – 60,000
1.1.2021 60,000 --- 60,000
=190,192
190,192*10% 60,000 - 19,019 190,192 – 40,981
31.12.2021 60,000
=19,019 =40,981 = 149,211
31.12.2022 60,000 14,921 45,079 104,132

31.12.2023 60,000 10,413 49,587 54,545

31.12.2024 60,000 5,455 54,545 0

TOTAL 300,000 49,808 250,192

97
6.1 Statement of Financial Position (B/S)
Disclosures for Finance Lease (Example 3)

Lessee - Obligation under Finance Lease

Balance as of 31 December 2021 $149,211
Less: Amounts under current liabilities 45,079
Balance under non-current liabilities 104,132

Lessor – Lease Payments Receivable

Balance as of 31 December 2021 $149,211
Less: Amounts under current assets 45,079
Balance under non-current assets 104,132

98
6.2 Notes to accounts for finance leases

• The entity shall disclose the total of future MLP at the end of
the reporting period (i.e., B/S date), and their present value, for
the following periods:

• Not later than one year

• Later than one year and not later than five years
• Later than five years

99
6.1 Statement of Financial Position (B/S)
Disclosures for Finance Lease (Example 3)
(a) (b) (c) (d)
Periodic Interest Reduction in Lease
Date payment $ expense $ lease liabilities $ liabilities $
= 10% x beginning = (a) – (b)
balance of (d)

1-Jan-21 250,192

1-Jan-21 60,000 --- 60,000 190,192

31-Dec-21 60,000 19,019 40,981 149,211

45,079 (N2)
31-Dec-22 60,000 (N1) 14,921 104,132
(amt. due in 1 yr)
31-Dec-23 60,000 (N3) 10,413 49,587 (N4) 54,545

31-Dec-24 60,000 (N3) 5,455 54,545 (N4) ---

TOTAL 300,000 49,808 250,192

100
6.2 Notes to Accounts for Finance Leases
Disclosures for Finance Lease (Example 3)
• Finance lease liabilities – MLP

Not later than 1 year $60,000 (N1)

Later than 1 year and not later than 5 years 120,000 (N3)
Later than 5 years -0-
Total 180,000
Less: Future finance charges on the finance lease (30,789)
Present value of finance lease liabilities $149,211

• The present value of finance lease liabilities is as follows:

Not later than 1 year $45,079 (N2)

Later than 1 year and not later than 5 years 104,132 (N4)
Later than 5 years -0-
Total $149,211

101