🧮 Sales-Type Lease Warehouse Simulation — CPA FAR Exam | Intermediate Accounting

Hello and welcome to the session. This is Professor Farhat in which we will take a look at a CPA exam simulation. You can call it that. You can call it a CMA case. You can call it an exercise or a problem for your college courses. It does not really matter. We will be dealing with accounting for leases. So here's the scenario. On June 30th, X1, Adam leased a warehouse equipment from Manufacturer Inc. So Adam need needed this equipment. The lease term is 4 years. Adam will make eight semi-annual payment of $478,767 each, payable June 30th and December 31st. So this is important. This is not an annual payment. This is a semi-annual payment. Therefore, we have eight payments. And this is important. So n equal to eight. When you go to the time value of money, you have to look at the n equal to eight. And whatever interest rate is given to you, you have to cut it in half. The first payment is due immediately on June 30th, X1. So this is important. This means this is an annuity due. Annuity due means that first payment is due immediately. The equipment cost is 2.8 million to the company that's leasing the equipment, Manufacturer Inc. Now the lease term is 4 years. This is the payment. The discount rate is 9% annually. When you go to the table, you would use 4.5% because it's semi-annual. And the equipment cost is 2.8 million. So for this transaction, we are going to classify it as a sales type lease. Now, is why is it not an operating lease? It's just a sales type lease. We could move on. You need to know the difference between sales type lease and operating lease. Remember, sales type lease if it meets one of the five conditions, we will assume here that it met one of the five conditions. Because our concern in this problem is the journal entries and the computation. We are going to ignore income taxes and remember this is an annuity due problem. So, here's what we are looking at. We are looking at June 30th X1 where we pay immediately Adam will pay immediately 478,767 and the money manufacturing would receive this. Then December 31st, Adam will make another payment. Third payment, fourth payment, fifth, sixth, seventh, and eighth payment. So, this is what we are looking at. This is the deal. The deal is you make eight payment of this amount starting with the first payment today. Here's what we need to compute. We need to compute four things. The first thing is we need to compute the selling price of the equipment as of June 30th because the manufacturer they don't tell us what's the price of the equipment. So, how do you find the price of the equipment? You guessed it. We're going to perform a computation. We have to find that, which is the present value of the annuity. We have to prepare the journal entries for the initial journal the initial entries when we here the manufacturer when the manufacturer the lessor initially record the sale. Remember, this is a sale. First, we find the price. Then we are going to record the journal entry. Then we are going to determine the lease receivable balance as of December 31st X1. In other words, what's the balance at the end of the year? Then we are going to determine the income statement account. What goes on the income statement for the lessor? So, notice I'm focusing on the lessor. The lessor is the owner that's in in quotes selling, not leasing, but selling the equipment to Adam. So, we're going to go over each each step separately. Let's go ahead and get started with step one, figuring out the selling price. 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, what's the selling price? The selling price is the present value of all those payments. How do you find the present value? You have You have to use an interest rate, and the interest rate is 4.5 because the stated rate is 9% annually. Adam will make the payment twice a year. Great. Number of periods, I told you it's eight because it's 4 years, eight period. And the present value annuity factor, you go to the table. N equal to five, I equal 4.5, and the factor is 6.8927. Now, I just gave you this factor. If you don't know how to use this time value table, you need to do so. You need to know how to find the present value of an ordinary annuity annuity annuity due present value of a single amount. Those are skills you need to be familiar with for the exam day. So, what's the final computation? So, once we have all of this, we can take the payment multiplied by the present value factor of the annuity due to get to the selling price. And if we do that, we'll come up with a selling price of approximately three 3.3 million, 3,299,997 rounding. I'm just going to keep saying 3 million. That's the selling price. But well, you have to remember on the CPA or the CMA exam, they always try to trick you and to they might give you the present value annuity factor for the ordinary annuity and the annuity due. They may give you to the ordinary annuity and the annuity due. Remember, you are dealing with annuity due. Now, sometime it will be an annuity due, but they would only give you the ordinary annuity factor. All what you have to do, figure out the ordinary annuity and add the first payment. So, just the shortcut. So, make sure you're using here if you're giving the annuity due factor, you would use that. If the first payment is 1 year later, use the ordinary annuity. So, the CPA exam always try to trick you on this, little bit of the CMA, but definitely the CPA exam. Now, what we find out is the selling price for the manufacturer. Simply put, they're selling this asset as far as they're concerned, 3.3 million. Well, let's journalize the entry. They will debit but they're they're not getting the money now. For now, they have a lease receivable of 3.3 million and sales revenue of 3.3 million. And the company would record the cost of the sale removing the asset. Remember, the asset has a cost that they're selling, a cost of 2.8. Now, they will they will they will expense it 2.8 and they will credit either equipment or inventory depending on how they account for this piece of asset. Is this everything? No. Remember, Adam will have to make the payment the first payment immediately on that date, June 30th, X1. Therefore, the company would receive cash 478,767. They will debit cash and they will immediately reduce the receivable. At this point, there is no interest revenue. No interest revenue because this is the first payment and interest is a factor of time, no time has elapsed. We signed the deal June 30th, we make the first payment June 30th, no interest revenue as far as the manufacturer. Now, the second payment, which will be done on December 31st X1, 6 months later. Well, what we have to do here is we have to figure out how much of the payment is interest, how much of the payment is toward the receivable. Remember, we started with a balance, a beginning balance on June 30th, 3.3 million, just rounding. Then we made the first payment, $478,767. This payment goes 100% against the principal and it reduces the principal to 2 million 821,230 on the Now, we have to take this beginning balance as of June 30th and figure out the interest that will be recorded, interest revenue, from June 30th till December 31st. So, we're going to take this beginning balance multiplied by 4.5 and this is the interest revenue. Now, this is the total payment. This payment will be split between interest revenue and the remainder of it will be $351,812 will be against the principal amount and the balance is reduced to 2 million 469,418. Now, again, we're going to going to to make another payment June 30th X2. We'll take this balance * 4.5% and that will be the interest revenue. And the 478 will be split between the interest revenue and the remainder will be the principal. And in case you're wondering what the journal entry is, maybe I should just give you the journal entry. We'll debit cash 478,767. We will credit interest revenue. Interest revenue was da da da da da da 126 955 and we will credit lease receivable 351,812. And this is how we come up with the journal entry. Now, you might be asked what's the balance as of December 31st X1. This is the balance. You might be asked what's the balance as of June 30th X2. Then you have to make another payment, split the payment between interest and principal, reduce the principal and you will be asked for that. You might be asked what is the effect on the income statement for for year X1. And this is what we will discuss next. What's the income statement impact impact as of December 31st year X1? Because you could be asked that question as well. They report that sales revenue of 3,299,997. They subtracted cost of goods sold on the income statement. They have approximately a gross profit of a half a million. That goes on the income statement. Plus they earned 126,955 and that amount is from the interest that they earned on this lease. Therefore, the sales revenue is 3.3 million, the gross profit is approximately half million and interest revenue is 126. And that's basically the impact on the income statement as of as of year one. So, remember the sales type lease allowed the manufacturer to recognize a selling profit on day one like a sale plus there's an ongoing interest revenue over the lease of the term. So, there's two income stream, one is the profit on the sale itself, which is they realize when they sign the deal and the other profit is from financing the transaction. Uh what should you do now? Well, if you're studying for the CPA exam, CMA exam, you're a college student, the best thing to do is to go to Farhat Lectures, look at additional CPA exam simulation exercises, true-false, AI tools, AI quizzes, additional quizzes, AI flash card. The best investment you can make is invest in yourself, invest in your career, invest in your professional certification, and God bless.