Hello and welcome everyone to our lesson today, accounting for leases. We're going to start with an overview today for leases, the contract, the terms that we're going to be using, different types from the lessee, different types from the lessor. We're going to have an overview set up so that we build a concrete base for accounting for leases and understand different aspects from the lessee's point of view and from the lessor's point of view. We are going to start first by defining what a lease is? The lease contract is an agreement in which the lessor conveys the right to control the use of unidentifiable asset to the lessee for a specific period of time for that specific asset. In return, the lessee is committed to make what we call lease payments. You will notice that when we talk about the lease payments, we mean more than just the periodic payment. The periodic payment is one component of lease payments, and that's why to distinguish between lease payments in general versus periodic payments, the lease payments is more inclusive. What does lease payments might include? Number 1, those periodic payments that I talked about that are determined in the least contract. Number 2, there could be a purchase price if the lease allows the lessee to purchase the asset at the end of the lease, that will be included as a lease payment also, beside the periodic payments. A third case could be a guarantee by the lessee of a certain residual value at the end of the lease. In such a case, there could be a certain amount or a value or a payment that is guaranteed by the lessee towards the lessor that will be included and also what we referred to as lease payments. Number 4, the lease payments could also include termination penalties. Have the lessee had to cancel the lease for any reason before the scheduled termination of the lease? There is a fact that I wanted to talk and I wanted to bring up to our attention, time value of money concepts in leases is extremely important. We're going to use it extensively throughout the accounting, whether it's for the lessee or the lessor. This is because those lease payments that we mentioned earlier will be made over a lease term, a long-term, and obviously, if the long term is there, then we will take the time value of money, and that's why we're going to use the present value with a single sum or ordinary annuity or annuity due. Thus, both the lessee and the lessor will be required to calculate the present value of those expected payments or collections from each one's perspective and account for that in their relative books. The discount rate from the lessor's point of view will represent his or her desired rate of return on the lease contract. I as a lessor, I'm leasing that to the lessee and I need a rate of return. So that is what the discount rate that will be used by the lessor. When this rate of return is unknown to the lessee, the incremental borrowing rate for the lessee should be used in discounting those payments to calculate the present value that will be accounted for at the inception of the lease. Now, let's start by overviewing the various types of leases. It's not one lease contract. Obviously, there are some criteria and each type, once we identify the type, the accounting treatment will be different. From the lessee's point of view, from the lessor's point of view. From the lessee point of view, there are two options, either, it's a finance lease or an operating lease. Obviously, the accounting for each will be different. From the lessor's point of view, there is a sales-type lease or an operating lease. From the lessor's point of view there is an extra decomposition or just take classification, a second reclassification of the sales-type. We distinguish between whether it's a sales-type with profit or without profit. The table in front of you summarizes those options, all different types of leases from the lessee or the lessor point of view. Aside from the issue of whether the lessor would have profit or not on a sales-type lease, both the lessee and lessor have two alternatives. From the lessee's point of view, it is either a finance or an operating lease, while from the lessor's point of view, it is either a sales-type or an operating lease. What determines for each of them, whether it is either or? Accountants classify a lease contract as a financing lease or a sales-type lease from the sales perspective, if at least one of the following five criteria is identified in the lease contract, otherwise, it's simply an operating lease for both of them. Those five factors are stated by FASB. The first one is that the transfer of the leased assets ownership criterion, meaning that the lease allows automatic transfership of ownership towards the end of the lease. The second, that there is a bargain purchase option, what does that mean? That there is a very good price at the end of the lease for the lessee to purchase that asset, that it's more realistic that the lessee will exercise that option. The third criterion is what we call the lease term, that the lease term the period, covers significant portion of the useful life of the asset. We still stick to the 75 percent criterion, but it's not identified clearly in the new lease standard. But we still have if the lease term covers more than 75 percent of the useful life of the asset that is guaranteeing or that's honoring that that criteria has been fulfilled. Fourth one is that the present value of the lease payments cover significant portion of the fair value of the asset. Again, we use a threshold 90 percent, although it's not identified. If 90 percent of the fair value is covered by the present value of the lease payments, then that criterion is counted to be fulfilled. The last criterion, if the asset has a specialized nature that has not other alternative use. If that is the case, then obviously it will be considered as a finance lease from the lessee's point of view or a sales-type. In conclusion of this lesson, we need to understand that the way we account for a lease contract depends on the classification of that particular lease, which actually depends, as I said, on one of those five specific criteria that we discussed earlier. Any of those five criteria fulfilled in the lease contract will turn the lease to a finance lease from the lessee and a sales-type from the lessor. Otherwise, if none of those five criteria have been fulfilled in the lease contract, then it will be accounted from both sides as an operating lease. Thank you.
