 Hello and welcome to this session. This is Professor Farhad in which we would look at an accounting for leases and specifically we're going to be looking from a less seized perspective. So we're going to look at this problem and answer the following question. Is this an operating lease or a finance lease? And we're going to journalize the entries at the commencement of the lease and any related entries for 20x1 and 20x2. So let's go ahead and take a look at this accounting for leases exercise. Adam entered into an uncancellable lease with Maggie medical equipment. So Adam is the less see and Maggie is the less sore. The commencement date of the lease is June 1st 20x1. The annual lease payments starting at the commencement date of the lease. So this is basically an annuity due because immediately Adam will have to make the first payment of $20,471.94. A bargain purchase option 4000 bingo. If there's a bargain purchase option, it means we are dealing with a finance lease. So basically we can have answered the first question. Why? Because bargain purchase option is one of the five criteria. As long as you meet one, it will become a finance lease. We just met this one. The lease term is five years. Economic life of the asset is 10. Now this is important. Although the lease term is five, the economic life is 10. We're going to see later and I'll explain it later. We're going to be using the 10 year to depreciate and I'll explain why we'll use the 10 year life. The less source costs the $60,000. We don't care about this information for now because we are doing accounting for the last C. The fair value of the asset is $91,000. It means if Maggie wants the salad today, she will charge $91,000. The less sort implicit rate is eight, which we already know. The less incremental rate is eight. They're the same. But since we know the less sort, it's good enough. And Adam uses reversing entries. So what we're going to do next, we're going to compute the lease liability for Adam and we're going to prepare an amortization schedule and journalize the entries, at least the first two, three entries to be familiar with how to we, how do we journalize entries for LSE? Before we proceed any further, I have a public announcement about my company, farhatlectures.com. Farhat accounting lectures is a supplemental educational tool that's going to help you with your CPA exam preparation, as well as your accounting courses. My CPA material is aligned with your CPA review course, such as Becker, Roger, Wiley, Gleam, Miles. My accounting courses are aligned with your accounting courses, broken down by chapter and topics. My resources consist of lectures, multiple choice questions, true false questions, as well as exercises. Go ahead, start your free trial today. No obligation, no credit card required. So let's go ahead and start by establishing the liability because when you have a lease, you're going to debit an asset and credit a liability. So the question is, how much is the liability? Well, let's see. We're going to compute the present value of the payments, the present value of the payments, which are again, they are an annuity due payment plus guaranteed residual value. There is no guaranteed residual value here. Adam is not guaranteeing anything. The present value of a guaranteed residual value, but we don't have any, the present value of a bargain purchase. We do have a bargain purchase. We compute the present value of that. Let's go ahead and do that. We're going to use n equal to five, i equal to eight. The lease term is five years. The interest rate we are using is eight. Therefore, we're going to first compute the present value of the rental payment, which is the factor is 4.31213. Again, you are using the present value of an annuity due. So the present value is 88,280. Then we find the present value of the bargain purchase, which is $4,000 times the present value factor of one. Now, in your textbook, in your CPA review course, there could be a little bit of rounding, but all in all, the present value or the total is 91,000. So this is going to be the liability that's Adam's going to put on his books and start to amortize as well as not amortize, start to account for the interest expense and the reduction of that liability. And we're going to be amortizing, which is the depreciation of the asset. What I'm going to do now, I'm going to switch to an Excel sheet and show you the amortization schedule and show you the journal entries and explain their impact and their importance. So this is the amortization schedule starting with the lease liability of 91,000. I just showed you how we compute this. So what we do first, it's let's journalize the entry for that 90,000. For that 90,000, what we're going to do, we're going to debit right of use asset, which is the asset and credit the liability of 91,000. So this is the journal entry for the 90,000. Now, what happened is immediately Adam made a payment of 20,472. So immediately this payment would reduce the balance for the liability of 20,472. And there will be no interest component because this payment was made on the same date. So therefore the balance after we make this payment for Adam will be 70,582. Let's journalize the entry for the payment. Again, there is no interest component. Therefore, Adam will debit the lease liability would reduce the liability and will credit cash. And that's the payment. Now, Adam will have to close their books at 12, 31, 20x1. So from June 1st, 20x1 till 12, 31, 20x1, there are seven months. And what's going to happen? Adam will have to accrue any interest for that period. So now we're going to accrue the interest. Well, to accrue the interest, let's first compute kind of two lines of the table, just to make sure we understand how to do it. Now the payment will be always be the same, 20,472. So on June 1st, 20x2, Adam will have to make the payment. Of this payment, how much is interest? Well, how do we compute the interest? We are going to take the balance of the liability as of the beginning of the period times the interest rate. And the interest rate happens to be 8%, which will become to 5,642. And the remainder, which will be the amount, which is 20,472 minus the interest payment, is the amount that's going to reduce the liability. Then we'll have the new balance for the liability, which will be 55,698, which it means it went down. Then June 1st, 20x3 will make another cash payment. The interest expense will be $4,456 rounding. And it's based on the prior balance times 8%. And since we paid $20,471, $4,455 is interest, the remaining is receivable. And we keep on going. Now this is the interest for the whole year. But now we have to stop at December 31st of every year and compute the accrued interest. Therefore, what's going to happen at December 31st at 20x1? We're going to have to debit interest expense $32,91, credit lease liability $32,91. Now where did this $32,91 came from? Well, it's the interest expense for the full year times $712. Why $712? Again, June, July, August, September, October, November, and December. Be careful. This is June 1st date. Therefore, this is the interest expense and the interest liability. And I also told you that Adam uses reversing entries for simplicity. It means the following day after the financial statements in quote are technically issued. Okay, what's going to happen is we showed the expense, we showed the liability. Adam will go back and reverse this. Reverse means the exact opposite. We'll debit the liability, we'll debit the liability, and we'll credit the expense to remove its effect. Why it's for simplicity. We can keep it if we want to, but for simplicity, we can do that. Are we done yet? And the answer is no, we are not done at all. What's going to happen is Adam's going to have to book depreciation, depreciation expense or amortization basically amortize the asset. How much are we going to amortizing the asset? We're going to be amortizing the asset over 10 years. Why over 10 years? Why over 10 years? I'll have to explain why over 10 years. Because if you remember, we had the lease term of five years. That's the lease term, but we have a bargain purchase and we expect to exercise their bargain purchase. And this is why we consider the lease as a finance lease. Therefore, we technically own the asset for 10 years because we're going to have it. We're going to own it. Therefore, what's going to happen, we're going to take the 91,000 divided by 10, which is yearly, then multiplied by 712 because we need to only account for 712 because from June 1st till the end of the year. So this is the amortization expense. Then on June 1st, what's going to happen is we are going to have to make the payment. The payment will be 20,472. Of this amount, 5,642 will be interest expense and the lease liability will be 14,830. And this is basically all coming from the table. So this is everything that I did here is based on this entry in the table. And that's why it's very important that you know how to journalize the table. Now, again, at the end of 20x2, at the end of 20x2, what do we have to do? We have to book another seven months of interest, then we reverse it, then we book the depreciation. Also here we have to book, you know, we could also book another five months of depreciation if we want to bring our, you know, we could book another five months of depreciation if we want to bring our books up to date if we are publishing any financial statements for that matter. But we're assuming we are not. Then let's complete the table. Again, we're going to have interest liability, interest on the liability 3174, which is the prior balance times 8%. The remaining is the principal, the balance will go down. Again, the last payment, the last full payment will have interest and interest in principle. And notice the interest is going down because the balance is going down. The reduction in the liability is going up. Okay, notice 14, 16, 17, 18, more of the payment is going toward the liability. And the last payment is 4000, which is for the bargain purchase. And as a result, the balance will go down for the liability will equal to zero. Because remember, we discounted, we included this 4000 bargain purchase in the 91,000. What should you do now? You should go to far hat lectures and work MCQs, true false. Look at additional exercises. Leases are an important topic. Why? Because it's going to involve time value of money. It's going to involve a liability like situation. It's going to involve journal entries. It's going to involve an amortization schedule. And this is for the less see. So make sure you understand the less see in the next session, you would look at the same example dealing with the less source. So you would see how the less see that the transaction, you would see how the less sorted the transaction and you can compare them side by side. Actually, I have it right here in the Excel sheet. What should you do now? Again, study hard, stay safe. Good luck. The CPA exam is worth it.