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Lease Classification Questions for FAR CPA Exam
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May 3, 2024
Pass your CPA exams faster with this free training: https://www.superfastcpa.com/passnow In this video we'll walk through lease classification example questions for lease accounting on the FAR CPA exam. We cover short term leases, finance leases, operating leases, sales-type leases, and direct financing leases, both from the lessee and lessor side. Important Links: Don't have a review course yet? The best thing you can do is get a free trial from several courses and see which one YOU like the best. Get free trials from the top 3 courses here: Wiley CPAexcel: https://www.superfastcpa.com/cpaexcel Roger CPA: https://www.superfastcpa.com/rogerreview Surgent CPA: https://www.superfastcpa.com/surgent Get our free guide "The Busy Candidate's Guide to Passing the CPA Exams Fast" and 500 Free MCQs here: https://www.superfastcpa.com/free Also check our podcast, the CPA Exam Experience podcast on iTunes here: https://cpa-exam-experience-superfastcpa.captivate.fm/listen Or just search "superfastcpa" in your favorite podcast app and you'll find it. Here's some of our popular videos: The question I get asked the most:
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In this video from SuperfastCPA, we're going to cover leases, how to classify leases
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So first, when you're looking at a problem, you want to know if you are dealing with the
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accounting side for the lessee or the lessor. So the lessee, of course, is the party using the equipment and making payments to basically
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rent the equipment. Although with these finance lease types, sales type, or direct financing lease, really a
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sale is taking place. But the three types for the lessee would be, you could have a short-term lease, an operating
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lease, or a finance lease. And then on the lessor's side, you'll either have an operating lease, a sales type lease
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or a direct financing lease. So on the lessee side, a short-term lease is any lease that's less than 12 months
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And as long as there's no agreement in place where the title transfers to the lessee at
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the end of the lease, because then that would be a sale and would need to be accounted for
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that way. If it's just basically a rental agreement and it's less than 12 months, the lessee debits
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lease expense and credits cash or accounts payable as the monthly payments are made
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The operating lease, the lessee is going to record a right of use asset and then a lease
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liability account on the balance sheet. The lease expense, it's a single line item as an operating expense in the income statement
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and the lease expense is composed of interest plus the amortization of the right of use asset
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But again, it's presented just as one line as an operating expense
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With a finance lease, the lessee will also record a right of use asset and a lease liability account
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Interest and amortization expense are presented separately on the income statement. So in a different video, we will go through the actual accounting for the leases, the
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lease payments, the right of use asset, the amortization, all those things
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The lessor, on the lessor side, for an operating lease, the lessor is going to keep the asset
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on their balance sheet and it continues to be depreciated. Lease revenue and depreciation expense are presented on a gross basis in the income statement
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For a sales type lease, the asset is derecognized on the balance sheet
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Then they would take the net investment in the lease and record that
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The net investment account, really what that is is the sum of the minimum lease payments
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the sum of the present value of the minimum lease payments. The net investment account is increased by interest income and decreased by payments collected
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Selling profit or loss is recorded at the commencement of the lease
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That's the differentiator between this sales type lease and the direct financing lease
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Interest income is based on the effective rate of interest for the lease
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Now for the direct financing lease, it mostly works the same. The asset is derecognized on the balance sheet and then there's a net investment in the lease
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that's recorded. The net investment account is increased by interest income and decreased by the payments collected
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And again, this is where it's different. The selling profit is deferred and any selling loss is recorded at the commencement of the lease
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Interest income is based on the effective rate of interest in the lease
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So now we'll go into some example problems for how you would classify a lease
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So this first one, Swift Inc. entered into a five-year lease with Taylor Inc
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The lease does not transfer ownership at the end of the lease term and it includes a purchase
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option, which is not reasonably expected to be exercised by Swift. The leased asset has a 10-year economic life, no residual value
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The present value of the annual lease payments are equal to 80% of the asset's fair value
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If the asset has no alternative use to Taylor at the end of the lease, how should Swift
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classify the lease? Would it be classified as a sales-type lease, an operating lease, a short-term lease, or
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a finance lease? Now if you want, you can pause the video and look through this, make your decision, and
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then we will go into the solution right now. So the answer to this is a finance lease
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Now if we come back, we're of course talking on the lessee side of things
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So it's a finance lease. So why is it a finance lease
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Here's the explanation. First of all, Swift is the lessee in this case and Taylor is the lessor
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If the lease is longer than one year, then we know it's going to be either a finance
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lease or an operating lease. So there are five criterion for when you're evaluating a lease
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If it meets one of the five criteria, then it is a finance lease
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And if it doesn't meet any of the five criteria, then it would be an operating lease for the lessee
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So the five criteria. Does the lease transfer ownership of the asset to the lessee
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No it does not. Does the lease contain a purchase option which is reasonably expected to be exercised by
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the lessee? We saw that the purchase option is included but it's not reasonably expected to be exercised
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So no. Is the lease term 75% of the assets useful life? No
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It's 5 out of 10. Is the present value of the lease payments at least 90% of the assets fair market value? No
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We know that that is 80% of the assets fair value. So we're all no's so far
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Is the asset of such a specialized nature that it has no alternative use to the lessor
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after the lease? Yes. The asset has no alternative use to Taylor so how should SWIFT classify the lease
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That is what gives us one yes. That's all we need. So this is a finance lease
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SWIFT will classify this lease as a finance lease. A few other points
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Again, if it didn't meet any of the five criteria then it would be classified as an operating lease
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A sales type lease is what the lessor would classify the lease as as long as it met one
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of the five criteria. Again, a short term lease is any lease that's 12 months or less
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So now we will just change the facts a little bit and we will do a problem that deals with
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the lessor side of things. So the facts are the same. SWIFT entered into a five year lease with Taylor
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Ten year economic life. A present value of the annual lease payments equal to 80% of the assets fair value
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This part is different. The present value of the annual lease payments plus the guaranteed residual value equals
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the fair market value of the underlying asset. If it is probable that Taylor will collect the lease payments and the guaranteed residual
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value, how should Taylor classify the lease? Would it be a sales type lease, an operating lease, a direct financing lease, or a finance lease
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So the answer is a direct financing lease. The explanation. Again, SWIFT is the lessee, Taylor is the lessor
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In this case, none of the five criteria are met. But for the lessor, there are two more considerations that you have to look at before you just classify
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this as an operating lease. So the first, the original five, those don't apply
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For the lessor only, you then look at, does the present value of the lease payments plus
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any guaranteed residual value equal or exceed the fair value of the asset
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And then the second one is, is it probable that the lessor will collect the payments
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meaning all the lease payments, and the guaranteed residual value at the end of the lease term
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If both of those are true, then the lessor has a direct financing lease
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Now again, if none of these apply, if none of the five are true, and then either one
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of these is not true, then it is a operating lease for the lessor
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So that's the distinction. So at this point, let's look at this hopefully easy to understand guide to classifying a lease
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So on this side, we have the lessee, we have the main five criteria right here, and then
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you have the lessor's side that deals with everything in green. Lessee, everything in red, the main five criteria for the difference between an operating lease
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or a sales type lease, which to a lessee is a finance lease
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So on the lessee's side, is it a yes to any of the one through five
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Does ownership transfer? Is the purchase option likely to be exercised? Lease term being greater than 75% of the economic life of the asset, are the lease
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payments totaling greater than or equal to 90% of the assets fair value, and is the asset
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so specialized in nature that it is of no use to the lessor after the lease
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If it's a yes to any of those five, the lessee has a finance lease
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If it's a no to all five, then it is a operating lease
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If the lease term is less than 12 months and there's nothing about the transfer of
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ownership of the asset, then it's just simply a short term lease
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Now on the lessor's side, again, if it's a yes to any of one through five, then you have
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a sales type lease for the lessor, whereas the lessee again would have a finance lease
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If it's a no to all five, then you come down here for six and seven
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Again, only for the lessor. Do the lease payments, the total of the lease payments plus the guaranteed residual value
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is that greater than or equal to the fair value of the asset
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If that's a yes, you come to number seven. Is it likely that the lessor will collect everything, meaning all the lease payments
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and the residual value? If those are both a yes, then the lessor has a direct financing lease
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This is pretty rare. Those do exist and you could see this on the test, but the direct financing lease is pretty rare
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Normally, it's going to be yes to one of these five, which gives you a sales type lease
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or if it's no to all seven, where if it's not yes to any one of these five, it will
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usually be no to all seven, which would give you an operating lease, whereas both the lessee
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and the lessor have an operating lease. But this number six and number seven, it does exist only for the lessor, so you do have
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to consider those two things. So that is the guide to classifying a lease based on the criteria
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We'll do one more example problem. Dimple entered into an agreement to lease an ice cream mixer from Smile for 10 months
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for $100 per month. The fair value of the mixer is 800 and its useful life is 24 months
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How should Dimple classify the lease? Would that be an operating lease, short term lease, a direct financing lease, or a finance lease
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So hopefully you know where this is going. Entered into an agreement for 10 months
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That is the key piece of information. There's nothing mentioned about the title or the ownership changing hands at the end
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of the lease, so this is a short term lease. The lease period is less than 12 months
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This is a short term lease. The accounting is very simple. Dimple would debit lease expense and credit cash or accounts payable each month for the
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$100 payment. And then on Smile's side, they would just be debiting cash and crediting lease revenue
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for $100 each month. And if you'd like more help with your CPA process, you can get our free guide that will
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help you start the process and avoid making very costly mistakes. It's called the Busy Candidate's Guide to Passing the CPA Exams Fast
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This is tailored towards how to fit in enough study time each day, even if you're extremely
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busy and working full time. You can get it at superfastcpa.com slash free, or just text FASTCPA to 44222
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YouTube so that you stay updated with those. Thank you for watching and we'll talk soon
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