 Hello and welcome to this session in which we would look at direct financing lease accounting. This topic is covered in intermediate accounting as well as the CPA exam. This topic specifically direct financing lease accounting gives students issues for multiple reasons. One is you have to understand how the time value of money works if you are dealing with leases. Also we have different type of leases. We have sales type lease. We have operating lease. Now we have direct financing leases. Then we have accounting for leasing for the less sore as well as accounting leasing for the less C. So notice there are so many different combination in this session we'll focus on direct financing lease. Now whether you are an accounting student or a CPA candidate, especially if you are a CPA candidate, I strongly suggest you take a look at my website farhatlectures.com. I don't replace your CPA review course. What I do is I explain the leases in details separately each type of lease less C less sore with examples. So I can be a useful addition to your CPA review course by helping you understand the material better you can add 10 to 15 points to your CPA review score past the exam. Now your risk is one month of subscription. Your potential gain is passing the exam. This is if you subscribe to my website. Also my website is designed to mirror image your CPA review course. So I have a CPA review course for Wiley, one for Becker, one for Roger, one for Glyme. So they match, they match your CPA review course. So it's easy to find the information and if not for anything, take a look at my website to find out how well is your university doing or not doing for the CPA exam. Also on my website, I do have various cover including intermediate accounting as well as many other courses. Please connect with me on LinkedIn if you haven't done so and only then you can view my LinkedIn recommendation students who use my system to pass the exam so you can get a better feeling, more confidence about my product. Please like this recording, share it, connect with me on Instagram and Facebook. So the first thing I am going to go over is this graph and hopefully by looking at by the, if you are looking at direct finance leasing, I'm assuming you know what is sales type of leasing and you know what's operating lease, sales type or finance lease, whatever you want to call it or capital lease. So let's take a look at this decision tree and remember the lease for a sales type lease to be considered a capital or a finance lease, it has to meet one of these five criteria. What are those five criteria? Transfer of ownership. Does the lease transfer ownership of the underlying asset to the leasing by the end of the lease? If the answer is yes, we are dealing with a finance sales type lease. If the answer is no, we look to the next question. Does the lease grant a lease see an option to purchase the underlying asset? That's in that option price is reasonably certain to be exercised. It's basically a bargain. It's called a purchase option test. If the answer is yes, we're done. We're dealing with a finance lease, sales type lease. If the answer is no, we would look at the third question. The lease term is the lease term for the major part of the remaining economic life of the underlying asset. Here they're saying the remaining economic life. Usually we look at a 75% plus. If the answer is yes, then we are dealing with a finance lease. Otherwise, we go to the fourth question, the present value test. And we're going to be focusing on the present value test here in this session. Does the present value of the sum of the lease payment and notice plus and any lease residual value guaranteed not reflected in the lease payment equal or exceed substantially all of the underlying asset sphere value? And hopefully you are familiar with these tests. Simply put, if we take all the payments plus the lease residual guarantee, that's assuming it's guaranteed and we add them and we find the present value for those present, we add the present value of those two payments. Do they exceed substantially all of the underlying fair value asset? And this number is 90%. So do they represent 90% of the fair value of the asset? If the answer is no, we are dealing with a finance lease. Otherwise, the last question is, is this asset have any alternative use of the answer? To all these questions is no, we cannot have a lease classify as an operating lease. It cannot be a finance lease, a sales type lease. So this is what you should know this. You should know this information if you are looking at direct financing lease. Now we're going to be introducing a new category. Here we go. Lessor, we're dealing with the lessor, the person that's leasing the asset can use a third lease qualification, what's called the direct financing lease in one special situation. So we need to discuss this special situation. And once we need to discuss this special situation, we'll see the journal entries for it. When the lessor give up control of the asset to the lessy, but there is an involvement of a third party. This is important. So simply put, if you remember this test here, the present value test, the present value, we have to add all the lease payment and any residual value that's guaranteed. Okay, together, they have to exceed 90%. Under certain circumstances, a third party, so rather than the lessy and the lessor, the third party will guarantee the residual value. When you have a third party involvement, you might have a direct financing lease. It means you will add the direct, the third party guarantee. And if the third party guarantee, residual guarantee exceeds 90%, which is the substantial, substantially all of the underlying asset fair value, then you are dealing with a direct financing lease. So on the direct financing lease, we are looking at three parties, the lessy, the lessor and the third party. Simply put, again, if it meets, this is another picture of this, if it meets any of these five options, you have a sales type finance lease. If it does not, you have an operating lease, unless you have a third party that's guaranteeing the residual value in this transaction. Under those circumstances, you will have a direct financing lease. So what happened is you are passing this test through the third party guarantee and we'll see an example how it works. Now, the basic difference between a direct financing lease and a sales type lease relate to when do we book the profit on the sale? When do we book the profit on the sale? And when I say finance lease, we're looking at sales type, so just FYI, sales type lease. So when do we book the profit on the sale? And a sales type lease, and hopefully you understand this, we book the profit immediately. When we book the journal entry, I will work an example to remind you how we do so, because it's important to see the sales type lease vis-a-vis the direct financing lease. In a direct financing lease, you're going to see the profit is deferred and recognized over the life of the lease. So whatever profit we make from financing this transaction, we are not going to book immediately, we are going to take this profit over the life of the lease. The best way to illustrate this concept is to work an example. Assume that robotics company, which is the lessor, and enters into a lease agreement with Amazon for the use of quick robotics package picker. So Amazon wants to lease a robot. The lease commencement date January 1st, 2021. The lease term is three years. The lease agreement is non-cancelable, requiring, that means you can't get out of it, requiring equal rental payment at the end of each period. We are dealing with ordinary annuity. The picker, which is the robot, has a fair value at the commencement of the lease of 30,000 and a carrying value of 28 with an estimated residual value of 6,000 at the end of the lease. So here's what we have. This is the fair value. This is the cost of the asset and the 6,000 is the residual value. The estimated life is five years. Amazon provides a guarantee that the residual value will be at least 6,000. So notice in this transaction, in this transaction we have robotics and Amazon, and Amazon is guaranteeing the residual value of the robot. There's no third party involved here. Notice the lease contained no renewal option and the picker revered to robotics at the termination of the lease. So notice when Amazon is not going to own it, it's going to go back to robotics. Robotics sets the annual rental rate to earn 6% per year. This is the implicit rate on their investment. So the first thing we're going to compute is the payment that robotics going to require Amazon to pay. So the first thing we're going to compute the payment, hopefully we learn how to do this in prior session. We'll do it again. So here's what's going to happen. The fair value of the lease payment is 30,000. Then we subtract from it the present value of the residual value, which is 6,000 times the present value factor 3n equal to 3i equal to 6%. You might be saying, Professor Farhat, where did you get the 0.83962? If you are studying leases, you should be pretty comfortable with the time value of money. If you are not comfortable with the time value of money, this is where you would go to, guess where? Farhatlectures.com. And I have lessons. The first thing when I start my CPA courses, that goes with your CPA courses, the time value of money. So if you're asking, where did this number coming from? Well, this is what I suggest you do because I cannot explain the time value of money now. The assumption is you know it by heart. So the present value factor is 0.83962. Therefore, the amount, the present value of the 6,000 is $5,037.72. You will take the fair value minus the present value of the residual value. You will come up to this number. This is the number that the lessor will need to recover from the lease payment, which is this much. Now what we do is we'll take this amount and we'll divide by the present value of the annuity factor. So we're going to take this number and divide it by the present value annuity factor again, n equal to 3, 3 periods, i equal to 6. And the factor is 2.67301. The payment is $9,338, $9,338.64. This is the payment that robotics expect to be paid from Amazon. So all I did is find the payment. Now what type of a lease is this? That's the first thing because this is the most important thing. Well, let's take a look at what we have here. Well, we have the five tests. Transfer of ownership. Did the ownership transfer? Nope. Transfer of ownership that did not occur, the asset revert to robotics. So there's no transfer of ownership. Purchase option. We didn't see a purchase option, a bargain purchase option. The lease term. Well, the lease term is 3. The life of the asset is 5. 3 divided by 5 is 60%. So it didn't meet any of these tests. Well, let's see if the present value test, the present value of the lease payment. Now let's compute the present value. The present value of the payment is $9,338.64. We're going to multiply by the present value factor n equal to 3, i equal to 6. That's going to give us $24,962.28. Then we add to it the present value. Remember the the Amazon's guarantee in the residual value. We add to it the present value of the residual value and will give us this number, 30,000. Well, 30,000 is 100% of 30,000. So it's more than 90%. Therefore, the present value of the payment plus the present value of the residual value, the guaranteed residual value equal to not equal to equal exactly to the fair value. So we are dealing with a sales type lease right now. We're dealing with a sales type lease and everything that I'm doing so far, I hope you are comfortable with this because we should have reviewed or explained this topic. The reason I'm doing this first, then when I move to the direct finance lease, it will be a very small switch that you have to be aware of. And there is no indication that this asset has any has any alternative use. Therefore, this is a sales type lease under number four under number four. Now let's do the journal entry for the sales type lease. Again, everything that I'm doing now should be a review. The robotics will debit at least receivable of 30,000. They will debit cost of goods sold of 28. They will credit sales revenue of 30,000. They sold it and they remove the robotics from their inventory for 28,000. So the first thing I want you to know this is robotics booked a profit of 2000. And this is a sales type lease. They met one of the five options, which is the present value. Therefore, they booked 2000 of profit immediately when they make the sale. Now I'm going to switch. I'm going to switch the scenario. Let's assume the residual value is guaranteed by an unrelated third party. So Amazon is no longer guaranteeing the residual value. Okay, who's guaranteeing the residual value? A third party. The less sore classified the lease as a direct finance lease here. What they're saying is, guess what? We did not really sell it. We're financing the lease. Do you see what's happening here? So that's the assumption here that we are making. We are making that the guarantee is a dual value. What makes the difference whether a lease is a sales type lease or a direct financing lease. What entry do we make if we now say that this is a direct financing lease? We still have a receivable of 30,000. We no longer have a sale, though. We are going to credit inventory for 28,000 and the profit of 2000. It's not going to be booked. Now it's going to be called a deferred gross profit. You have to know that the third gross profit is a contra receivable, contra assets, specifically contra receivable. And that's why we are starting with a balance on the credit side of the third profit of 2000. So what happened is this 2000 here that we considered a profit under the sales type lease and we booked. Now it's being considered the third gross profit. And what are we going to do with this? We are going to earn it, earn it over the life of three years. So simply put, we're going to take 2000 and earn it over three years. Now if you're asking if it's going to be the straight line equally, no, it's not going to be equally. This is what's going to make this a little bit more interesting. But this is the initial entry. So this is a sales type and this is direct financing. What is the difference? The difference is that it became direct financing when Amazon did not guarantee a residual value. A third party guaranteed there is a dual value. Now we need to know how to process the journal entry because under sales type lease we already learned how to do this when you make the payment. Now we need to learn how to do it under direct financing lease. The first thing we do in a normal sale robotics would receive lease payment over the life of the lease, which on the present value basis equal to 30,000. Simply put, look at here, we have a lease receivable of 30,000. You see this? A lease receivable of 30,000. Therefore, what we're going to say, we're going to amortize this lease receivable at 6%. Notice here, we're going to treat it as first, if it's a sales type lease. So notice here, although it's direct financing, but we're going to need this amortization schedule, you will see why. We're going to start 1,120, the balance of the receivable. We have receivable balance. Then we're going to make the first payment. We have an annual lease payment. We already computed the payment. Then we compute the interest on the receivable. How do we compute the interest on the receivable? Well, we're going to take the 30,000, the previous, the beginning of the period, lease receivable times 6%. That's going to give us 1,800. The remaining is a reduction in the lease receivable. Now, the lease receivable is $22,461.31. Then we're going to do the same thing. A year later, 12, 3121, we're going to get another payment. They're going to pay us $9,338.64. The same payment will always be the same. The interest is $22,461.36 times 6%. We'll give us the interest and simply put this payment, part of it is interest. First, you find out the interest. What's left is receivable, reduction in the receivable. Then this receivable would reduce the $22,461 to $14,470. Then we're going to make, we're going to get the third payment. Same thing. The third payment will be split between interest and the interest is based on the previous book value of the receivable times 6% and the remaining will go to the lease receivable. The lease receivable will reduce the previous balance of $14,470 to $6,000. Then here comes the guaranteed residual payment of $6,000. The balance of the receivable is zero now. So notice what's going to happen. The interest that we earned, so please listen to me carefully here. This is important. Listen to me carefully because you're going to be, you're going to thank me like five minutes later if you listen to me carefully here. The interest component of the lease is $4,015.92. This is the interest component. Simply put, robotics because they had a lease of $30,000. They wanted to earn 6%. They're going to, they're receiving payment of $9,338, three payments. Therefore, the interest that they earn on this deal is $4,015.92. Hold on a second. Yes, that's interest. That's fine. But then they also earn or they're going to be deferring $2,000 of profit. So the interest is a separate component. They're going to be earning interest on this deal. That's fine because they're financing the transaction, but also they're going to earn a profit on, unquote, the sale of 2000. How do we find out how to amortize? So we're going to have to create another schedule. And I don't think on the CPA exam, they would ask you to book entries for direct financing lease, but we're going to do it anyway just so you're comfortable with it. Okay. So here's what's going to happen. You're going to have to create another direct financing lease amortization schedule. Here you're going to start with your net receivable. So simply put in a direct financing lease. Robotics receive the same payment, which is received. Robotics receive the same lease payment, which is on a present value basis equal to 28,000. Now, what we have to do, what we have to do, remember, remember, they sold the additional 2000 is profit. Therefore, the present value is based on 28,000. Now, what's going to happen? We have to choose an interest rate that's going to amortize this 28,000 over three years. Now, I never sold, I never, at least based on previous, previously released AI CPA questions. Usually, if they ask you the question, they will give you the rate 9.5. This rate, it's going to amortize this 28,000 net lease receivable. Okay. So what did the 9.5 came from? Well, obviously, you have to compute it, but you don't have to compute it. It will be given to you if that computation is necessary. Now, we're going to amortize the lease under as a lease receivable of 28,000. And you will see why in a moment, why we are doing this. And using interest rate of 9.5, we're going to go through the same thing, same concept. We're going to say the payment is $9,338.64. We're going to take this amount multiplied by 9.5. And that's going to give us the interest on the receivable based on a 9.5, based on a 9.5, 9.5 interest rate. You might be saying, what is that interest rate? So I'm going to tell you what it is. Okay. Remember, we are earning interest of 6%. So the interest of 6%, a dollar amount over the life of the lease is $4,015. Remember, we still have to book another 2,000 of profit. To tell you the truth, the difference between 9.5, not the truth, to explain what's happening here, you have 9.5 minus 6% is 3.5. The extra 3.5 is going to represent this 2,000. And you will see that in a moment. Now, so this is how we're going to be doing the amortization. We're going to say $9,338.64. Part of it is interest, part of it is reduction in the lease. Again, the same concept. This amount would reduce the lease to $21,321.36. Then the process repeats itself. We're going to say, okay, we're going to be receiving the second payment, part of it interests based on the new balance of $21,232. The remaining is reduction in the principle and the balance will go down to $14,008.25. And the third payment, you guys got the concept. Then we receive 6,000. Notice what happened to the interest under this schedule. The interest under this schedule is $6,015.94. So notice the difference between them, guess what? $2,000. So what's the difference? Why? So why do we have to schedule? The reason we have to schedule is because when we are booking the journal entry, we have to amortize some of that 2,000. We have to turn it from the third profit. Remember, we have 2,000 of the third profit. Remember that T account I showed you? The third profit, when we first booked the entry, we have 2,000 of the third profit and we're going to be amortizing it. So that's why we need those two schedules to find the difference. So how much of it is truly interest of the revenue and how much of it is the third profit? So that's why we have to prepare those two schedules. And that's why I don't think you'll be expected to do this much on the exam. I mean, who knows, they might give you a problem like this, but I highly doubt it. Let's look at the journal entry now. We're going to debit cash, $9,338.64. We're going to be receiving a check from Amazon for that amount. Now, remember, now we are ready to book some of the profit of the third revenue. And the third revenue will be $860. How did we come up with this figure? Here's how we came up with this figure. That's why we have two tables. We're working from two tables. We're going to take $2,660. And we're going to subtract from it the interest component of $1,800, the pure interest component. As a result, we're going to have the third revenue of $860. So this $860, so what happened, let's go back to the third profit account. Remember, we started with $2,000. Now, we recognize $860 of it. Now, we have a new balance. Now, what is our revenue? What is our total revenue? Our total revenue is $2660. Our total revenue is right here. This is our total lease revenue. But remember, part of it is $860. Part of it is interest. But this is what we credit. We credit the lease revenue. And obviously, we have to reduce the receivable $7,538. Okay, $5,738. So notice we are using two different tables to book the entry. Again, the reason is because we have part of the revenue is interest, part of the revenue is the third profit. In a sales-like lease, we only have interest revenue because the profit was booked at the beginning of the lease. And direct finance lease, which is this session, this is what makes this a little bit not complicated. It takes several steps. Now, let's go ahead and make the second, well, this is the first payment. Now, here's what you can do. Again, so you'll understand this better if you want to understand this better. This is an amortization schedule for the third gross profit. We're starting with $2,000. The first payment, remember, the interest component, the total revenue was $2,660. The interest component was $1,800. The difference between those is the amount of the third revenue. Now, we still have the third revenue of $11,140. Next time, we receive another payment, that the third revenue is $677.85. And our third revenue will go down to $462. If we're looking at a T account, so we're starting with the third profit, we started with $2,000. We're going to reduce it by $860. We're going to reduce it by $677.85. We're going to reduce it by $462.15. As a result, the third profit will go down to zero. So this is where you get the third profit component for every payment. And remember, it's being amortized. It's being spread over three period, over three period. How did we do it? Well, we have to prepare to schedule to determine which part is the third profit, which part is interest, which part is interest revenue, and book it appropriately. Now, how do we report things on the balance sheet? Because you could be asked about this. Well, after the first payment, what's going to happen is your least receivable will be the gross amount minus $7,538.64, the reduction in the least receivable, therefore will be $22,461. Then last, remember, the third gross profit is a contra receivable. So you're going to reduce it from receivable $2,000. We start with $2,000 minus $860, which is give us remaining $1,140. So the net receivable after the first payment is $21,321.36. Now, after another payment, you would reduce it and you would reduce this by so next period will be reduction by $677.85, and the $22,461 will be reduced by the amount of the principle, which we'll see next. Let's make the entry for $21. Again, the entry for $21, the cash is always the same. The third gross profit I already showed you, it's going to be $677.85. The lease revenue is $20.25.53, and we have a reduction in the least receivable of $7,990.96. Again, going back to the schedules, going back to these schedules. So if you're wondering where this is coming from, $20.25.53 and $7,990, they're all coming from these tables. Okay, so this is the revenue, and this is the reduction in the receivable. Okay, all right. That's the second payment. Let's take a look at the third payment. The third payment, same exact thing. The cash is the same. We know that the third gross profit, lease revenue, and a reduction in the receivable, a reduction in the receivable. Okay, so we may, obviously, you can make, this is 2022, if there's more payments, you know how to do the payment. And guess what's going to happen? Last, last, we're going to be receiving an annual lease payment of $6,000 because it's a guarantee of residual value. They're guaranteeing this amount. We debit inventory, put back the inventory back, and credit lease receivable. We removed the lease and we debit back the inventory. So this is the last entry. So this is the life of a direct finance lease, simply put. This is the life of a direct finance lease. You can, again, review the schedules to get comfortable with the numbers where every number is coming from so on and so forth. But this is the best way for me to explain the concept for you. Once again, I would not worry too much about direct financing, at least I will be comfortable, I will be comfortable with it in a sense that it involved a guarantee by a third party. I highly doubt it you will be receiving a simulation on it. It doesn't mean you won't, but I highly doubt it. But you might have to answer a multiple choice question about it. So I gave you more than a multiple choice question. Make sure you are prepared to do so. Once again, if you take a look at my website, farhat-lectures.com, I create my courses to mirror image your CPA review course. Good luck, study hard and stay safe.