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Lease Classification Questions for FAR CPA Exam - YouTube
Channel: SuperfastCPA
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in this video from super-fast CPA we're
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going to cover leases how to classify
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leases so first when you're looking at a
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problem you want to know if you are
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dealing with the accounting side for the
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lessee or the lessor so the lessee of
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course is the party using the equipment
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and making payments to basically rent
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the equipment although with these
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finance lease types sales type or direct
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financing lease really a sale is taking
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place but the three types for the lessee
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would be you could have a short-term
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lease an operating lease or a finance
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lease and then on the lessor side you'll
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either have an operating lease a sales
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type lease or a direct financing lease
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so on the lessee side a short-term lease
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is any lease that's less than 12 months
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and as long as the there's no agreement
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in place where the title transfers to
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the lessee at the end of the the lease
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because then that would be a sale and
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wouldn't need to be accounted for that
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way if it's just basically a rental
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agreement and it's less than 12 months
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the lessee debits lease expense and
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credits cash or accounts payable as the
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monthly payments are made the operating
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lease the lessee is going to record a
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right of use asset and then a lease
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liability account on the balance sheet
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there the lease expense it's a single
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line item as an operating expense in the
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income statement and the lease expense
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is composed of interest plus the
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amortization of the right of use asset
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but again it's presented just as one
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line as an operating expense with a
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finance lease the lessee will also
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record a right of use asset and a lease
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liability account interest and
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amortization expense are presented
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separately on the income statement
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so in a different video we will go
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through the actual accounting for the
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leases the lease payments
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the the right of use asset the
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amortization all those things the lessor
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on the lessor side for an operating
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lease the lessor is going to keep the
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asset on their balance sheet and it
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continues to be depreciated lease
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revenue and depreciation expense are
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presented on a gross basis in the income
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statement for a sales type lease the
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asset is D recognized on the balance
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sheet then they would take the net
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investment in the lease and record that
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the net investment account really what
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that is is the sum of the minimum lease
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payments the sum of the present value of
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the minimum lease payments the net
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investment account is increased by
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interest income and decreased by
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payments collected selling profit or
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loss is recorded at the commencement of
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the lease that's the differentiator
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between this sales type lease and the
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direct financing lease interest income
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is based on the effective rate of
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interest for the lease now for the
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direct financing lease it mostly works
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the same the asset is D recognized on
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the balance sheet and then there's a net
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investment in the lease that's recorded
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the net investment account is increased
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by interest income and decreased by the
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payments collected and again this is
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where it's different the selling profit
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is deferred and any selling loss is
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recorded at the commencement of the
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lease Instron interest income is based
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on the effective rate of interest in the
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lease so now we'll go into some example
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problems for how you would classify
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lease so this first one swift Inc
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entered into a 5-year lease with Taylor
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Inc the lease does not transfer
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ownership at the end of the lease term
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and it includes a purchase option which
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is not reasonably expected to be
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exercised by Swift the leased asset has
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a 10-year economic life no residual
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value the present value of the annual
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lease payments are equal to 80% of the
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assets fair value if the asset has no
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alternative use to Taylor at the end of
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the lease how should Swift classify the
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lease
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would it be classified as a sales type
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lease and operating lease a short-term
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lease or a finance lease now if you want
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you can pause the video and look through
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this make your decision and then we will
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go into the solution right now so the
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answer to this is a finance lease now if
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we come back we're of course talking on
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the lessee side of things so it's a
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finance lease okay so why is it a
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finance lease here's the explanation
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first of all Swift is the lessee in this
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case and Taylor is the lessor if the
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lease is longer than one year then we
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know it's going to be at least or we
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know it's going to be either a finance
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lease or an operating lease so there are
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five criterion for when you're
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evaluating the lease if it meets one of
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the five criteria then it is a finance
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lease and if it's if it doesn't meet any
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of the five criteria then it would be an
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operating lease for the lessee so the
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five criteria does the lease transfer
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ownership of the asset to the lessee no
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it does not
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does the lease contain a purchase option
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which is reasonably expected to be
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exercised by the lessee we saw that the
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purchase option is included but it's not
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reasonably expected to be exercised so
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no is the lease term 75% of the assets
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useful life no it's five out of ten is
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the present value of the lease payments
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at least ninety percent of the assets
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fair market value no we know that that
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is 80 percent of the assets fair value
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so we're all knows so far is the asset
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of such a specialized nature that it has
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no alternative use to the lessor after
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the lease yes the asset has no
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alternative use to Taylor so how should
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Swift classify the lease that is what
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gives us one yes that's all we need so
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this is a finance lease Swift will
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classify this lease as a fine
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Alysse a few other points again if it
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didn't meet any of the five criteria
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then it would be classified as an
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operating lease a sales type lease is
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what the lessor would classify the lease
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as as long as it me as long as it met
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one of the five criteria again a
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short-term lease is any lease that's
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twelve months or less so now we will
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just change the facts a little bit and
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we will do a problem that deals with the
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lessor side of things so the facts are
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the same Swift entered into a 5-year
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lease with Taylor ten-year economic life
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a present value of the annual lease
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payments equal to 80 percent of the
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assets fair value this part is different
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the present value of the annual lease
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payments plus the guaranteed residual
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value equals the fair market value of
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the underlying asset if it is probable
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that Taylor will collect the lease
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payments and the guaranteed residual
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value how should Taylor classify the
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lease would it be a sales type lease an
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operating lease a direct financing lease
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or a finance lease so the answer is a
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direct financing lease the explanation
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again Swift is the lessee Taylor is the
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lessor in this case none of the five
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criteria are met but for the lessor
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there are two more considerations that
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you have to look at before you just
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classify this as an operating lease so
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the first the original five those don't
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apply for the lessor only you then look
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at does the present value of the lease
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payments plus any guaranteed residual
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value equal or exceed the fair value of
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the asset and then the second one is is
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it probable that the lessor will collect
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the payments meaning all the lease
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payments and the guaranteed residual
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value at the end of the lease term if
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both of those are true then the lessor
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has a direct financing lease now again
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if none of these apply
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if none of the five are true and then
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either one of these is not true then it
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is a operating lease for the lessor so
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that's the that's the distinction so at
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this point let's look at this
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hopefully easy-to-understand guide to
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classifying the lease so on this side we
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have the lessee we have the main five
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criteria right here and then you have
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the lessor side that deals with
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everything in green
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let's see everything in red the main
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five criteria for the difference between
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an operating lease or a sales type lease
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which to a lessee is a finance lease so
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on the lessee side is it a yes to any of
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the one through five does ownership
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transfer is the purchase option likely
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to be exercised lease term being greater
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than 75% of the economic life of the
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asset are the lease payments totaling
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greater than or equal to ninety percent
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of the assets fair value and is the
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asset so specialized in nature that it
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is of no use to the lessor after the
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lease if it's a yes to any of those five
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the lessee has a finance lease if it's a
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no to all five then it is a operating
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lease if the lease term is less than
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twelve months and there's nothing about
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the transfer of ownership of the asset
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then it's just simply a short-term lease
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now on the lessor side again if it's a
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yes to any of one through five then you
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have a sales type lease for the lessor
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whereas the lessee again would have a
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finance lease if it's a no to all five
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then you come down here to four six and
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seven again only for the lessor do the
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lease payments the total of the lease
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payments plus the guaranteed residual
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value is that greater than or equal to
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the fair value of the asset if that's a
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yes
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you come to number seven
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is it likely that the lessor will
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collect everything meaning all the lease
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payments and the residual value if those
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are both a yes then the lessor has a
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direct financing lease this is pretty
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rare okay those do exist and you could
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see this on the test but the direct
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financing lease is pretty rare so it's
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either normally it's going to be yes to
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one of these five which gives you a
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sales type lease or if it's no to all
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seven where if it's not yes to any one
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of these five it will usually be no to
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all seven which would give you an
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operating lease whereas both the lessee
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and the lessor have an operating lease
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but this number six and number seven it
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does exist only for the lessor so you do
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have to consider those two things so
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that is the guide to classifying a lease
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based on the criteria we'll do one more
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example problem dimple entered into an
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agreement to lease an ice-cream mixer
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from smile for 10 months for $100 per
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month the fair value of the mixer is 800
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and it's useful life is 24 months
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how should dimple classify the lease
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would that be an operating lease short
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term lease a direct financing lease or a
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finance lease so hopefully you know
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where this is going
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internal entered into an agreement for
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10 months that is the key piece of
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information
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there's nothing mentioned about the
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title or the ownership changing hands at
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the end of the lease so this is a
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short-term lease the lease period is
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less than 12 months this is a short-term
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lease the accounting is very simple
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dimple would debit lease expense and
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credit cash or accounts payable each
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month for the $100 payment and then on
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smile' side they would just be debiting
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cash and crediting lease revenue for
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$100 each month and if you'd like more
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help with your CPA process you can get
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our free guide that will help you start
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the process and avoid making very costly
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mistakes it's called the busy candidates
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this is tailored towards how to fit in
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you're extremely busy and working full
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