 Hello and welcome to this session in which we would look at finance lease from a less seized perspective. In the prior session, we looked at the difference between finance leases and operating leases. And I showed you when is a lease considered a finance lease, when it's not a finance lease, which is not, it's an operating lease. Now the best way to illustrate the concept of a finance lease is to actually look at an example. So I'm gonna go over the rules again for a finance lease. Also I'm gonna go over the actual journal entries and what you need to know for a finance lease from a less seized perspective. So to work this example, we're gonna assume we're dealing with Boeing Capital Corporation, a subsidiaries of Boeing and Delta Airline. They signed a lease agreement dated January 1st, X1 that calls for Boeing to lease a mobile airplane ladder to Delta beginning January 1st, X1. And this is what we are looking at this mobile airplane ladder, which we're gonna call it a ladder. Now let's take a look at the details of the agreement. Well, the term of the lease is five years. It's non-cancelable, which is important because we need that requirement, requiring equal rental payments of 20,000. So the deal says, well, we're gonna give you this ladder. However, you're gonna have to make five payment at the beginning of each year, starting the day that you signed the lease. So starting today. So we're dealing with an annuity due. Why is this important? Because when you go to the tables, you have to know that this is an annuity due, not ordinary annuity. If you don't know, if you're not familiar with this annuity due, ordinary annuity, you may wanna go to Farhad Lectures and look at the time value of money concepts. That's one. The fair value of the ladder is 95,000. This is the fair value if you want to buy it today. And the economic life of the asset is five years. Well, that's the economic life and that's the lease life. We're gonna come back and talk about those in a moment. The expected residual value is greater than 5,000, which is greater than the guaranteed amount. Therefore, we will ignore the residual value for the sake of this exercise. All what I want you to do now, or know at this point is, once the ladder is back to Boeing, the value of the ladder should be more than 5,000. This is the guaranteed residual value. Once that's the case, from the less C, from the less C, from Delta Airlines, we don't have to worry about this 5,000. I'm gonna have a separate session explaining guaranteed and unguaranteed residual value, but for now, I made it easy where we don't have to worry about it, but we'll revisit this topic later on. There's no renewal options for this lease. The ladder, again, would revert back to Boeing, a determination of the lease, and Boeing can do something with it. Basically, they can sell it to a third-world country airline where they can get some cash for it. Delta incremental borrowing rate is 5% per year, which we know. Delta depreciate on a straight line basis similar equipment that it owns. And Boeing sets the annual rental rate to earn a rate of return of 4%, and Delta is aware of this. Well, of course, we know how much do we earn, how much we would need to earn 5%. Now, we also know how much Delta will charge us. Delta is charging us 4%. Since we know it's 4%, we're gonna be using this rate, because we know the rate. If we don't know the rate, then we would use our incremental rate, which is the rate that if we needed to borrow the money. So for the present value computation, we're gonna be using 4% because we know the rate, and that's the rate that Boeing sets. The first thing we want to know is we want to establish whether this lease is a finance, or if it's not a finance, it's operating. You already know it's a finance lease, but let's see under what condition we met the finance lease conditions. And those are the five tests, or the five conditions that I talked about in the prior session. The first test, is there a transfer of ownership in this deal? I don't see it. There is no transfer of ownership. Therefore, it's not a finance lease yet. Is there a purchase option? I did not see a purchase option. I did not see that, for example, Delta can buy this ladder for $100. Specifically, the purchase option has to be a bargain, enticing the less see to buy it. I did not see that in the deal. The lease term, is it equal to 75% or more of the economic lease life of the asset? And the answer is yes. Actually, it's equal to 100%. So we're saying this ladder will have a five year life and Delta is having the lease for five years. So it's consuming all the life of the asset. At this point, we have a finance lease. That's it. We know we have a finance lease. How about the present value test, since we're going through all the tests? Well, is the present value greater than 90%? Well, we did not compute the present value yet. We're gonna compute it shortly, but the fair value is 95. As long as the present value come up to 90% of the fair value, we should be in good shape. And let's see, just kind of get an idea. What's 90% of 95,000? Just kind of prepare ourselves, times 0.9. So as long as the present value are greater than 85,500, the present value of the payments, then it will meet a finance lease. Not that we need it, because we already know it's a finance lease. Alternative use test? No, yes. No, in a sense that it doesn't meet that test because Boeing can resell or release this asset to a third party. So alternative use test is yes. So it doesn't, yes means we don't meet that test. We don't have to, because we already met the finance lease test. Now, what we're gonna do now, we're gonna go over the journal entries for this example. Before we go over the journal entries, most likely you are an accounting student or a CPA candidate. And I'm glad either or you're at the right place. You have arrived. What I suggest you do is to go to my website, farhatlectures.com, and subscribe to my resources, lectures, multiple choice, through false exercises that's gonna help you understand better this topic. I don't replace your CPA review course. I help you along your accounting courses. Give it a try. You are watching because you need help. Connect with me on LinkedIn if you haven't done so. Like this recording, share it with other. If you're watching, it's helping you. It might help others. Connect with me on Instagram, Facebook, Twitter, and Reddit. So first, let's compute the present value of the liability because we have a liability, okay? And let's see from the liability we can find out what should be our asset. Because remember, once we have the least asset, we have to debit an asset and credit a liability. So what is the asset and what's the liability? Well, we're gonna find out what's the present value. We're gonna take $20,000 multiplied by the present value factor 4.62990. Remember, this was an annuity due. And the present value is 92,598. Remember, what we talked about, as long as we are above 85,500, we are more than 90% of the fair value of the asset. So also, we need the finance lease under the fair value test, but we don't have to worry about this. Now we know this is the asset, 92,598, and this is the liability. And we use 4% because that's the implicit rate. We know the rate that the Boeing charging us is 4%. Now we debit right-of-use asset, credit, lease liability. Again, we put an asset on the books and we put a liability on the books. And this is the day that we signed the lease. We have an asset and we have a liability. Also, on that same day, if you remember, we made a payment. Immediately we made a payment of 20,000. Immediately we're gonna reduce our liability by 20,000 because there's no interest involved and we are going to credit cash by 20,000. Remember, this payment is due immediately the same day that we signed the lease, the same day that we put the asset on the books. Now what would the company do next? Well, what they would do next is they will prepare an amortization schedule for the lease because they want to know how much of their payment goes toward the lease, how much of their payment goes toward the interest, so on and so forth. Starting with January 1st, 20X1, we have a lease liability of 92,000, 598, and a lease asset but this is an amortization schedule for the liability. Also on January 1st, immediately we made a payment, 20,000. As a result, this payment reduce our liability by 20,000. Our liability became 72,598. Then a year from now, we're gonna be making another payment. Lease payments are always the same, 20,000. How do we compute the interest component? How do we compute the principal component or the reduction in the liability? We're gonna take the balance times 4%. The balance times 4% will give us $2,903.92 for the interest component and whatever's left from the 20,000 of the 20,000, this much is interest and the remaining is principal, which is 0.08, eight pennies missing. Again, what's gonna happen after this, our liability will go down to 55,507 because we're gonna reduce our liability by 17,096, which will bring us down to 55,502. Then the process repeats itself of the $20,000 payment. We're gonna take 55,502 multiplied by 4%. It's gonna give us an interest component of $2,220. Notice the interest component is lower than the prior period and hopefully this makes sense because the liability went down, which means the interest expense should go down and the remaining goes toward the principal. Again, we reduce the principal by 17,780. The principal now is 37,722, all the lease liability is that much. We multiply it by 4%, we repeat the process and by the time we make our last payment, guess what? We have a zero liability because we made the payment. Our total interest expense on the liability, our total interest expense is this much and we reduced the liability. Remember, the liability was $92,598. We reduced it down to zero by the time we are done and we made payments in cash of 100,000. Now let's take a look at the journal entry. So this is the table. You need to understand how to read the table. It's very important because you might be asked actually as a simulation to prepare simply this table and this will be worth one whole simulation and worth a lot. So let's take a look at December 31st, 2021. So by the end of the first year, remember you don't make the payment on January 1st, but by the end of the first year, you have to debit interest expense $2,903.92. This is December 31st. The following day we'll make the payment and credit a liability called lease liability $2,903.92. Now remember, we have an asset. What do we do with assets? We have a long-term assets. We amortize, we depreciate the asset. Therefore, we're gonna debit amortization expense $18,519.60 which is taking the asset itself divided by five years, which is the lease term and it's gonna give us amortization of $18,519. So we make those two journal entries December 31st, 20x1 by the end of the first year. Okay, now what would our balance sheet looks like and what would our income statement looks like as of December 31st, 20x1? On the balance sheet, we are going to have a non-current asset of $74,078.40. How did you come up with this figure? It's the asset, original value of the asset minus the amortization expense, minus the amortization expense. This number here gives us a non-current, a long-term asset of $74,078. Now they might ask you, the question could be, what is your asset book value at the end of year one? Well, that's the asset book value. They may tell you, what's the book value at the end of year two? Well, you're gonna deduct an additional $18,519.60. So be aware, this is point, not comma, 0.60. So be aware of what you are being asked. You could be asked many things. Also, on the balance sheet, you're gonna have to show your current liabilities. What are your current liabilities? What are you expected to pay in liabilities? Well, here we go. We already booked, we accrued interest liability of $2,903.92. And you're gonna have to make a payment, reducing the liability in the next year, which is the following day of $17,096.00. Now this is 0.08 rounding. Simply put, you have current liabilities of 20,000. Part of it is interest, part of it is principal. They're both a liability. They will go under current liabilities. That's your current. So remember, you have a short term. They might ask you about the short term. They might be asking you about the long term. Make sure you know the difference between the two. What goes on the income statement? On the income statement, you are going to have the interest on the liability, which is $2,903.92. And you're gonna have the amortization expense that you booked here. So those will be two expenses. Remember for finance leases, you're gonna have two expenses. When we look at the operating lease, we're gonna have one expense. Don't worry, we'll talk about that later, but the point is to remember you have two expenses. And this is what goes on the income statement. Now what's gonna happen the following day? You're gonna make the payment. You're gonna cut the check because the check is paid on January 1st. On January 1st, you're gonna debit lease liability 20,000. You're gonna credit cash 20,000 because you already recorded the expense. So that's so you don't have to differentiate between two. You already recorded the expense. Therefore, all what you're doing is you're reducing your liability. Let's assume that Delta purchases the ladder from Boeing for 5,000 at the termination of the lease. They will debit the equipment, the ladder and they will credit cash for 5,000. What should you do now? What you should do now is go to farhatlectures.com, subscribe, work multiple choice through false exercises. That's gonna help you reinforce the concept of leases. A very important concept, whether you are an accounting student or a CPA candidate. Don't shortchange yourself. Accounting is important. Accounting is critical. Good luck, study hard and of course, stay safe.