 Hello, and welcome to this session in which we will discuss operating lease. So the first thing we want to know is what is an operating lease? Well, it's easy. An operating lease is a lease that's not a finance lease. Well, that doesn't help me much. So what is a finance lease? Well, a finance lease is a lease that meet one of the five tests, only one of the five tests to be a finance lease. Let's go ahead and review what are the five tests because we already discussed finance lease from a less source perspective as well as from a less seized perspective. In this session, I'm going to be discussing operating lease from the less sore as well as the less see in the same session. But let's go ahead and review what a finance lease is a finance lease if it meets the test of a transfer of ownership. It means there's an agreement at the end of the agreement, the product, the asset will be transferred from the less sore to the less see. If the answer is yes, you have a finance lease. Well, what's the second test purchase option? It's specifically we call it a bargain purchase option. It means there's a good deal that the less see would never pass out will never will never say no to. Well, if there is a part, if there is a purchase option, then we have a finance lease. If not, we have no finance lease. Three, the least term, the least term should equal to 75 or more of the economic life of the least property. So if you lease the property for more than 75% of its economic life, then guess what? You technically purchase the purchase the product or the asset. Therefore, you have a finance lease test number four. You compute the present value of the lease payment of their equal to or greater than 90% of the fair value of the asset. You technically purchase the asset. You have a finance lease and the fifth test alternative use test. What does the alternative use test mean? It means if this asset is unique to your business, simply put the less sore that there's nothing they can do with this asset once it's revert back to them. Well, if it's specialized of a specialized nature, there's no alternative use to it, then it's a finance lease. So if it's a finance lease, if it meets any of those five options, if it fails all of them, if it fails all of them, then we have an operating lease. And obviously in this session, we're going to be dealing with an operating lease. So I told you up front, the deal that we're going to be working with will fail all these tests. Now, bear in mind operating lease will debit an asset at the commencement of the lease and will credit a liability. And this is relatively a new rule. I say relatively because I remember when I used to teach operating lease when that wasn't the case. So I always, every time I teach operating lease, I have to remind my students, although most of you don't know the old rules, but the old rules is you did not have an asset, you did not have a liability, but that's not the case anymore. When you start the lease at the commencement of the lease, you have an asset and you have a liability to be more specific, just like a finance lease, a finance lease, you will have an asset and you will have a liability at the commencement of the lease. However, when it comes to operating leases, you're going to see in contrast to finance lease, you're going to have only one expense rather than two. Now the best way to illustrate this concept is to actually look at an example. So I'm going to be using the same example with a slight modification for the example that we used for a finance lease and make it fail, the finance lease, turn it into an operating lease. Assume Boeing Capital Corporation, the subsidiary of Boeing and Delta Airlines, signs a non-cancellable three-year lease agreement, it's non-cancellable, it's important, dated January 1st, 2021, that calls for Boeing to lease a mobile airplane ladder, I'm going to call it a ladder, to Delta beginning January 1st, 2021. Here's the deal. So you need to know what the deal is. Cost and fair value of the ladder is 60,000, so this is the fair value. The estimated economic life of the ladder is five years. Unguaranteed residual value at the end of the lease is 12,000. Simply put, Delta will give back the lease to Boeing and there's an unguaranteed, it means they're not responsible for anything, but they think it's going to be worth 12,000. No renewable option. The ladder reverts back to Boeing at the end of the lease and the implicit rate is for Boeing is 6%, which we know. So let's go over the test. Is there a transfer of ownership? There's no transfer of ownership. If you look at the deal, it doesn't say the ownership transfer to Delta. Is there a bargain purchase option? I don't see a bargain purchase option. What about the lease term? Well, the lease term is three years. The life of the asset is five, if you take three divided by five, that's 60%. That's less 75%. We failed this. What about the present value of the lease payment? Is it equal or greater than 90% of the fair market value of the asset? Well, I need to compute my payment, which is I don't know yet. I need to compute my payment. Is there an alternative use test? Of course, Boeing can take this ladder into what? Lease it to another airline company so they can use it. So it also failed this test. So there is an alternative use test, alternative use for this asset. The only thing that we need to know now is the present value of the lease payment. Now, we already know upfront, we're going to fail this test, but nevertheless, we have to learn how to compute the present value of the payment. And actually, we don't have the payment itself. So we need to compute the payment, compute the present value, and the fair value we know at 60,000, compare the present value of the payment versus the 60,000. Now, before we look at the present value of the payment, most likely you are an accounting student or a CPA candidate looking to learn about operating leases. That's great. You have arrived. I can help you. I provide you with lectures, multiple choice through false additional resources that's going to help you on my website, farhatlectures.com. I don't replace your CPA review course. I don't replace your accounting course. The reason you are watching me right now, it's because you are looking for operating leases and you did find me. That's great. You are in the right place. Go a step further. Take a look at my material. Subscribe. It will help you tremendously. Connect with me on Instagram if you haven't done so. Like this recording. Share it with other. If it's benefit to you, it might benefit other people. Connect with me on Instagram, Facebook, Twitter, and Reddit. Let's compute the payment first. Well, how do we compute the payment? We're going to take the fair value of the letter, which is 60,000 minus the present value of the residual value or the, another residual value, the guaranteed residual value or un-guaranteed. It doesn't matter. We deduct the present value. And that's going to give us 10,075 dollars and 44,44 cents. And this is basically we're looking at n equal to three, i equal to 6% using the period and rate that we use. And this is the present value of a single payment. Hopefully you are familiar with the time value. Otherwise, if not, go to far hat lectures and learn about your time value of money. At this point, the assumption is you know how to use the present value tables. That's going to give you the amount to be recovered from the payment, 49,924. We're going to take 49,924 divided by 2.8333. This is going to be a present value annuity due because the first payment in this deal will be due immediately. So the first payment will be due immediately. And that's, that's why I multiply it by this rate. This is i equal to six, i equal to 6% and equal to three, the present value of an annuity due, not ordinary annuity. So the payment will be 17,620 dollars and 8 cents. Now we already know the present value of the payment 49,924 divided by 60,000. The, it's 83%. 83% is less than 90%. So also we failed the present value, the 90% test. Therefore, we failed all five finance lease test. What are we looking at here? We are looking at an operating lease. Well, if we're looking at an operating lease, let's go ahead and start to look at the journal entry for a lessee first. So the lessee is Delta Airlines, which is basically the rentor of the, of the ladder. On January 1st, 20X1, what's going to happen is they are going to debit an asset, as I told you, an operating leases. We're going to debit the asset for the present value that we computed 49,924.56 and they're going to have a lease liability for 49,924.56. Also on the same date, they're going to make their first payment. Well, the payment is 17,620 dollars and five pennies. We debit the lease liability immediately. There's nothing to do because it's the same date. There's no interest component yet and we credit cash for that amount. Now also for an operating lease, we're going to prepare an amortization schedule and this is what the amortization schedule would look like. We have the date annual lease payment interest on the liability reduction of the liability and the lease liability. The lease liability started at this amount, 49,925. Then immediately the same day, we made the payment. Therefore, the lease liability is down to 32,305. Now on the CPA exam, they might ask you, what is the balance of the lease liability after the payment? Well, the balance is 32,305 or they might ask you, what is the balance two years, which is a year later? Well, we're going to see what the balance is a year later after you make the second payment, but the point is you need to know how to read and sometime actually create those amortization schedule, maybe in a simulation. So make sure you know how to read them, interpret them, you know how to extract the information from them and how to build one from scratch. So what would the entry looks like December 31st, 2021 after the first year went by? Well, guess what? We're going to be crediting return rate of use asset. We're not going to have an amortization expense. We're going to have only one expense that we're going to have only one expense and we're not going to say whether it's amortization or interest, it's going to be included in both. So a year later, here's what's going to happen at the end of the first year. We're going to debit lease expense for this amount, 17,620.08. We're going to credit lease liability for this amount, $1,938.33. And this is basically the interest component. So this is technically the interest, although we don't call it interest. We don't call interest expense and an operating lease. Listen to me carefully. There's no interest expense. There is no amortization expense. The term is lease expense and it's only one expense. And the reason I'm emphasizing this, it's because you already sold the finance lease, which is treated differently. So under operating lease, there's no interest expense. There is no amortization expense. This is basically part of the new deal is because they don't want you to treat it as you have interest and amortization, then it's technically like a lease expense. So that's why it's an operating expense. Then we credit right-of-use asset for the principal and basically this amount is the plug, which is this amount here, the principal amount, and it's going to reduce your $32,305 to $16,623. And that's going to be your balance in year two. And this is usually what they ask on the CPA exam. What is the balance after the first year? Well, that's the balance. That's the balance of the liability. Then you are going to pay off the liability by debiting the $17,620.05 minus, not minus, and credit cash to remove the liability, to remove the liability. This lease liability represents the interest component, which is the 1938 and the principal component, which we said it's going against the amortization plus the principal. So this the lease liability is reducing both. Now, remember, notice what we did. We did one expense, one expense and that expense include both interest, in quote, interest and amortization, but it's only one expense. Now, what's going to happen a year later for December 31st, 20x2, actually this is, this should be x2. So December 31st at the end of x2, we'll do the same thing. We are going to debit an expense for this much, credit lease liability for this portion here, for the technical interest, technically the interest and the remainder will be toward the principal, then we pay off the liability. Now, let's take a look at this transaction from the less source perspective, which is Boeing. The less sore, the good news is we'll classify the lease as an operating lease just like the less say. So there's no different rules for the less say and the less sore. It's an operating lease for the less say and operating lease for the less sore. What does that mean? It means the less sore will keep the asset on the balance sheet and recognize revenue in each period. Why? Because I did not really make the sale. This is only a rental agreement. Although the less see have an asset called right of use asset, but I am keeping the asset. If I'm keeping the asset, I also have to depreciate the asset. This is not a sale agreement. An operating lease is not a sale agreement. It's a rental agreement. It's a rental, not a sale. Therefore, the less sore is keeping the asset and they would recognize revenue as simple as that. Now, what's going to happen when we sign the lease? When we signed the lease, automatically Delta wrote a check for 17,620. We're going to debit cash credit unearned revenue. So from Boeing's perspective, we did not really earn any money because we just signed the lease. We're going to have to wait until they start to use the asset. December 31st, 20X1 a year went by. What's going to happen is we're going to reverse this unearned revenue. Now we earned the revenue and we're going to credit lease revenue for 17,620. And we're going to do this basically. Again, at the beginning of 20X2, we will have unearned revenue when we get the money, then we'll have at the end of the year, reverse it and make it into earned revenue. So this process would repeat itself for the next three years. Now, are we done yet? Not yet. The less sore also would depreciate the asset over five years. Now you're saying the lease is three. I don't care about the lease. The less sore own the asset. They own the asset for five years. Therefore, they will depreciate the asset. And for the sake of this illustration, they're going to be using the straight line method. So they're going to take 60,000 divided by five, and they're going to depreciate the asset over the next five years at $12,000 per year. They could use any depreciation method that doesn't matter. I happen to use the straight line. What should you do now? To learn more about operating leases, go to farhat-lectures.com and work MCQs through faults and exercises. 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