Finance Leases Explained: Step-by-Step Lessor Accounting Simulation

Hello and welcome to this session. This is Professor Farhat in which we would look at an exercise CPA exam simulation CMA case whatever you want to call it between lessor and lessee. In this example we would assume that the less that the lessor is Maggie and the lessee is Adam. So the lessor is the person that owns the property and we will be performing the accounting for the lessor because this session focuses on the lessor. Here's what we have. The commencement date of this lease is June 1st X1. The annual lease payment is given to you as $20,471.94. As I always tell you sometime you might have to compute this but not in this example the payment is given to you. The payment timing the beginning of each year. So this is an annuity due and to keep it simple it's a yearly payment. The lease term is 5 years. The economic life of the equipment is 10. There's a bargain purchase option for 4,000. Notice it says a bargain. The fair value of the equipment is 91,000. Maggie's cost for that equipment is 60. The implicit rate is 8%. The lessee internal rate is 8%. And reversing entries are used by Maggie because we're doing the accounting for Maggie. So in this session we will go over nine different things. Why do I say over nine different things? That's not the only thing you can go over but if you are giving this as a multiple choice I want you to see that that I can ask you nine different questions about this data. Actually I can ask you more but I kept it at nine. This could be a complete simulation. I will treat it as a simulation for this purpose. But in the real world or not real world, on the exam, I could give you as I could give you this as a multiple choice and ask you at least nine different questions. What are they? We need to classify the lease, compute the lease receivable, look at the entry at the commencement of the lease, the first payment, the interest accrual, the reversing entry, the second entry payment, the amortization schedule, and based on the amortization schedule, I could ask you several questions. Then, I'll ask you a depreciation question about this exercise at the end. Well, 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, first, let's classify the lease. Here is our the checklist for the lease. Ownership transfer, we're not told anything about the owners- ownership transfer. Is there a bargain purchase option? I told you, look, there's a bargain purchase option. If this is a yes, that's it. This is a finance lease. The economic life is 50%, it doesn't qualify under economic life. All what you need is one out of the five. The present value would not need even to compute, and this is not a specialized equipment, it failed that. All what we need is one one criteria, and that criteria is we do have a bargain purchase option. A bargain purchase option allow the lessee to buy the asset. So, we assume is basically the lessee will buy the asset. Therefore, we will treat this as a finance lease because it's a bargain. It's a good deal. No one's going to skip over that deal. Remember, you need only one criteria to meet this finance lease. And yes, this is a finance lease under a bargain purchase option. Sometimes you might have two you might meet two criterias or three criterias. That's fine. You only need one of them. So, that's the first question. Now, we need to understand the annuity due and the present value factor. Remember, the payment for this lease starts at the beginning of the lease life. At the beginning of each year, it means we are dealing with an annuity due. The first payment is due on June 1st, X1, the same day at the start. Here we have no interest payment. Therefore, the way we compute the present value is we look if to find the present value of an of an annuity due, you can take the present value of an ordinary annuity times 1 plus the interest rate if the annuity due is not giving. Now, the present value of an ordinary annuity n equal to 5, i equal to 8%. This is the ordinary annuity is 3.99271. But, we're not looking for the ordinary annuity. We're looking for the annuity due. You can take this annuity, add 1 plus the interest rate, and this is the annuity due. Now, often time on the exam, they will give you the table. They will give you the table for the ordinary annuity, and they will give you the table for the annuity due. So, you have to understand you're dealing with an annuity due. Or they may not, they might give you the ordinary annuity, and you can convert the ordinary annuity into an annuity due. And this is what we're looking at for this ex- exercise. The first payment is due immediately, then we have 1 2 3 4 5 6 Oops. 1 2 3 4 5 6 payment in a sense that the last payment is the bargain purchase. So, the bargain purchase payment is included in the present value calculation because the lessee is expected to exercise it. And that's what That was the reason why we we could have assumed fairly that this is what type of a lease? A finance lease, technically a sale. Now, let's compute the lease receivable. The lease receivable is the present value of the payment plus the bargain purchase. So, simply put we need to find the present value of this. That's what we're looking at here. So, step one is the present value of the annual payment. We have an annuity and we already figured out the factor. Therefore, the present value of those payment 88,000 to 80. So, again all what I did is I figured out the present value of this portion of this portion cuz this is an annuity. What else do I need to compute the present value for? I need to compute the present value for the bargain purchase. Remember, you have to pay this 4,000 only one time. It means you are using the present value of a single amount. N equal to 5, I equal to 8. The factor is .68058. If you don't know what these factors are, you have to go to my time value table. Therefore, the present value of this is 2,720. We add them up and this will give us a lease receivable of 91,000 and this will be our lease receivable. Let's journalize the lease receivable. Date June 1st, X1, when we actually record the lease. There are two journal entries. One is for the receivable and the sale, and the other one is for the cost because here we have a profit on that sale. Therefore, entry one, debit receivable, credit sales revenue for 91,000. And what we just did, we just recorded the sale component. Now, remember, in this exercise, we have a cost component that we have to worry about because this is a dealer. This is a sale sales type lease. We have a profit. If the fair value equal to the cost, it will be financing you're simply financing. Here, we're not. Actually, we are financing, but we have also a a profit. So, it's we basically two two things. Now, we have a cost of 60,000. So, immediately, the company made a profit of 31,000, a profit up front. Is this the only profit? No. They are going to also enjoy the interest component of the profit because they are financing the the they are financing the transaction. Now, keep in mind, Adam paid one uh the first payment immediately because this was an annuity due. The first payment happens on the same day. Maggie will debit cash, and they will credit the receivable. Notice, they will not account for any interest revenue as of yet. Not because there's no interest revenue, because no time has passed for the interest to accrue. Therefore, debit cash, credit receivable. And basically, the balance of the receivable after the payment, and this is important, is 70,528. Why do I say after the payment? Because after the payment is made, we have the new balance, and based on this new balance, we will compute our interest revenue into the future. So, when the balance changes, your interest revenue will change as well. So, after the first payment, the lease receivable is 70,000 528, and this becomes the base for the interest computation going forward. Well, let's take a look at a partial lease amortization schedule, basically all of it. So, we started with 70,000. Um first, we made a payment. That payment reduced the balance to 70,000 5 528. Remember, the original balance was 91,000. Then, on June 1st, we made another payment. How do we allocate what goes to the interest and what goes to the principal? We will take the beginning balance of June 1st, X2. We multiply it by 8%. This is the interest component. And if if if 5,642.24 is interest, the remainder of the payment, 14,829.70, goes toward the principal, and the principal goes down. This becomes the new principal. Then, next period, we'll take this principal multiplied by 8%. We'll find the interest component of the payment. This much goes toward toward the interest, this much goes toward the principal. Few things I want to show you. As time goes by, your interest revenue goes down because your balance goes down. And as time goes by, the portion uh the reduction in the receivable goes up because more is going toward the principal. More of the payment is going toward the principal. And this is how I compute my interest revenue. This is the reduction, basically, and this is the ending, which is the beginning minus the reduction, the ending balance. Now, let's take a look at accruing interest as of December 31st, X1, accruing interest. It means you have to accrue the interest. You did not receive it yet, but something you have to record before getting the interest. That's perfectly fine. I I hope we're all familiar with that. If the last payment was made June 1st, and until December 31st, we have 7 months if we're counting from that. This ensure the income statement shows the correct revenue. So, because the lease started June 1st, therefore we are going to accrue the interest to show you how we would accrue the interest. Step-by-step computation, we'll take the beginning balance of the lease * 8%, which will be the annual interest. We're not computing the annual interest. We are computing the annual interest from June 1st till December 31st, which is 7 / 12. Therefore, the accrued interest is $3,291. Now, we need to journalize this entry. What do we debit? We debit interest receivable, and we credit interest revenue for this amount. Why? Because we did earn it, but we did not receive it in cash yet. So, the interest receivable is a balance sheet account, money owed to the lessor not yet received. Interest revenue is actual revenue on the income statement for year one. So, keep that in mind. Only 7 months. Remember the 5,000 642 is will be recognized for the full year. Now, we need to take a look at reversing entries and why Maggie uses them. So, what are reversing entries and when Maggie why Maggie uses them? Remember on December 31st, we booked we debited interest receivable 3,291, we credited interest revenue 3,291. Now, why did we do that? We did that to make sure the revenue is properly reflected as of December 31st. This revenue is properly reflected December 31st. And this receivable is probably reflect proper properly reflected December 31st. Why? Because if we prepare the financial statements, all the accounts supposed to be up-to-date. And up-to-date means up-to-date update your receivable, update your your revenue. Fine. The following day, what you can do is you can flip the accrual. Flip means remove this because all what you needed is for December 31st to show the revenue and the receivable. So, the following day, and most software will will automatically do that, they will flip it. We will credit revenue, debit receivable. So, simply put, remove this receivable and remove this revenue. So, why did we do that? Well, we did that because when we issued the December 31st, we have to show what we have. But on January 1st, for simplicity, let's take this one out. Why? Because we are going to get the full payment on June 1st, and we would record the full payment. So, when we get the full payment of cash, we will credit the full year interest revenue. It means from June 1st X1 till June This is June 1st X2. And we remove the receive We reduce the receivable by the full amount. So, why do we do this entry? For simplicity. Now, if we did not if we did not book this entry, then when we receive the cash, the interest revenue will be the difference between $5,642.42 and $3,291.32. That will be the interest revenue. The lease receivable will be for the full amount. But we also have to credit the interest receivable of $3,291.31. So, why did we do this flipping on January 1st or the reversing? to simplify the record. So, after the reversing interest revenue has a credit balance, then the full amount 5,642 is recorded on June 1st X2. The net interest revenue is the full amount, okay? Which is equal to the 5-month. But, what we do is for simplicity, we just kind of remove the accrual, so we can record the full payment. Let's take a look at the second lease payment. The beginning balance times 8% will give us the full interest. Cash received minus the principal will give us the minus the interest will give us the principal reduction. And as I told you to keep it simple, we're going to assume we are using reversing and we are reversing the reversing, so we reverse it on January 1st, we kind of back it out, and this will be the entry on June 1st X2 including all the revenue. We just saw this, but this is a breakdown of the detail. So, the new the new lease receivable is 55,698 because the prior balance was 70,528 minus the reduction in the balance. And the interest for the period, remember for the first 7-month was $3,291.31, and the remaining 5-month January through June was $2,350.93. If we add them up, they will add up to this much, but it's it's it was reported in two different accounting period. Now, let's take a look at this requirement. Does the lessor record depreciation? And the answer should be maybe on a simulation, yes or no. And I hope you know that no, there's no depreciation. Why not? Because when we when we recorded this transaction, we removed the asset. We removed the asset from the books. We recorded the receivable. We recorded a sale and a gain. Since the physical asset is no longer on our books, there's nothing left to depreciate. The lessor only ongoing asset related to the list receivable, which is a financial asset not a depreciable one, not property, plant, and equipment. So, remember asset on the books in a financing lease, it's gone. In an operating lease, yes, will stay. In a financing lease, there's no depreciation because the asset is gone. Under an operating lease, yes. Revenue type the up upfront profit, yes, there is a profit upfront from a finance lease if there is a profit. Sales minus what? Sales minus cost of goods sold. So, exam summary, remember the lessor sells no depreciation in operating lease, the lessor rent. The asset would still be with them and gets depreciated. This is a comprehensive example. I know I work many examples for leases because you cannot work enough enough of them enough of them. Why? Because you need them. You need to understand because you have a lessor, you have a lessee. This is about the lessor. Make sure, you know, when you're studying for the lessee, we have enough examples for the lessee as well. The point is to be 100% comfortable in understanding, executing the steps, the journal entries, the balances, the present value computation. A lot of moving pieces, but we can help you. Farhat Lectures can help. 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