Leases 2: Lessee’s Subsequent Accounting

In this video, we’ll continue to look at
a finance lease as the lessee, the renter. We just did the journal entries at commencement
for a finance lease. Let’s pick up where we left off. And focus on the journal entries after commencement. Which means that time has elapsed. And what happens with the passage of time? Accruals. For finance leases we have two primary accruals. Interest and amortization. Let’s see how this works with an example. [Transition] The prompt reads: “On January 1, Y1, Lessee leases a machine
from Lessor for 3 years.” This tells us it’s a lease question. An important part of the exam is organizing
the information they give you and anticipating where the question is going. Here, let’s organize the lease provisions. We just read that the lease term is 3 years. Back to the prompt. “The lease terms include annual payments
of \$100,000 starting at commencement.
And then to be made on December 31 before each year of use. The present value of the annual payments is
\$283,339. The machine's fair value is \$300,000 and its useful life is 4 years. Lessee depreciates using the straight-line
method. Lessee knows the implicit rate of the lease
is 6%.

Provide Lessee’s journal entries at December
31, Y1.” This sounds familiar. We just did the journal entries for January
1, Y1, in the prior video. Now, the question stem asks for lessee’s
journal entries at December 31, Y1. The end of the first year. And it’s asking for Lessee’s journal entries. Make a note. Who’s the lessee again? The prompt says, “Lessee leases a machine
from Lessor.” That means that Lessor initially had the machine. Lessor is the owner. Then Lessee is the renter, who pays to use
the machine. And we said that this is a finance lease. Which means, it looks like a rental. But, it’s really a purchase with a loan. Let’s set up a chart for the loan calculations. There are 5 columns. But don’t worry. Most of them are just rote. Like column 1, Date. Column 2, Payment. Column 3, Interest Expense. Put the 6% rate at the top of the column,
so it’s easier to see.

Column 4, Lease Liability Reduction. And Column 5, Lease Liability Balance. Let’s start the date column with the commencement
date, 1/1/Y1. The prompt says that annual payments start
at commencement, 1/1/Y1. Then they move to December 31, before each
year of use. So, the lease starts on 1/1/Y1. Then on the same date, Lessee makes the first
payment for use of the machine in year 1. Note, when you make a payment at the beginning
of the period, we call it an annuity due. It’s like paying rent on your apartment. You pay on the first, the beginning of the
month, for that month you live in your apartment. Here, we’re paying on January 1st, the beginning
of the year, for the first year we use the machine. The next payment is on December 31, Y1, to use the machine in year 2. And the last payment is on December 31, Y2, to use the machine in year 3. Then, the lease ends on December 31, Y3. The next column is the payment. And it’s the same each time, 100,000. Plug it in down the line. 1/1/Y1 100,000. 12/31/Y1 100,000. 12/31/Y2 100,000. Next, let’s do the lease liability balance
at commencement.

In the prior video, we made these journal
entries at commencement. We recorded the lease liability at 283,339. Note, the lease liability is the amount lessee
still owes in lease payments. This lease is for 3 years, which makes it
a noncurrent liability. And like other noncurrent liabilities, we
record this at present value. So, the lease liability is the present value
of the lease payments lessee still has to make. Essentially, it’s the loan principal. Here, the only lease payments we have are
the annual payments. Discounted to present value they equal 283,339. That’s our beginning balance. Starting with our first payment on 1/1/Y1, Note, part of the payment goes to interest
and the rest gets plugged to the principal, the lease liability.

For interest, let’s put in zero. Because interest is an accrual. It occurs with the passage of time. On 1/1/Y1, no time has passed. Then there is no interest expense. That means that the entire payment, 100,000, gets allocated to lease liability, our loan
principal. Then the lease liability balance is calculated
as 283,339. Minus the lease liability reduction 100,000. Equals 183,339. And that makes sense. If you make a payment at the beginning of
the period, none of it goes to interest. It all goes to the loan principal,
which is called lease liability. Next, 12/31/Y1. A full year has passed. We can accrue for interest expense. That’s the previous period’s lease liability
balance 183,339 times the 6% rate. Equals 11,000. This means that of the 100,000 payment, 11,000 is allocated to interest. Then the remainder goes to lease liability,
the loan principal.

Calculated as 100,000 minus 11,000 Equals 89,000. This reduces the lease liability, the loan
principal. Calculated as the prior period’s ending
balance 183,339. Minus this period’s lease liability reduction
89,000 equals 94,339. Next, 12/31/Y2. Another year has passed. We can accrue for interest expense. That’s the previous period’s lease liability
balance 94,339 times the 6% rate. Equals 5,661. Okay, it really equals 5,660, but I’m just going to round up here to 5,661. This means, that of the 100,000 payment, 5,661 is allocated to interest. Then, the remainder goes to the lease liability,
the loan principal. Calculated as 100,000 minus 5,661 Equals 94,339. Which reduces the lease liability, the loan
principal. Calculated as the prior period’s ending
balance 94,339. Minus this period’s lease liability reduction
94,339. Equals zero. Woohoo! Don’t be shy. We’re accountants. That zero made us all feel warm and fuzzy. Before we celebrate too much, let’s do our
journal entries. It’s 12/31/Y1. A full year has passed since commencement. And what do we get with the passage of time? Accruals! The lessee has 2.

First, for interest and second, for amortization. Let’s start with the interest accrual. Which we calculated as 11,000. We’re the lessee, the renter paying to use
the machine. That’s going to be interest expense, increasing. Debit. What’s the other side of the entry? Lessee is making a payment for 100,000. When you make a payment, you pay with cash.

That’s cash decreasing. Credit. Are we done? We still have a difference and it’s on the
debit side. It’s the difference between the cash payment
100,000 And interest expense 11,000. Which equals 89,000. What’s this for? *Counting clock sound* The lease liability reduction. Which makes sense. We made a 100,000 payment, Of which 11,000 is allocated to interest. Then the rest goes to the lease liability,
our loan principal. Next, the amortization. Remember, this is a finance lease. It’s really a purchase with a loan. When we recorded the lease at commencement,
We recorded an asset, just like a purchase. Only we recorded it as
a “right of use” asset. That’s an intangible that represents the
right to use the leased asset.

And just like other assets we purchase,
we depreciate the right of use asset. The only tweak is,
instead of depreciating the actual machine. We amortize the intangible, the right of use
asset. Which we recorded as 283,339. The prompt tells us that Lessee depreciates
straight-line. Then the question becomes do we amortize over
the lease term, 3 years. Or the useful life, 4 years? Here’s the rule. Amortize over the shorter of the lease term
or the useful life. Except! There’s always an exception. Except, if you hit Criteria 1, ownership transfer or Criteria 2, reasonably certain purchase option. Then use the useful life. Why do we do that? Because in these two cases, the lessee actually
buys the asset. At the end of the lease, the lessee takes
the asset and it belongs to the lessee. Well, if the lessee is going to own it anyway,
We should amortize it over the useful life. In this problem, we do not have Criteria 1
or 2. Thinking back to the prior video, We met criteria 3,
75% or more of the asset’s life.

And criteria 4,
Present Value of the lease payments were 90% or more of fair value. Then, we just go with the rule, not the exception. So, we use the lease term, 3 years, to calculate
amortization. Let’s calculate. Right of use asset 283,339. Divided by 3 years. Equals 94,446. Amortization is an expense and it’s increasing. That’s a debit. What’s the other side of the entry? A reduction of the right of use asset. Credit. Do our debits equal our credits? Yes, they do. *Jackpot sound* Just to summarize, For finance leases, the lessee records 2 accruals. Interest and amortization. For interest, set up your 5-column table. Column 1. Date Column 2. Lease Payment Column 3. Interest Expense Column 4. Lease Liability Reduction. And Column 5. Lease Liability Balance Then, to amortize the right of use asset,
Use the shorter of the lease term or useful life. Except! if you hit criteria 1, ownership transfer, or criteria 2, a reasonably certain purchase
option. Because both of these mean the lessee will
eventually purchase and own the asset. Then amortize over the useful life. With a Debit to amortization expense
and a credit to the right of use asset.

Alright, I’m not going to kid you. Leases is not easy. But take good notes and try to reproduce the
solution to each of the problems without peeking! That will help a lot. Next up, we’ll review how the lessee accounts
for a finance lease when there is a reasonably certain purchase
option. You want to be sure to hit these points on
the exam. So, stay with me. I’m Liz Cho, with Test Prep, In a Snap! *Music*.