 Hello and welcome to the session in which we would look at an operating lease example. On January 1st, year X7, the Lesor company leased a warehouse to the LSC company. The lease is for 20 years. The leased warehouse has a cost of 22 million and was purchased on January 1st, year X7. The warehouse is depreciated using the straight line over 50 years with no salvage value. Lease payments are 1.8 million, payment are made at the beginning of the year. Lesor incremental borrowing rate is 8%. Assume a calendar year ending for both Lesor and LSC. So the first thing when you have a lease problem is to determine whether that lease is an operating lease or a finance lease. I already told you this is an operating lease. Nevertheless, I'm going to go over the conditions to make sure it fails all conditions. I don't see a transfer of ownership option here. I don't see a bargain purchase price. If I take the lease life divided by the life of the asset, it's only 40% of the life. We're looking for 75%. It fails this, it fails this, it fails this. Well, there is an alternative use for a warehouse, so warehouse can be used for anything. So it's not a specific asset. Therefore, it failed that test and you're going to see later it's going to fail the present value test. However, what we're going to do in this problem, we're going to journalize the entries for the Lesor S4 as well as for the LSC. Let's go to the Excel sheet to do that. 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. Starting with the Lesor, the Lesor on 11 2007. They purchased, we are told here, they purchased this asset. Therefore, on 11 2007, they will debit the warehouse building. They paid 22 million and they will credit cash. What else happened? Well, they immediately received because they bought the asset and they leased it. They received their first payment of 1.8 million. That's also on the first day. They will debit cash, credit unearned revenue. Why? Because they have not earned the revenue yet. That's for the Lesor. Now, a year later, by the end of the year, they will earn the revenue. By the end of the year, they will prepare an adjusting entry, debiting unearned revenue and crediting lease revenue. So, they will earn the revenue. Notice from 11 2007 to 1231 2007, they earned the revenue. Are we done with the Lesor? And the answer is not because the Lesor in this example still own the asset. It's a long-term asset. What do you do when you have an asset that's long-term? What do we do? We depreciate the asset. Therefore, we also have to depreciate this warehouse over 50 years, straight line, no salvage value. The depreciation expense 440,000, credit accumulated depreciation 440,000. So, those are basically the entries for the Lesor. Now, let's take a look at the Lessee. What would the Lessee do? Well, the Lessee, when they lease the asset, they're going to have a right of use asset, which is an asset, and they're going to have to record a liability. Although this is an operating lease, now we're going to have to record an asset and a liability. How much is the asset and the liability? It's going to be based on the present value of the payment. We're going to be making $1.8 million. It's going to be n equal to 20, i equal to 8%. If we go to the present value table, we see that the factor is 10.6036. If you don't know the present value table, we'll go to the present value lessons, and the present value is $19,086,480. So, we will debit the asset, right, of use asset, credit, the liability. You remember I told you earlier that we're going to take a look at the 90% fair value test? Now, what we do, if we take 19 million, this amount here, the present value, divided by the fair value, which is 22 million, why do we assume the fair value is 22 million? Because the less sore, the less sore purchased it for 22 million. So, that's the value of it. If we do compare those two numbers, we see that the present value payment equal to 86%. Therefore, it's less than 90%. Again, it fails the fifth test. So, are we done yet? Not at all. The last C will debit an asset, credit, a liability. Remember what the last C did? Immediately, they have to make a payment. So, if they make a payment immediately, they're gonna credit cash, 1.8 million. And they would reduce their liability for 1.8 million because they immediately made the payment. Therefore, if we look at the liability, at this amortization schedule, they started with 19,086,480 dollars. And on the same date, they made a payment, which in turn reduced their liability by 1.8 million to come down to 17,286,000. Are we done yet? Not at all. Now, by the end of the year, we have to prepare an adjusting entry. And remember, under operating leases, we only have one expense and that is lease expense. The lease expense is 1.8 million. So, this is the adjusting entry we'll make at the end of the year. Then we are going to credit lease liability and the right of use asset. How do we do this? Here's what's gonna happen. 1231, again, we're gonna have to compute the interest component of things. And what's the interest component? The interest component is the prior balance of the lease liability times 8%. Well, that's 1,382,000. That's the lease liability. That's technically, in quote, the interest component. Again, we don't debit interest expense, but that's the interest component. So, this lease expense include interest of 1,382,918. Then the remainder is the right of use asset. The right of use asset is basically a plug for the amortization component, which is the technically the reduction of the liability. Now we have a new lease liability of 16,869,000. So, this is the journal entry that we make at the end of the year. Then the following day, we make the cash payment. When we make the cash payment, we are going to debit the lease liability 1.8 million, credit cash 1.8 million. So, what happened is this, one expense and that expense basically encompass the interest and the amortization. That's the difference in operating leases. Now, also we have the annual payment, which is the 1.8 million. This is what we did in this entry and those two are booked in this entry and we only have one expense. Then we have a new balance and we keep on going. Now, if you happen to go for the next 20 years, if you happen to increase this, it's not gonna go down to zero because I made up those numbers. Just in case you're going through this. So, this is basically what you have to know. As far as the CPA exam or your intermediate accounting course, if you could do the first two years, you will be fine. What should you do now? Go to Farhat Lectures and look at additional resources, multiple choice through false additional resources that's gonna help you do better. Good luck, invest in yourself and stay safe. Operating leases is an important topic.