📊 Direct Financing Lease — Intermediate Accounting

Hello and welcome to the session. This is Professor Farhat in which we would look at direct finance lease. Now the first thing I want you to know about direct finance lease, it's a classification by the lessor alone. It's not a classification by the lessee. Remember the lessor is the person or the party that owns the property like the landlord and the the landlord allows the lessee to use the property. So under the lessor, they can classify a lease as a sales type lease and we did cover that. They can classify the lease as an operating lease and then we did cover that and there's a third category which is called the direct financing lease where the lessor can will be able to classify the lease as a direct financing lease. Now I'm going to tell you the key point and why a lease could be a direct finance lease. Now I'm going to tell you also most CPA exam courses, most CMA exam courses don't go in depth and explaining the reason why it's direct finance lease. I'm going to try to make sense of it as much as possible because it's very important to understand the reason. The reason why it's a direct finance lease not a sales type lease. So this is what I'll try to do in this session. First, set the ground why it's a direct financing lease and after that I always work an example to consolidate the knowledge and I will show you the example side by side if it was a sales type lease versus a direct financing lease so you will understand the big picture. The key word in all of this is control and you're going to see why I I say that and control and within control it's going to come something called residual value. And who is guaranteeing the residual value is important. It's going to determine the control aspect of the transaction and based on that we will determine whether the lessor will classify the lease as a sales type lease, operating lease or a direct financing lease. Let's go ahead and get started. >> Before we proceed any further, I have a public announcement about my company, farhatlectures.com. My AI turns any lecture into a complete study system. You can create summary table, formulas, and example from each lecture. Flashcard builds from the lesson itself. A quiz built on the lesson. And as a bonus, convert any lecture into a portable short audio on the go. So, it helps you with the retention. No noise, no generic responses, just clarity based on that specific lecture. Don't just watch, interact, test yourself, and retain the material using Farhat AI. Now, go to farhatlectures.com now and see how the AI can help you understand, practice, and retain the material. >> So, for a lessor, what they have to do is this. They have to make a determination. We have a lease. Is it a valid non-cancelable lease? We assume it is. Then we have to see if we meet one of the five leases criteria, which are do we have ownership transfer in this lease? Do we have a purchase option, which is a to be specific a bargain, a good deal? Um are we are we leasing the asset for the majority part of its economic life? And remember, the key here is 75%, especially for the CPA exam, we need to use something specific. How about if we compute the present value of the lease payments? You know, is it the the it's for the majority of the value of the fair value of the asset? And the key here is if it's more than 90%. And if the asset has alternative use. If any of the answers we need only one yes. If there's an ownership transfer, then guess what? We met one of the sales type criterion, then we have a sales type lease. So, all you have to do is meet one or if it's an alternative use, yes or no. Now, assuming we meet one of them, we have on our hand a sales type lease. And if we have a sales type lease and we have a cost is giving and a fair value is giving, then we compute a profit and we record the profit at the commencement of the lease. Basically, we have a sale. That's how we treat a lease. It's a sales type lease and we have a sale. If the answer is no to all these test. So, we did no no, there's no bargain purchase, not for the major economic life, no the present value test did not pass on the lease payment only and there is an alternative use, it means it's not specialized asset. If the answers are no, are we done yet? No. Uh is it automatically an operating lease? Not yet. We have to look at one more thing and that one more thing is we have to see if the present value of the payments, notice the present value of the lease payment plus, notice here, plus a third party residual guaranteed. If those are greater than equal to substantially all of the fair value. And again, the test still at 90% quantitatively, especially for the CPA exam and the CMA exam in college courses. Now, in reality, they will, you know, they might use something else. And of course, we have the collection of payment and residual value is probable. We always have to assume that we can collect the payment and the residual value. But here we have to focus on residual value and specifically third party residual value. What does that mean and why it why is it important in changing what's going to happen here? Okay, if we meet both of those, if the present value of the payment plus the third party residual guarantee now equal or greater than greater than or equal to substantially all the fair value of the asset, we have a direct financing lease. Again, what does residual value mean? Residual value mean at the end of the lease, someone will guarantee the value of this asset. Usually in a sales type lease if in the sales type lease if we have a a residual value guaranteed, that means the lessee, the renter, is guaranteeing the value of the asset. But what what does that mean? What does it mean if the renter if the lessee is doing so? If the lessee says, "I promise that when I return this asset, it will be worth at least 6,000. If not, I will pay the difference." Now the lessee taken on the jewel value risk. What does that mean? It means the lessor transfer all the risks and reward of ownership to the lessee. The lessee is responsible for risk and reward because they are guaranteeing because I'm going to recover my payments plus the residual value guaranteed. So essentially, I sold the asset and that's why it's a sales type lease because someone is guaranteeing the residual value. I'm going to get that value back. But what we're saying here, it's a it's a lessee doing that guaranteed. Therefore, it's a sales type. Now if there's no guaranteed, nobody guaranteed the residual value, the lessor will keep the asset on their books. They bear all the risk assuming it's an operating lease. How about we introduce a third party? And this is bit unusual, but we we have to understand that it does exist in the real world. So maybe an insurance company, maybe a bank, some other entity that's not the lessee. So here we have the lessee, the lessor, and a third party is doing what? A third party is guaranteeing the residual value. Maybe the lessor is asking the the asking that third party. Maybe the lessee is asking the third party to guarantee, but someone is guaranteeing that residual value, the third party. We don't care, but there's a third party involved. So what difference does it make if a third party is guaranteeing that? Well, when the lessee guaranteed the the residual value, they bear the risk. And the lessor is fully protected. So, we sold the asset. But something different when a third party guaranteed the residual value. Let's think about it. The lessee did not take on the residual value risk. What does that mean? It means the asset has not been fully transferred economically to the lessee. But at the same time, the lessor is protected. So, hold on a second. The lessor is protected means they sold the asset. Mean they don't they don't bear they there's no risk for them because it's guaranteed, but it's not the lessee that's guaranteeing that risk. So, it's like it's it's it's a unique situation. So, the lessor's risk from the asset is converted into a risk from a third party. Well, because of that, now the lessor will have what we called a credit risk. And credit risk means now you're looking at the less at the third party to guarantee whether we get paid or not. Not the asset risk. It's a credit risk. So, FASB says, "Okay, since you did not really transfer the asset to the lessee, but you found an outside party to cover your downside, well, you did not earn your selling profit because you did not technically sell it to the lessee. You're essentially acting like a finance institution, like a bank, like a finance company. So, that's why in a direct financing lease, the lessor is treated as the lender, not the seller. That's why there's no profit That's why there's no profit. There's no profit like in a sales type lease. In a sales type lease, we actually sold the asset. Here we are playing the role of a lender. And what did trigger that role? That third-party guaranteed. Again, and how how did we start with that? Because the present value of the payment plus because we failed all of those. So, first we failed all these tests. Then we would look if there's a third party plus the payment will give us 90%. If that's the case, then we act as if we are the financee. Think of it this way. I'll make it even I'll make a simpler analogy. Imagine a bank gives you a car loan. Great. The bank doesn't say we made a 3,000 profit today because they did not sell it when they hand over the money. Because they did not they earn their interest income as you make your payment. And if you default, the bank takes the car. So, the car is their backup protection. And a direct financing lease works exactly the same way. The lessor is financing the lessee's use of asset. And the third-party guarantee, like the collateral protection, the lessor will earn interest, nothing more, until the less the lease is fully paid off. So, when they have a direct financing lease, when we fail all the five tests for the lease, but now we have a third party that's guaranteeing the residual value. And if you take that guaranteed residual value plus the present value of the payment, they're equal or greater substantially all the fair value of the asset, which is 90%. We have a finance lease. Technically, we are financing the transaction. We don't have a sales-type lease. We don't have the profit. All our profit is interest. Wow, that's a lot. Okay, but that's basically what a direct finance lease. If you want if you want me to to summarize this as much as possible, you cannot make a profit because you're financing the lease. That's it. Why? Because you have a third-party residual guarantee that made that 90% threshold. If we don't meet any of these if even if we did not meet this test here, there's no third party, then we have an operating lease and we go back to operating lease and we hopefully we all know how operating leaks operating operating lease work. We have a separate recording for that. So, remember in a direct financing lease we introduce this present value of lease payment plus a third party residual guarantee. And when we do the when we do the present value, we want to get the 90%. Then we'll look at an example and collect collection of payment of residual guarantee is probable. We always have to make this assumption, otherwise uh we don't have really a true lease here. So, what's a direct finance lease? A direct financing lease is is a lessor lease classification. Remember, this is for the lessor. The lessee don't have this classification where the lessor act as a financier, as a banker, not a seller. The lessor does not recognize an upfront selling profit. Instead, all income is earned over time as interest revenue and we will see that. You might have a profit upfront, but you cannot recognize that profit upfront. You will recognize it as interest income as you are financing the transaction. Few things you have to know, no day one profit. We talked about this. There's no sales to record, there's no cost to record, there's no profit to record on day one. We use the net investment approach. The lessor record a net investment in the lease at the carrying amount of the asset, not the fair value. If the fair value was given, we don't use the fair value, we use the carrying amount, which is the present value of the payment. The difference between, if there's any difference, the difference between the fair value and the carrying value is deferred and that's the profit in quote deferred. Now, the old rules we used to carry a deferred profit. Don't worry about the old rules, we have to move on. Now, what we do, we'll take that profit and we will include the profit in the interest revenue. We will account for it in the interest revenue. How? Just bear with me. I'm giving you the theory for now. Now, how do we compute the revenue? We would use the effective yield recognition. So, interest revenue is recognized using an effective yield that makes the present value of future cash flow equal to the net investment balance. So, somehow you have to change the interest rate stated and you will see how. We We don't have to do it, but I'm going to show you what does that mean, and earn the interest revenue based on the effectively how much you are earning. And why effectively? Because the interest rate stated is based on the payment, plus you would have to use the profit that you deferred, if any. Now, if you don't have any deferred profit, then it's the same interest rate. Now, the best way to illustrate this, as in everything, is to work an example. So, now, if you are tired by so far what I covered so far, take a break. Think about why it's a direct lease, direct financing lease. Think about it for a moment, come back and work the example. Why? Because I I invested some time to explaining why it's a direct financing lease. In most CPA review course, they cover the direct financing lease in this time frame that I just covered, which is I don't. I want to make sure you understand why. Just understanding is important, so you will never forget it. Because there's a third party guaranteeing the residual value. And that third party guaranteeing the residual value allowed us to to consider the lease as a direct financing lease, not an operating lease, because we already failed the sales type. So, let's take a look at this example. Robotics LLC leases a quick robotics package picker to Anson, the lessee. Now, Bank of America, an unrelated party, guaranteed the residual value. So, we have a third party. Usually, hint hint, if they throw in a guaranteed residual uh a party guaranteeing the residual value, you're may most likely heading toward direct financing lease, but be careful in case you met the sales type lease, it could be a sales type lease. The lease commences January 1st, X0, with a payment due each year, ordinary annuity, at the end of the year, December 31st. Robotics believes collection is probable. Okay, we need that requirement, it's there. The commencement of the lease, January 1st, X0. It's a 3-year uh lease. The payment is due at the end of the year, ordinary annuity, in case you find the present value. The fair value of the picker, the fair value is 30,000. The carrying amount is 28,000. It means there's a difference, there's a $2,000 if it's going to be a direct financing lease, which we will, it's going to be a third profit, and we're going to see how we do with this, how we deal with this. The residual value is 6,000. And what's neat about the residual value, it's guaranteed by Bank of America, which is a third party. The economic life of the asset is three. So, let's look at the lea- lease versus the life, lease versus life, we failed the 75%. The implicit rate is 6%. And at the end of the lease, the asset reverts back to Robotics. There's no transfer of ownership, so we failed one test. Collection is probable. There is no bargain purchase. So, what happened here is, if we look at the at the first five, no ownership transfer, we failed that. Purchase option, there's no purchase option, we failed that. 3 / 5 is 60% below the threshold, we failed that. The present value of the payment, if we compute the present value of the payments, it's 24,962, which represent 83% of the 30,000. Again, we failed the 90% as that sounds The alternative use assets expect to have alternative use. We failed that. So, we failed all of those. This is not a sales type lease. Now, we have a third party involved. How about if we take the present value of the payment and we add to them the present value of the Bank of America guarantee. Present value plus the Bank of America guarantee, we have a 30,000 100% of fair value substantially all met of the fair value or what we need is 90%. We met that and we said collection is probable. We met that. Voila, done, bingo, we have a direct financing lease. Now, if we didn't have those, that lease will be an operating lease. So, it's not a sales type lease, but we were able to meet the criteria for the direct financing lease. We treat it as a direct financing lease. Now, let's go ahead and start to solve this problem step-by-step with a journal entry. So, first, let's find the present value of the residual value step-by-step. 6,000 6% 3 years present value of a single amount. 0.83962. The present value of that amount is 5,037. Then, we would look at the present value and this is the detailed computation mathematically. The present value of the payment, we have to deduct what we're going to be getting from Bank of America as a residual value. What's left is 24,962. Then we look at the annual rental payment and we if we find the amount of the rental annual payment if we take the what we need to recover divided by the present value annuity factor 6% 3 years, we found the payment. The payment is 6,300 $38.64 and I showed you how to find the payment. The payment was not given. We had to compute the payment here. We should know how to do this. We covered it in prior recording when we looked at sales type uh sales type transaction. Now, if we look at the present value of the three payments plus the present value of the of the residual value, we got it, 30,000. Just a verification mathematically. Now, how do we book the the lease? Remember, we book the lease at the carrying amount, not fair value. So, net investment in the lease, the carrying amount. Be careful, that's a common mistake that students make in a direct finance lease, we use the carrying value, not the book value or only. Be careful. Why 28 not 30,000? Because the 30,000 is the selling profit. The profit is earned over time via a higher effective yield. Not selling at day one. We don't That difference of 2,000 is not recorded in day one. It's implicitly deferred. Now, the good thing about the CPA CMA exam, you don't have to compute that implicit rate. It will be given to you or you just don't need to do it. Okay? But, remember, the immediately think net investment income equal to the carrying value, not fair value. Okay, just be careful on the CPA CMA exam or in your courses as well. So, how interest is computed, don't worry about this, but we're going to be using an effective rate once we find out what we should earn. We should be earning 9.4994, which is 9. almost 9.5%. So, the effective yield to earn the additional 2,000 is 9.5. Now, this is the net investment balance, 28,000. How did we find this? You don't have to You don't have to figure this one out. The cash we would receive, the payment, remember, we computed this. Definitely you have to compute the payment at $9,338.64. To find the interest revenue, you multiply the balance, I'm sorry, you multiply the the payment, not the payment, the balance, 28,000 by the interest, you figure out the interest revenue portion, and anything left from the $9,338.64 that's not interest revenue, it goes against the reduction in investment, which is $6,678.80. It would reduce the investment to $21,321.20. Then, another payment is received of $9,338.64. Again, we'll take the prior balance, $21,321 * 9.5. We'll find the interest revenue, and the interest revenue is going down because the balance is going down, and the remainder is toward the principal until the balance goes down to the residual value, and guess what? Bank of America will guarantee this residual value, and the whole thing will go down to zero. Now, if we computed all our interest revenue, if we added all our interest revenue, it will add up it will add up to $6,015.92, which we effectively earned nine almost 9.5%. Now, here are the journal entries. You should know how to complete this because it's the same thing as in sales type lease. Debit cash, credit interest revenue for the first payment, credit the investment. Second payment, same thing. The only thing that's going to be different is the interest revenue will be lower, and you know, second payment, the interest revenue will be lower than the first, then the principal, then this is the last payment. Now, let's do what if. What if Amazon, the lessee, not Bank of America, had guaranteed the 6,000? If Amazon guaranteed that, we would be able to compute the lessee residual value within the payment, and we would have met a sales type lease. So, if the problem says Amazon, the lessee, guaranteed that residual value, we have a sales type lease. Just so you know this. The only reason we have a direct finance lease because we transfer that risk to a third party and that transferring the risk made the deal as a financing financing deal. Now, if it was a sales type lease, remember, we book the profit if it's a sales type lease, this is what would have been the entry. Debit the lease receivable for the full amount, debit cost of goods sold 25, credit sales 30, and credit inventory. And immediately we'd have a revenue of 2,000, that's recognized immediately. In a direct financing lease, you debit the investment 28. So, notice the investment here the receivable is 30, here it's the like in the investment or the receivable is 28 because you are financing. And the 2,000, you would account for that 2,000 later on in the payment. Later on in the payment when you increase the effective rate from 6 to 9.5. And this is the schedule side by side. This is a sales type lease. You're You're earning interest at 6% starting with a balance of 30,000. And you should know how to do this. And a direct financing lease, you're earning interest at 9.49. You're starting with a balance of 28. Now, here's what I want to show you. When all said and done, notice the interest earned over the life of the lease under the sales type lease is $4,015.92. The interest earned on the direct financing lease is $6,015.92. Well, guess what? The difference is, you guessed it, exactly $2,000. That difference of $2,000 is not really a difference. It's a timing difference. Why? Because the sales type lease, you took the $2,000 up front. Up front, the $2,000 when you recorded the sales and cost of goods sold at the commencement of the lease, you had a profit of 2K. So, guess what? The profit on both leases, the sales type and the direct, is 6,015 in total. The only thing difference is the timing. In a sales type lease, you got the 2,000 up front. And here's the picture of it. Notice, sales type lease, you get the 2,000 up front, plus your interest payment equal to 6,015. In a direct financing lease, you did not get the 2,000 up front, but you recovered the 2,000 in the interest payment, and your total was 6,015. Again, you you approximately earned 9.5. Don't worry about the rate. The good news is you don't have to compute the rate on the exam day. Exam questions usually uh they don't tell you this, but you want to know which method produce higher income in year one. You might have to know that. In year one, the sales type lease will produce more because they get more profit up front for year one. But overall, it's always the same. It's always the same profit. Now, here are the journal entries for both. So, notice under sales type lease, when you receive the first payment, your interest revenue is 1,800. Under direct financing lease, when you receive your first payment, your interest revenue is 2,659. Sales type lease, the second payment, interest revenue 1,347. Direct financing, 2,025. So, you're recovering that 2,000 over the life of the lease, and this is the remainder of the journal entries, which you should be pretty familiar with. Few things I want you to see here about the CPA and CMA exam. Remember, under direct financing lease, net investment is the carrying amount, not the fair value. Be careful. No day one selling profit in the direct financing lease. You need a third party that's guaranteeing the transaction. You would use the you'll end up using the effective yield. Sometimes it's the same as the implicit if there's no profit. Same total income over over time and the sequence matters. Sequence means what? First, you test for a sales type lease and this is where we started. If it doesn't, see if we have a third-party guarantee in the deal. The present value of that plus the collectability, the PC. And if we don't have any of those of both, if we don't have any not any if we don't have both of the second test, then we go well with the operating lease. Let's take a look at this multiple choice question from farhatlectures.com. A lessor record a net investment in a lease at 45. The fair value of the leased asset is 48 and the carrying amount is 45. This is mostly most likely is what? Sales type lease, direct financing lease, operating lease, finance sublease. Let's remove the easy one, finance sublease. We could also eliminate operating lease because we're adding a net investment in lease. We're not looking at rental revenue. That's out. So, we're between sales type lease and direct financing lease. Well, you have to know in a direct financing lease, you would record the net investment at the carrying amount, not the fair value. Not the fair value. That's all you need to know. And by doing so, it you will not record any profit as well. And it's And the initial investment is recorded at carrying value. If there's any profit, let's assume it's 3,000, that profit will be deferred in the interest revenue because as a in a direct financing lease, what you are doing is you are financing the transaction. That's what you are doing. And because you're financing the transaction, there is no profit on the sale, so it's not a sales type lease. Your profit is the interest revenue. Therefore, you would recapture any profit in the interest revenue because you are financing the lease. It's a direct financing lease. Now, if you are using Farhat Lectures, you could always ask the AI to explain the topic, explain the correct and incorrect answer, create a similar MCQ for you. At the end of this recording, what I'm going to tell you is this. What you should do now is go to Farhat Lectures, whether you are a CPA, CMA accounting student, look at additional lectures, simulations, multiple choice, AICPA questions, AICPA video simulations, AI resources. The best investment you can make is invest in yourself, invest in your knowledge. Stay safe and God bless.