 Hello and welcome to this session in which we will discuss finance lease specifically from the lessor's perspective in the prior session We also looked at finance lease, but we looked from a lessese perspective Remember the lessor is the in quote the owner of the asset the lessee is the Renter of the asset the one that's using the asset. Here's the good news to classify a lease Under a finance lease whether you're a lessee or a lessor the classification tests are the same. They're identical So that's the good news. So whatever we learned in the lessee accounting finance it applies to the lessor So the classification test which is remember there are five of them I will briefly review them are identical to that of the lessee to determine the classification of the lease whether that lease is a finance lease or an operating lease which is we're gonna be dealing with finance leases in This session in the next session. We'd look at operating lease So when we have a finance lease for the lessor we're gonna consider this as a sales thigh police So when I say finance lease Sales lease or sales thigh police. It's the same thing because when it's a finance lease as if the owner is Selling the asset to the renter now How do we know if the owner is selling the asset to the renter? What if the if the lessor if the owner in substance in essence Transferred control now. We're gonna see what does it mean? How do you interpret transfer control of the right of the use of the asset? Then guess what the lessor has a sales thigh police? It means the lessee took ownership or consume a substantial portion of the underlying asset If that's not the case if the lessor in essence or in substance does not transfer ownership Which is gives control to the lessee all the lessee consume a substantial portion of the asset Then we have at our hand an operating lease Now, how do we how do we determine this transfer of control? Well, remember the five tests that we go through this is a review first We have to have a non-cancellable agreement We have to have a legitimate agreement of course because no contract without an agreement for leases will really exist Then we have test of ownership test Does the transfer of ownership occur at the end of the lease if the answer is no, you don't have a finance lease Purchase option do we have a purchase option on that lease and specifically when we talk about a purchase option? It has to be a bargain purchase option enticing enough to let the lessee by the asset if the answer is no We don't have a finance lease is the lease term equal to 75% of the economic life of the lease property 75% or more If the answer is no, you don't have a finance lease Present value of the lease payment equal to or greater than 90% of the asset the asset that we're gonna be working with is the ladder That's why I call it ladder, but it's an asset if the answer is no, that's not the case We don't have a finance lease is there an alternative use test if there is no alternative use test in other words We leased something we leased an asset a ladder and that ladder is so specialized to that company Technically we sold it for them. So if so, we have to pass the alternative use test Let's assume there's no alternative use test then we have a finance lease. So here just for the sake of illustration Remember no alternative use. It means the asset is not useful for the lessor They can do anything with it when they get it back technically the lessee bought it Therefore we have a finance lease so notice for all these knows they fail the finance lease But this know will give you a finance lease now if this answer was yes And the all the others were no then we have an operating lease because it did not pass the test Accounting of for sales lease is simple if it's a sales lease Remember what do you do when you sell an asset and you sell it on account? You have a receivable so the lessor account for the lease in a manner similar to an asset sale What does that mean? It means I'm gonna have a receivable Specifically I'm gonna have a lease receivable nevertheless. It's a receivable and since I sell the asset I'm gonna remove the asset. So simply put I'm gonna debit a are basically simple accounting credit sales Debit cost of goods sold credit the asset inventory. Okay, this is basically when you sell using perpetual inventory system This is the entry that you make now the AR is called a lease AR and the asset and the inventory is really a Particular asset, but the concept is the same now. How do we? Capitalize lease receivable so this amount lease receivable. What is it equal to when we debit lease receivable? What does it equal to it's gonna equal to the present value of the payment received? Remember the lease would involve a series of payment remember when you lease something the the person The last seed that you leased it to will give you payments. Well the lease receivable you have to Find the present value of those payments plus so notice here plus for the lessor You also have to find the present value of the residual value So when it comes to the lessor and we'll talk about the residual value later on in a separate session The lessor would always find the present value of the residual value to compute to compute the lease receivable Whether that residual value is guaranteed or not So this is what's this is how we record the lease receivable the present value of the payment plus the present value of the Guaranteed or unguaranteed residual value and the best way to illustrate this is to take a look at an example We're gonna take a look at the same example slight changes slot change change it slightly, but basically the same example that we looked for the Let's see assume that Boeing capital Which is a subsidiary of Boeing company and Delta Airlines signs the lease agreement dated January 1st X1 That calls for Boeing to lease a mobile airplane ladder We're gonna call it ladder to Delta beginning January 1st X1 So we have two parties Boeing and Delta Airlines now We're gonna go over this example and show you the details of it Which we saw on the prior and the prior session Before we do that most likely if you're watching you are an accounting student or a CPA Kennedy if that's the case great You have arrived Please go to farhat lectures calm I can help you the reason you are watching because you found me on YouTube and you're looking for some help go a Step further go to farhat lectures calm subscribe. I can give you additional information I don't replace your CPA review course. I'm a supplemental tool to your CPA review course I give you access to lectures multiple choice through false exercises. That's gonna help you understand your accounting courses That's gonna help you understand your material your your leases your bonds your CPA material better If you have not connected with me on LinkedIn, please do so take a look at my LinkedIn recommendation Please click on the like button on this video if you're liking it like it Why not it doesn't cost you anything it helps me it helps others connect with me on Instagram Facebook Twitter and Reddit So here are the details for the deal between Delta and Boeing the term of the lease is five years It's non-cancelable. You always have to have it non-cancelable. Otherwise It's if you have an agreement where either party can walk away with no penalties No stiff penalties and it's not really a deal It's requiring eco rental payment of 20,000 now, although it's I told you it's 20,000 I'm gonna show you how to compute this payment in this example because it's important that you know how to do so The fair value of the latter is 95,000 or the fair value is important here The fair value of the latter is 95,000 It means if they want to sell it today, they would sell it for 95,000 with an estimated economic life of five years So notice five year economic life five year lease it met one of the lease it met one of the lease It met one of the lease requirement, which is 75 percent greater than 75 percent of its economic life here The lease is 100 percent of the economic life We have a finance lease the expected residual value after five years is 2,926 and you're gonna see why I made this number. So there's no renewal option The ladder would revert back to Boeing at the termination of the lease. That's fine Delta incremental borrowing rate is 5% Boeing sets an annual rate of 4% per year and we know this rate and the collectability of payment by Boeing is assured Remember, we are doing accounting for the less sore So it's very important to understand that if the collectability is not assured not probable You really don't have an agreement. You don't have a sale because think about it. It's easy to lease things to anyone Why just tell them you could find someone that beats. Okay, I'm gonna lease you this But if they cannot pay you you didn't really do any good Well, because anybody will take your asset and use your asset, but you want to make sure that this individual this party You can collect from them collectability is assured Now the cost of the ladder for Boeing is $80,000 This is giving because we need to compute the cost of goods sold So this is the information that we are giving and we already we already know that this is a finance lease because the economic lie The lease term and the economic life are 100% so the first thing I'm gonna show you how to compute the payment Although I gave you the payment of 20,000, but here's what you do You will take at the you will take the fair value of the least asset 95,000 Then you deduct from it you deduct from it less the present value of the residual value Which is the residual value is 2926 you multiply it by the present value factor And this is n equal to n equal to four percent I'm sorry n equal i equal to four the interest rate is four n equal to five five periods And this is the present value factor So the present value of the residual value is two thousand four hundred and five dollars You will take a look at the fair value minus the present value of the residual value Now why are we doing so to find the payment because the payments that the lessc pays Should be the payment amount received by the lessor for the least payment So those are the payments that cover your Lease that cover your lease Okay, the residual value that asset is is is is given back to you So you don't have to cover the payment from that you have to cover the payment for the lease payment Therefore they should be 92,595 in total Now what you do is you you have to find the payment you will take this amount You divide this amount by the present value factor of an annuity do which is 4.62990 I keep mentioning those you know those Decimals like 0.82 and here there is no decimal. That's a present value factor If you're not familiar with what I'm coming where this is coming from Please go to far hat lectures and look at my time value of money If you're doing leases you need to be very familiar and comfortable with the present value of money So I'm not going to cover this here. I have five to six lessons explaining the concept never nevertheless You will take the amount to be received By the lessor from the lessc payment and you'll divide it by the present value factor of an annuity Do why annuity do in this example because the first payment was due immediately January 1st x1 Which is this happens to be the factor and if you do so you're going to come with approximately 19,990 a Point something you round it at 20,000. So this is how we came up with that payment This is how we came up with the payment. So this is the payment Sometime it's giving I gave it to you and I showed you how to compute this now Let's go back to our lease receivable. How would our lease receivable looks like it's equal to 95,000 It's composed of the payments to be received from the Payment plus the guarantee residual value, which is the present value of those notice those together Those together will equal to the lease receivable, which is the fair value So the fair value is the lease receivable. Let's debit the lease receivable Let's put the lease receivable on the books of 95,000 credit sales 95,000 And I told you cost of goods sold the cost of the ladder for Boeing happens to be 80 Which was giving and credit inventory or credit the ladder or the asset for 80,000 So this is the entry that Boeing makes on January 1st 20 x 1 and by doing so notice they made a profit of 15,000 Because they on the income statement the sales of 95,000 is recorded a cost of goods sold of 80 They have a profit of 15,000 now Obviously, they're gonna make more profit from the interest on the deal But this is the profit that they make on the sale It's the profit that they make on the sale now They're gonna have to prepare an amortization schedule with the annual lease annual lease payment that they would receive interest on the receivable reduction of the receivable and the lease receivable The lease receivable we already know starting at 95,000 Immediately delta airline signs a check for 20,000 So well if they signs the check immediately Immediately the check would reduce the amount of 95 to 75,000 It's a reduction in the lease receivable because they sign the check on the same day There's no interest component to that payment. Well Boeing will debit cash credit lease receivable Then we're gonna have to compute the interest A year later Delta will make a payment of 20,000 Now boeing will have to determine how much of that payment goes toward the lease how much of that payment goes toward the Interest on the on the lease. Well The lease is 75,000 the interest rate is 4% will take 75,000 times 4% And that's going to give us an interest of 3,000. So first you compute the interest component and the interest is based on the Lease receivable times the interest rate, which is 3,000 So of the payment of 20,000, we're gonna say 3,000 is interest revenue Okay, we're gonna and this is in this entry we make on December 31st And that's why we debit lease receivable because the payment is received January 1st So this is December 31st 20x1 to accrue the interest So of the 20,000 we allocate 3 to the interest and obviously the remainder would be allocated to the lease receivable It's to the lease receivable itself, which in turn will lower the lease receivable to 58,000 Then the process would repeat itself then we'll make another payment. We'll we'll we're gonna have to make another payment on January 1st 20x2. Well on December 31st 20x1. We're gonna have to debit lease receivable 2,320 In credit interest revenue Now let's see what the balance sheet would look like as of December 31st 20x1 Well, here we go. We're gonna have a lease receivable of 3,000, which is this lease receivable Which is the interest component plus we're gonna have a lease receivable that we have to pay Soon the following day of 17,000 therefore under current assets We're gonna have a lease receivable in total of 20,000 and the remaining of the Least asset, which is non-current asset. It's it's a form of an investment If the if the 58,000 so we're gonna have a current asset Plus a non-current asset presented what we will show on the income statement on the income statement We are going to show three things. We're gonna show the sales of 95,000 Less cost of goods sold of 80,000 plus we're gonna show the 3,000 of interest revenue that we recorded on December 31st 20x1 to accrue the interest. So this is how we show things on the Income statement now on January 1st January 1st 20x 2 we're gonna receive the cash we debit cash and credit the lease receivable for 20,000 So the the lease receivable consists of 3,000 interests, which we already computed as interest revenue And 17,000 a reduction of the principal which already being reflected in this entry. Okay So that's the January 1st x1 now again if we want to do another accrue another interest the December 31st 20x2 so December December 31st 20x2 again, we will accrue interest revenue of 2,332 which is this amount here Then the following day will do the same thing And notice interest revenue went down because the lease receivable went down And the process would repeat itself year after year. So if you can if you can if you can Work the first two three years, then you can do Actually, if you can do two years you can do an amortization schedule of 20 years That's all the same. So make sure you know how to read this So after we make the payment the second the third payment The interest is 2320 the principal is 17,680 the principal goes down to 40,000 320, which is the lease receivable Then we compute the interest again based on the new lease receivable The interest revenue is lower the 20,000 goes to the interest revenue the remaining to the lease receivable So on and so forth now we're not done yet Because notice at the end of the lease it has to go down to zero at the end of the lease what's going to happen We're going to have January 1st 20x6 at the end of the lease We're going to have an interest component of 115 dollars and 89 cent which is this amount times 4 percent And we're going to have to remember we're going to get back the inventory bowing We means bowing bowing is going to get back the inventory remember the inventory will be referred back to bowing So when you give them back physically the ladder, they're going to debit inventory 2926 and remove the lease receivable. Therefore, we end up with the lease receivable of zero So this is the how how you would process the entries and this is how the Amortization schedule will show for the less so what should you do now go to farhatlectures.com work mcqs True false look at exercises look at additional resources Because you need to learn a little bit more invest in yourself. Don't sure change yourself Accounting is important if you're studying for your CPA exam. It's a long-term investment Good luck study hard and of course stay safe