Welcome back. In this lesson, we're going to do an example that shows how to classify a lease, and more importantly in some ways how to document it. So, we're going to use McFly Manufacturing. They are leasing a turret lathe for three years for payment of $1,000 per month. The value of the machine is $37,000. McFly has an incremental borrowing rate of 6.5 percent but the lease is priced to return five percent. The useful life of the machine is six years, and there's no purchase or renewal options. So, let's go to Excel. We'll make up a small worksheet that shows you how to classify it and to document the process. So, what we'll do here is, I've created a small spreadsheet that's for classification of the lease. This is good not just for doing a classification. At least, it's really important to document these things. There's a saying at the PCOB, "If it isn't documented, it isn't done". This is a great idea to do with every lease you have to create this kind of a documentation and put it in the file. So, I've put it in the lease payment of $1,000, the term of 36, the lease rate which we've assumed at 6.5 percent, the present value of $3,284, we've calculated it using the present value formula, and the term and the rate divided by 12 because it's a monthly payment. Then the fair value of the lease has been entered, and the useful life of the assets. So, when we go through there, we know that there is no transfer of title in the lease. We know that there's no bargain purchase in the lease. Now, we've calculated whether the present value of the minimum lease payments is greater than 90 percent of the fair value of the asset. We've come up with 88.66. So, even though it's close, it is less. We've also then looked at the lease term and compared to the useful life. So, it's 36 divided by the 72 months left in the useful life. It's only 50 percent. So, that's a no. We did this with some logical formulas that we put in here just so that you can see it automatically. It just helps avoid human error. Then we said if this value, if this cell is less than 75 percent, then it's a no, otherwise it would be a yes. We did the same thing up here for the present value calculation. If it's less than 0.9, that's no otherwise, yes. We'll show you how useful that can be right here because we're going to change the rate. So, the rate, implicit rate in the lease was 6.5 percent. We've assumed initially that she doesn't know the implicit rate and that's not the discount rate they would use. What if they do know it? Well, now they're going to use the rate implicit in the lease, and we suggested that that's five percent. So, let's change that to five percent. That's changed our present value, and it has changed it in a way so that it is now greater than 90 percent. So, it would qualify as a finance lease. So, the interest rate that you use, the discount rate is very important. A relatively small difference can make a difference in whether the lease is classified as a finance lease or an operating lease. This is particularly true with long-term leases because the longer the term of the lease, the greater the impact of a change in the interest rates can be. So, let's go back to our problem. So, let's summarize what we've done. We prepared a classification worksheet that shows at 6.5 percent that it would not be considered a finance lease, so it would be classified as an operating lease based upon McFly's incremental borrowing rate. Alternative facts. If McFly does know the implicit rate or it sometimes it is specified in the lease, the answer actually changes. Now, at five percent, we determined that the present value would be greater than 90 percent, and this lease would be accounted for as a finance lease. Now, the private companies have an option of using a risk-free rate which would again though it would biasing answer toward finance lease classification because as you notice, the lower the interest rate you use, the higher the present value, and therefore the more likely it will be a finance lease. What about related party leases? I mean, related parties can do whatever they want. They can sit there and make the terms favorable or unfavorable. This was an issue that the FASB decided, what should they do about this situation where related parties can manipulate the terms to meet their own particular needs? Well, they decided that we're not going to try to account for the substance of the transaction. We're just going to go with the legally enforceable terms and conditions of the lease. Now, we will make disclosure about that in the financial statements so that a user of the financial statements will know that this was a related party lease etc. But there's no special requirement to account for related party leases other than by the legally enforceable terms and conditions. Of course in the separate financial statements or the related parties, you would expect the classification and accounting would be the same for those leases. So, what's the impact of classification? Again, it has no impact on initial measurement of the lease obligation or right of use assert. That's going to be the same regardless of whether we've got a finance lease or an operating lease. But the significant impact will be in the subsequent periods, and that will be including measurement and recognition of lease expense and classification of the cash flows. So, it is still important to do the classification to document it properly. It's not going to affect that initial measurement but it will have an impact later on. So, thank you.
