 Hello and welcome to this session. This is Professor Farhad in which we would look at four different leases and we need to determine which of the leases is a finance lease and which of the leases is an operating lease. So simply put, in this exercise, you want to determine whether a lease is an operating lease or a finance lease. So this is very basic in terms of lease accounting because if you don't know whether the lease is a finance or an operating lease, that's it. You are wrong right from the beginning, right from the get go. And on the CPA exam, you might see a simulation like this, giving you different leases and telling you whether to, for example, from a drop-down box, tell me whether this is an operating lease or a finance lease. It's as simple as that. You could have a simulation about this or the simulation may not be as clear as this where I'm giving you the information. You might be given documents about the useful life, the fair value, maybe an email about the lease payments. And you have to collect the information to collect the information, put it together, then go through the test. So in this session, all the information is given. You have to make a decision about whether a lease is a finance lease or an operating lease. 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. Now, let's start with lease A. Lease A is eight-year. That's the term of the lease that doesn't tell us much so far. The use for life is 12. The fair value of the lease is 88,000. There is no bargain purchase option. The annual lease payment is ordinary. It means they start a year from now and the payment for all those leases are $10,000. The less or implicit rate known by the less C is five. The less C's incremental borrowing rate is five. So now we're going to go through the test, the five test, and determine whether this lease is a finance lease or an operating lease. The first test is transfer of ownership. Is there a transfer of ownership? And I read all the data that I'm giving. I don't see anything about transfer of ownership. Therefore, we failed this test because there's four tests, transfer of ownership. Burgin purchase price. Is there a bargain purchase price? Clearly it says there is no bargain purchase price. And this is test two. For a lease, it's out. Lease term represent a major part of the expected life. Simply put, does the lease term represent the major expected life? We're going to give it a percentage. It's going to be greater than 75%. Let's see. If we take eight divided by 12, eight divided by 12, we see that this is 66.66%. So the lease term does not represent more than 75% of the asset major expected life. Therefore, we failed that test. This is test three. Test four, the present value of the lease payment represents substantially all the value of the asset. So what we need to do now, we need to find the present value of the payments. Remember, the payments are 10,000. So the payments are 10,000. We have eight payments. And we have to use an interest rate. We are giving two interest rates. And frankly, it's easy here because either rate you would use, the 5%, whether it's the implicit rate or the less C incremental rate. So which of these two 5% you would use? Well, you have to know. If you know the less or implicit rate known by the less C, if the less C knows the lesser implicit rate, you would use that one. And we know that rate. Now, if the less C wants to go out and borrow the money, they would also borrow at 5%, but we don't need this 5% because we already know the implicit rate of the lessor. So what's going to happen is this, we're going to go to the tables and go to eight periods. This is the present value of an ordinary annuity, eight period at 5%. And it's going to be 6.4621, which is 10,000 times that. That's going to give us 6.46321. And that's going to be 64,632. Now, if we take 64,642 and divide it by 88,000. So if we do that, that's going to give us approximately 73%. Also, we failed that test. We failed the present value of the lease payment. Specialized nature with no alternative use. We're not told anything about this. Therefore, we assume it's a no. So if you notice, lease A fails all five tests. Therefore, lease A is considered an operating lease. So the answer will be an operating lease. Let's go to scenario B. The scenario B, transfer of ownership, no. Well, there's no transfer of ownership for all of them. So we already know that, transfer of ownership, no. Bargain purchase price, let's say yes. I can stop right here and I can say bargain purchase price yes. Scenario B is what? Scenario B is a finance lease. So therefore the answer here is a finance. This is an operating lease. Let's go to scenario C. Scenario C, the lease term is eight years. The use for life is 12. There's no transfer of ownership. There is no bargain purchase price for this scenario. Lease term, let's divide 8 by 12. 8 divided by 12 is 66.66 that failed. Just want to let you know that lease B also, lease B, just FYI, if we take 8 divided by 10, lease B would also qualify under this lease term, lease term, because it's 80%. So far we've failed all the tests. Let's find out about lease C if we can get the present value test. Well, again, we're going to take the payment is $10,000, 8 and 5%. It's going to be again, 64,000. But now we're going to compare the 64,000, this number here, to 82. Let's do that. If we let's do it here. 64,000, 632 divided by 82,000. It's going to be less than 90. But let's do it. It's 78. Also, we failed that test. And there is no alternative use. Also, we failed that test. Therefore, we failed all the tests here. We failed all the tests. This is also an operating lease. Let's take a look at lease D. Transfer ownership none. Bargain purchase price none. We already know that the A divided by 12 is 66.66. So we failed that one. Now we have the implicit rate of 6%, known by the lessy, and the incremental rate is 5. Now we're going to do the present value computation, $10,000. We're going to go to the 8. And we're going to go to 6%. And it's going to be 6.20979. So 10,000 times 6.20979. And that's going to be 62,097 rounding 98. Now we're going to compare 62,097 to the fair value of this asset, which just happens to be 64. And we know that's going to be more than 90%. So if we take 62,097 divided by 64,000, it's not more than 90%. It's 97%. This is also a finance lease. So this is also a finance lease. So we have two finance lease and two operating lease based on what we based on the computation. Remember, you have to go through the test, transfer of ownership, bargain purchase. The lease term represent a major part of the expected life. Does the present value represent substantially all the value of the asset? And we measure this by 90%. And here we assume we're not told about any specialized nature with no alternative views. Therefore, for these all four, we always failed one. We always failed five. Those two, we always failed them. Lease B passed the finance under the bargain purchase. Also it passed it under the major part of the expected life. Lease C failed all five. And lease D was a finance lease under the 90% rule, which is the present value of the payments are more than 90% of the fair value of the asset, which is represent substantially all the value of the asset. What should you do now? Well, if you are not ready, if you feel this is what we did is complicated or you don't understand it, stop. You're not ready for the exam yet. This is basic. This is basically determining whether a lease is an operating lease or a finance lease. If you cannot make that determination, you cannot process journal entries. Go to Farhat Lectures and do what? Farhatlectures.com and work, MCQs, true, false. Look at additional exercises that's gonna help you do better. Invest in yourself, invest in your career. The CPA is worth it. It's a long-term investment. Good luck. I'm always here to help you. Stay safe.