Accounting for Finance Lease: Lessee’s Perspective Example. CPA Exam #Finance

hello and welcome to this session in which we would look at Finance lease from lsc’s 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 text-decoration: none;">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 going to go over the rules again for a bold; color: #1a73e8; text-decoration: none;">Finance lease also i’m going to go over the actual journal entries and what you need to know for a Finance

lease from lsc’s perspective so to work this example we’re going to assume we’re dealing with boeing Capital corporation as subsidiaries of boeing and delta airline they sign 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 this mobile airplane ladder which we’re going to call it a ladder now let’s take a look at the details of the agreement well 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 twenty thousand so the deal says well we’re going to give you this ladder however you’re going to 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 do 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 do ordinary annuity you may want to go to forehead

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 least like we’re going to

come back and talk about those in a moment the expected residual value is greater than 5000 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 5000 this is the guaranteed residual value once that’s the case from the last c from the left c from delta airlines we don’t have to worry about this 5000. i’m going to have a separate session explaining guaranteed and guaranteed

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 the boat 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 you know get some cash for it delta incremental borrowing rate is five percent per year which we know delta depreciate on straight line basis similar equipment that it owns and boeing sets the annual rental rate to earn a

rate of return of four percent and delta is aware of this well of course we know how much do we earn how much we would need to earn five percent now we also know how much delta will charge us delta is charging us four percent since we know it’s since we know it’s four percent

we’re going to 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 uh for the present value computation we’re going to be using four percent 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

href="https://cashnews.co/finance" style="font-weight: bold; color: #1a73e8; text-decoration: none;">Finance it’s operating you already know it’s a none;">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 a transfer of ownership in this deal i don’t see it there is no transfer of ownership therefore it’s not a none;">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 the slider for 100 specifically the purchase option has to be a bargain in enticing the last c to buy it i did not see that in the deal the lease term is it

equal to 75 percent or more of the economic lease life of the asset and the answer is yes actually it’s equal to 100 percent so we’re saying this slider 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 none;">Finance lease how about the present value test since we’re going through all the tests well is the present value greater than uh 90 well we did not compute the present value yet we’re going to compute it shortly but the fair value is 95 as long as the present value

come up to 90 percent of the fair value we should be in good shape and let’s see just kind of get an idea what’s 90 percent of 95 thousand just kind of going to 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 not that we need it because we already know it’s a text-decoration: none;">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 need that test we

don’t we don’t have to because we already met the Finance lease test now what we’re going to do now we’re going to 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 foreheadlectures.com and subscribe to my

resources lectures multiple choice through false exercises that’s going to 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 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 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 a leased asset we have to debit an asset and Credit a liability so what is the asset and what’s the liability well we’re going to find out

what’s the present value we’re going to take 20 000 multiplied by the present value factor four point six two nine nine zero remember this was an annuity do and the present value is ninety two thousand five ninety eight remember when we talked about as long as we are above eighty five

thousand five hundred we are more than ninety percent 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 this is the asset 92 598 and this is the liability and we use four percent because that’s the that’s the implicit rate we know the rate that the boeing charge in us is four percent 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 put 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 twenty thousand immediately we’re

going to reduce our liability by twenty thousand because there’s no interest involved and we are going to Credit cash by twenty thousand 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 over the interest so on and so forth starting with january 1st 20×1 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 reduced our liability by 20 000 our liability became 72 598. then a year from now we’re going to 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 going to take the balance times four percent the balance times four percent will give us two thousand

nine hundred three dollars and ninety two cent for the for the interest component and whatever is left from the twenty thousands of the twenty thousand this much is interest and the remaining is principal which is point zero eight eight pennies missing again what’s gonna happen after this our

liability will go down to fifty five 000 507 because we’re going to reduce our liability by 17096 which will bring us down to 5502 then the process repeats itself of the 20 000 payment we’re going to take 55 000 500 502 multiplied by four percent it’s going to give us an interest

component of 2220 notice the interest component is lower than the prior period and hopefully this makes sense because the liability went down which is it means the interest expense should go down and the remaining goes toward the principal again we reduce the principal by 17780 the principal now is

37 722 or the least liability is that much we multiplied by four percent 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 reduce

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 20×1 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 2 900 3.92 this is december 31st the following day will make the payment and Credit a liability called lease liability two thousand nine hundred three dollars and ninety two cent 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 18519.60 which is taking the asset itself dividing it by five years which is the uh lease of the lease term and it’s going to give us

amortization of 18519 so we make those two journal entries december 31st 20 x1 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 20×1 on the Balance

Sheet we are going to have a non-current asset of seventy four thousand seventy eight dollars and forty cent how did you come up with this figure it’s the 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 seventy four thousand zero seventy eight now they might 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 going to deduct an additional eighteen thousand five nineteen point sixty so be aware this is point not comma point sixty so be aware of what you are being asked you could be asked anything also on the Balance Sheet you’re going to 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 2 900 3.92 and you’re gonna have to make a payment reducing the liability in the next

year which is the following day of seventeen thousand ninety six dollars now this is 0.08 rounding simply put you have current Liabilities of 20 000 part of it is interest part of it is principle they’re both a liability they will go under current Liabilities

that’s 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 2 900 3.92 and you’re going to have the amortization expense that you booked here so those will be two expenses remember for none;">Finance leases you’re going to have two expenses when we look at the operating lease we’re going to 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 going to happen the following day you’re going to make the payment you’re going to cut the check because the check is paid on january 1st on january 1st you’re going to debit lease liability 20 000 you’re going to

Credit cash 20 000 because you already recorded the expense so that’s so you don’t have to differentiate between the two you already recorded the expense therefore all what you’re doing is you’re reducing your liar ability let’s assume that delta

purchases the ladder from boeing for 5000 at the termination of the lease they will debit the equipment the ladder and they will Credit cash for 5000. what should you do now what we should do what you should do now is go to farhat lectures.com subscribe work multiple choice through

false exercises that’s going to help you reinforce the concept of leases a very important concept whether you are an Accounting student or a cpa candidate don’t sure change yourself Accounting is important Accounting is critical good

luck study hard and of course stay safe