Tuesday, June 28, 2022

Finance Lease Vs Operating Lease (Lessee’s Perspective)

Hello and welcome to this session in which we will discuss the difference between finance lease and operating lease financially sometime called a capital lease now before we proceed i would like to remind you what we did in the prior session we talked about what is the lease advantages of leasing and the players in the leasing industry.

Now we're going to look at what is a finance or operating lease regardless whether a company classifies a lease as a finance lease or as an operating lease in both situation leases are capitalized now why am i saying this because in the past and hopefully you don't remember this because this was maybe a few years ago the old rules under.

Operating lease you did not have to capitalize the lease but what does capitalize mean it means every time you have a lease you have to put an asset on the book and a corresponding liability well based on the old rules which is you don't have to worry about but the reason i'm giving.

You the old rules because it's going to help you in understanding why we do certain things based on the old rules if the lease was an operating lease you did not have to have an asset and a liability if that was the case now you have to have an asset and a liability whether you have a finance.

Lease or an operating lease now why would why would that be important because companies we would would try everything to do to classify the lease as an operating lease this way they don't have to put the liability or the asset now they like the asset but they don't like the liability so they prefer to keep both out that's not an option.

Anymore all leases now are capitalized also i'm going to start by talking from lsc's perspective from the renter and we'll talk about the less so later whether we have a finance or an operating lease and we're going to see the rules shortly here's what you need to know for a finance lease the lsc will have two expenses.

They will have an expense called interest expense obviously a lease is like a loan you're gonna have to incur interest expense on the lease and you're gonna be using the effective interest rate method so that effective interest rate method that's one expense the second expense is once you have an asset you're gonna depreciate you're gonna.

Amortize the asset on the right to use using the straight line method so you're gonna have two separate expenses for operating leases you're going to have one expense and you're going to recognize interest expense again you have a liability you have to recognize interest expense and you're going to amortize the right of use asset however.

Both of these expenses will be show showed showing in one expense called total lease expense and it's going to be the same from period to period so notice we have technically here under operating these two expenses but we show them as one expense under finance lease we're going to have two expenses just make sure you're aware of.

This when we start to work with actual examples so how do we classify a lease whether it's an operating lease or a finance lease because that's the that's the purpose of the session where we're going to look at substance over form we don't care what's in the agreement we're going to look at the substance of the.

Agreement if the agreement if the arrangement is effectively a purchase of the underlying asset then we have a finance lease so if the agreement technically gives purchase the asset rather than rent the asset then we have a lease how do we know that we purchase the asset there's a transfer of control or ownership.

How do we know that we have a transfer of control or ownership well simply put the less c takes ownership of the asset basically they take it they keep it or they consume the substantial portion of the underlying asset if they don't take ownership of it they used it they used.

Most of it like basically the asset is no longer useful for someone else or for the asset life technically they used all its life all its economic life well if not if if we don't take control or ownership of the asset then we have an operating lease again we look at substance over form now.

We have to be a little bit more specific i have not answered the question i'm just telling you what do we do whether we have an operating lease or a finance lease well we're going to look at condition actually it's one condition or it could be many conditions but you just need one condition to have a finance lease if you.

Have a finance lease then it's a finance lease if it's not a finance lease it's going to be an operating lease now what are those condition or conditions you just need one before we look at the conditions most likely you are an accounting student or a cpa candidate if you're listening to my lectures which is great you have.

Arrived i can help you visit farhad lectures.com i have additional resources lectures organized by your cpa review course organized by your college course multiple choice questions true false exercises that's going to help you do better i don't replace your cpa review course i'm going to help you i'm going.

To be in addition to that resource connect with me on linkedin if you haven't done so like this recording share it with other if it's helping you it's going to help other connect with me on instagram facebook twitter and reddit so what are the conditions that will help us determine whether a lease is a finance lease well the first thing we.

Have to have is an agreement between the two parties and that agreement cannot be cancelable and if it's cancelable there's a large penalty but simply put we have a legitimate agreement and we must meet one notice one of five conditions or what we call test remember only one so what are those tests or those conditions that we need to be.

Aware of first condition transfer of ownership test what does that mean we have to ask ourselves after the lease end do we transfer the asset to the last c by the end of the term so once the this is over would the let's see would the renter.

Take ownership if the answer is no i'm sorry if the answer is yes we have a finance lease if the answer is no we don't have a finance lease think if you rent an apartment if you rent an apartment after one two three years the ownership goes back to the to the owner you don't own it versus sometime when you lease a car at.

The end of its life although it's a lease they will give you the keys because we basically paid all of it so is there a transfer of ownership and let's assume we have an agreement and there's no transfer of ownership well we failed this test well that's only one out of five tests we failed this test the second test is a purchase option.

Test what is a purchase option test here what we're looking at is is there and is there an offer for a bargain to be specific a bargain purchase price that's reasonably to be exercised what does that mean let's assume you bought a vehicle a bmw a mercedes tesla whatever and you leased it for five years.

And after five years they tell you if you pay three thousand dollar you can keep the car and we all know after five years this car is worth for example ten thousand dollar any reasonable person will exercise this option we'll exercise this three thousand dollar because it's a bargain purchase no one will say no so if the.

Answer is yes we have a finance lease we're gonna say no we don't have a purchase option test so the the answer is no and usually on the exam they use a bargain purchase you're looking for a bargain purchase not any purchase you need a bargain that's going to entice you to buy it they're giving you the option.

To buy it because you have the right since you lease that you have the right to buy it so we're gonna fail this test let's look at the third test lease term test well we looked at the lease term how many what's the period is the lease term for a major part of the remaining economic life of the lease so simply put you are leasing this asset.

And this asset has a 10-year economic life how many years are you leasing this asset is it six years seven years eight years simply put if you are looking if you are for the major part of the economic life and how do we define the major part for us gab they use 75 percent or more so if you're going to have this asset for.

Seven and a half years out of its 10-year life well guess what you technically bought it it's yours you consume most of its economic life so we're going to assume here now we have a six year life we failed that test if we failed that test it's not a finance lease yet option four present value test well.

Here's what we're gonna do we're gonna compute the present value of the payments remember the lease will include payments you have to make payments series of payments those payments could be ordinary or annuity depending on ordinary annuity or i know what you do or they.

Could they could vary but it's simply you are looking at payment we use the present value computation using asserting interest rate which going to talk about which interest rate do we use in a moment and we add to that any guarantee residual value we'll talk about residual value not included in the payment so we compute the present value.

So why do we compute the present value we're going to compute the present value and compare the present value to the fair value and we ask ourselves is the present values let's assume we have an asset with a fair value of a hundred thousand so if you want to buy it today you pay a one hundred thousand what we did is we computed the present.

Value of the payments whether it's ordinary ordinary guarantee residual value blah blah blah and we find out the present value is ninety two thousand well ninety 000 is 92 percent of the fair value so if the present value greater than 90 of the answer is yes we have a finance lease if the answer is no let's assume we find out that it's only.

85 percent then you did not really pass that present value test that's the fourth test and we're going to assume here you failed that test so so far we don't have a finance lease yet the fifth and last test is the alternative use test well we ask ourselves is the asset of a specialized nature.

What does that mean it means once you are done with this asset it's so specialized even if you return it to the lessor they cannot sell it they cannot use it for anything else it's so specialized to your company if the answer is yes it's so specialized to your company we have a finance lease if the answer is no.

The lessor can do something with it then it's not a specialized nature because they can either use it themselves or lease it again for another company so if we fill all these tests if we fill all five guess what we have an operating lease when do we have a finance lease we need to meet one of them one of the five one of the we need.

To have one yes so notice here we need to have only one and one now what else do we have to know let's talk a little bit more about the lease term the lease term can be extended by the existence of a bargain renewal option what does that mean let's assume adam can lease a piece of equipment for a thousand dollars per month for the first two years then 100.

For the following two years well this is practically a bargain renewal option so so rather than paying a thousand dollars per month you're paying 10 percent how many years is this least herb it's four years so just know that if there's this bargain you use the bargain years also we need to be aware of present value tasks a little bit more what the first.

Thing is your payments could be fixed or variable payments means it could be the same payment every month different payments and the interest rate it could be fixed or variable interest rate for the purpose of the cpa exam usually they keep it simple fixed payment the annuity could be ordinary or i know what you do and.

That's why you need to be very familiar very familiar with the time value of money if not go to forehead lectures.com subscribe and learn about this your interest rate could be based on some sort of an index for example the consumer price index which was published today and we are experiencing an 8.5 inflation.

And it's rising so simply put your payment last year could have been a thousand this year you have to add 8.5 percent because the interest rate went up so your interest payment could be higher because based on the cpi you have to include the guarantee residual value in your present value in.

Your present value computation you have to include any purchase or termination option that are reasonably expected to be to occur if that's the case if you ever if you have a purchase option you have to include it in your present value computation and which discount rate do we use because that's important when you're doing present.

Value you have to use some sort of an interest rate which discount rate do we use well well the first thing is the implicit rate of the lessor if known what does that mean it's how much is the seller is the lessor charging us assuming we know this assuming we know this this is the interest rate that we use to compute.

The present value let's assume we don't know this information well we use then the incremental borrowing rate what is the incremental borrowing rate the incremental borrowing rate is what rate do we get charge if we go if we walk into a bank today asking them to asking them to borrow money to buy this.

Piece of asset well how much will the bank charge based on our credit rate credit history liquidity risk so on and so forth how much will they charge us well they charge us eight percent we use eight percent first the implicit rate if we know this that's great not it's the incremental borrowing rate.

What should you do now go to forehead lectures dot com work multiple choice true false exercises in the next session we're gonna start to look at actual examples that deals with finance leases operating leases this is an important topic whether you are a student or a cpa candidate don't shortchange yourself subscribe i can help you learn the.

Material it's an investment in yourself good luck and study and stay safe

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