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hello and welcome to the session this is Professor Farhad in this session we're going to look at additional features of lease arrangement some of them are important some of them are not as important at the prior session we look at the residual value I believe this is important we're gonna look at other least adjustments yes they are important but they're not as important as the bargain purchase option which we'll see most common on the CPA exam we're gonna look very briefly at the short-term leases and presentation and disclosure in this session before we proceed sorry I always show you what we did in the prior sessions so we did we have five different sessions that deals with Lisa starting with introduction to Lisa's finance leases for the lessee finance leases for the lessor operating leases for both lessee and result and the prior session we looked specifically at the residual value so we did cover this session now we're gonna be looking at other features that deals with leases the first thing we're going to look at is other adjustments and one of them is called executory cost what our executory cost and we need to know how they are treated it's that's also important especially if you're taking the CPA exam they may try to trick you executive costs are normal expenses associated with owning a leased asset such as property insurance and property taxes now how do we how do we handle an executory cost so how that how do we handle executor recourse well if executory costs are included and the fixed payment required so notice they are required they're part of the payment by the lessor so if you have to pay if they are part of the payment okay they should be included in the lease payment for the purpose of measuring the lease liability if they are part of the payment now what if they are not part of the payment payment by the lessee made directly to the taxing authority to the insurance company or to maintain repair and maintain the asset those are expensed so you have to be very careful why if they are part of the payment which is the scenario then what we do they are part of the lease liability so on you when you compute your when you compute you the present value you include them here you don't include them when you pay them directly to a third party when you pay them and Alessi paid them the person that's renting the asset paid them to a third party then they are not included in the lease liability they are considered an expense now why am i emphasizing this so sometime on the CPA exam they will tell you your payment is five thousand which include $1,000 that you pay directly to the taxing authority then guess what if you pay directly to the taxing authority you do the present value for a four thousand dollar payment but if they said five thousand five thousand dollar payment basically mandatory to the last sword which is include everything then then the payment is five now so so you have to be careful how they if it's included or you're paid to a third party lease prepayments and incentives so sometime what you do is you prepaid the lease or the lessor might give you incentive to do what to sign up for the lease so company adjusts the right of use of the asset which is there they adjust the asset for any asset for any lease prepayment lease incentive and initial direct cost so three things we have to be kind of know what the rules are for prepayments lease pre payments made by the lessee increase the right of the use of the asset so you make any lease prepayment it's gonna increase your asset least incentive payments made by the lessor to the lessee obviously it's gonna reduce the right of the use of the payment so if you pay for the asset upfront it's gonna increase the asset if the lessor gives you a reduction or they give you some sort of an incentive it's gonna reduce your cost therefore it's gonna reduce your asset then we're gonna have to look at initial direct cost incurred by D let's see okay so what are the initial direct costs we're gonna look at them first but the initial direct cost this is the general rule included by the lessee and we're gonna see what those initial direct cost is generally speaking they increase the asset they increase the asset so let's take a look at the initial direct cost what are the initial direct costs think about the cost that you incur because of this lease the necessary cost you incurred because you wanted to sign for deceased so those are incremental cost of a lease that would not have been that would not have not not then anchored if you if the lease was not been executed so if you did not execute the lease those cost would not exist this is what we my incremental cost think of this as the when we when we dealt with interest capitalisation the additional interest that you incur because you undertake this project is the incremental interest course here's the incremental interest cost is the cost that you include because you sign for that lease okay so what are some examples example of cost included annex occluded we're gonna see on the next slide by the lessee and the lessor so here's how it works what do we include and notice what we include and what we execute that makes sense we include Commission's including payment to employees acting as selling agent we include them legal fees resulting from the execution of the lease notice you are executing the lease lease document preparation cost incurred after the lease is executed consideration paid for a guarantee residual value by the unrelated party we're gonna see what this is later on but if that's the case it's included what do you execute the execute employee salaries you execute internal engineering cost that's to manufacture the asset you exclude legal fees for services rendered before the execution of the lease so notice you're including stuff that's happening after the lease has taking place negotiation lease term and conditions notice here you're still negotiating you did not really finalize the lease so it's an expense advertising cost depreciation costs related to idle assets because the asset is not being used it hasn't been leased yet those are exit executed executed let's take a look initial indirect cost incurred by the lessee now we are looking at the renter okay let's take a look at what do we need what do we need to do with those those are included in the cost of the right of the use of the asset but are not recorded as part of the liability so they are added to the asset but not liability okay so let's sort accounting now for the lessor now would the lessor it means the seller for the initial direct costs depending on the type of the lease for operating lease here's what we do with the operating lease LS or the third the initial cost and advertise them as an expense over the life of the asset so for the initial cost they're gonna be in a set and we will defer them there'll be the third as an expense so there will be amortized over the life of the asset if it's a finance lease for a sales type lease which is a finance lease the less sword expense initial and direct cost at the lease commencement why because they are expense to sell the asset if you really think about it I made an effort I incurred cost to sell the asset well in this situation I'm leasing the asset but as we said it's a finance leases like it's like an expense if I'm making an effort to to sell the asset I'm gonna expense it so that's why we expense them under the sales side please because they're considered the selling expense for the lessor the net the next thing we can look at is a bargain purchase option and what is a bargain purchase option if you remember one of the five conditions is we have the option to buy the asset and I always mentioned the option is a bargain purchase option bargain purchase option means what it means after B after three years or after five years the after five years we have the option to buy the asset at a reduced price reduced price so what happened is after five years the seller tells you you can buy this asset for $100 so that's assume it's a BMW 10 I don't know I am keep using BMW and the value of that BMW in five years it's estimated to be five thousand and they're telling you you're gonna you can buy it for a hundred well this is a bargain purchase option right so you're gonna go ahead and buy it this is what we mean by this well the bargain purchase option allowed allows the lessee to purchase the lease property for a future price that's substantially lower than the asset expected fear value I just explained it to you if a bargain purchase price exists if it exists the lessee must increase the present value of the lease payment by the present value of the option price when we calculate the present value we have to include in the present value computation the bargain purchase option so really that lets that samurai sodium-cooled in the present value include the payment the regular payment you include also after a guaranteed residual value remember if it's G residual value of the guaranteed residual value remember we have certain rules for this and you include also if there's a bargain purchase option so notice the present value could include three things the payment they guarantee residual value and the bargain purchase option again the guaranteed residual value depending if you're gonna if you're gonna have the fee if it's probable or you're gonna be short of the guarantee value look at the guarantee residual value session so this this is important for the eggs for the CPA exam just you need to know how do we deal with the bargain purchase option and again it's only from the lessees perspective not from the lessor because the lessee is responsible for that short-term leases were our short-term leases Elise and at the commencement of the date have 12 months or less what do we do with those we don't recognize an asset we don't recognize a liability basically what we do is we it's a regular expense we debit an expense and we credit cash basically okay renewal or termination options that are reasonably certain of exercised by the lessee are included in the lease term if there's anything like this it's included in the lease term but if it's less than 12 months it's basically in excess now let's take a look at the presentation and disclosure analysis and hopefully this is gonna put everything together summary of the lesson off would look at the lessee Spurs it's the render what does the lessee shows if it's a finance lease if it's a finance lease on the balance sheet they have to show the asset they have to show the liability if it's an operating lease they have sure to show an asset they have to show the liability under the old rules this did not exist under the old rules but now you have to put the asset and the liability on the books on the income statement you have an amortization expense you have an interest expense so you break down your expenses and amortization expense in an interest expense under the operating lease you only show an expense let's call lease expense now within the lease expense it's included the amortization and the interests are included but they are they are part of the lease expense you don't show them separately okay and we looked at this when we did work an example this is the presentation from the LES so what does the lessor shows on their balance sheet what was the when does the left sauce shows on the under income statement if it's a sale slide please they're going to show a receivable presented as a separate asset from all the other assets and they will they recognize the leased asset that means they remove the asset from their books they they they D recognize that and what's gonna happen they're gonna from the lease they're gonna have interest in revenue every year and the first year they're gonna have a profit when they sell the asset for example if they sold it for 100,000 the cost of a eighty-five they're gonna have a profit of fifteen this is year one it gets recorded in year one then the interest revenue will be for every year over the lease of the asset if it's an operating lease easy we continue to recognize the asset simply put we still have the asset we did not sell it subject to operating leases as property plant and equipment basically it's part of our property plant and equipment therefore we're going to recognize revenue from the from the lease on a straight-line basis basically we're recognizing revenue from the payment and we're still gonna depreciate the asset because we still have the asset on the books obviously if we have it we have to depreciate it disclosure what do we have to disclose less see endless soul must also provide additional qualitative and quantitative disclosure both numbers and explanation to help the financial statement users assess the amount timing and uncertainty of future cash flow because you want to help them understand you know what's our future cash flow they have to disclose the nature of its leases include in general description of the leases how variable payments are determine if there's variable payment the existence and terms conditions for options to extend or terminate the lease and residual value guarantees all this information will be in the notes information about significant assumptions in judgment and again the best way is to look at an annual annual financial statement and look at a sample additional disclosure by the lessee a quantitative information this is quantitative the dollar amount the total cost for the lease the finance lease cost segregated between the amortization of the right to use and interest remember if it's a finance this you have to break it down operating and short to operating and short-term least cost if you have short term lease cost show them separate from operating the weighted average remaining list and the weighted average of the count rate if they have more than one least you have to find out what's the weighted average discount rate for your leases the maturity analysis our finance and operating lease liability on annual basis of the minimum of five years and this makes sense leases if you think of leases leases are similar to that so what happened when you have a debt you have to show you the payment for the next five years so for leases you have to do the same thing you're responsible for doing so for the lessor what are some quantitative information and leased simulated income including profit and sale when the lease commences any interest income throughout the life of the lease income from the variable lease payment that there is very beliefs payment the component of the net investment in sales lease type maturity analysis of operating lease payment and separate maturity analysis for leases receivable management approach for risk associated with the residual value how do we how do we account for residual value if we have any type of risk management approach buyback arrangement or third-party insurance of any buyback arrangement or third-party insurance those are just basically disclosure okay analysis now this is gonna change a lot this is gonna change a lot what do I need might change a lot going forward when we grunt one when we run certain numbers when we run certain numbers or when we run certain ratios give us different figures based on the noodles with the increase of the in the use of asset and liability a number of financial metrics used to measure the profitability and solvency will change the first one is return on asset will will decrease what's happening now because we are adding an asset remember if it's what other finance or finance or an operating lease you have to debit an asset credit a liability you have more assets so your return on asset will decrease if you have more assets then your return on asset will decrease because the income is now spread over more what's return on asset it's some sort of a profit or earnings before interest and taxes depending on he computed it doesn't matter what's in the numerator divided by asset now your assets are increasing because you're adding more assets therefore if you add in more to the denominator your your ratio will go down so your return on asset will decrease your earnings before interest are depreciation and amortization would likely require some adjustments as companies amortize the right of the use of the asset remember if you have the asset you're gonna amortize it because you have to amortize it when you amortize it earnings before interest taxes and depreciation and amortization you're gonna look at it differently because your future amortization will go up so suddenly suddenly companies will have more amortization and the reason is because now they have an act a new asset that's the right to use of the right of use asset which is the leased asset and they have to memorize that to equity ratio will increase you simply put what's gonna happen is if you debit an asset and credit a liability well if your if your ratio is debt to equity and what happened if you're adding more liabilities because you're crediting new liability guess what your debt ratio will go up which is not good that to equity ratio will go up so for example in the past you might have only $100 of that now you you're gonna add ten dollars now you have one hundred and ten dollars your equity will stay the same then assuming your equity stay the same generally speaking then your debt to equity will go up and your interest coverage ratio will decrease of course because if you're increasing your expenses if you're having more amortization expense your interest coverage goes down because the more expenses the less is your interest coverage and this is again this is those are the noodles and we're gonna see how this this is gonna happen in the future in the next session most probably what I would do is work an example it basically emphasize what we learn up to this point and what I mean up to this point is basically maybe I will work an example that's gonna wrap up everything that we did up to this point so I'm gonna be adding this session here and actually up to this point we are I believe we are here so this is gonna be the sixth session that the seventh will be most most probably I'll try to work an example that's gonna emphasize some of the stuff that we learn up to this point if you have any questions any comments make means email me or see me in class if you're studying for your CPA exam always always always study hard and please subscribe and share