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  • We're now going to talk about leases, accounting for leases. And leases is an area that tends

  • to bother people as well because leases and bonds have a lot of similarities in that theyre

  • present value techniques, theyre dealing with amortization of things like discounts,

  • premiums, or in this case, a lease liability. What is a lease? A lease is where the lessor

  • conveys the right and risk of ownership to the lessee. It's kind of like..., I remember

  • back when I started in public accounting, a lot of kids would get a new job, and go,

  • Woo-hoo! I got to new job. I�m going to go lease a convertible BMW so I can impress

  • my friends.� What is the benefit of a lease? You can buy a nice car... rent or lease a

  • nice car without actually having any money to own it. But what we're looking at here

  • are different types of leases. Were talking about an operating lease, a capital lease

  • and so on, but it says here, �A lease is a contract which conveys the right to possess

  • and use the lessor's property for a specific period of time in return for periodic cash

  • payments. Our goal is to recognize the substance over form. It may be a true rental operating

  • lease or a purchase and sale which transfers all the rights and risks of ownership which

  • is considered a capital lease, also, a non-operating lease from the lessor standpoint. This is

  • covered by ASC 840.� So, in looking at a lease, we're talking about two different people,

  • the lessor and the lessee. As I said, in the past we have lessor, lessee, offeror, offeree,

  • consignor, consignee, bailor, and bailee and so on and so forth. So, let's look at the

  • two different parties. Here we have a lessor and a lessee. Again, the lessor leases it

  • to the lessee. Now, from the lessor standpoint, we have an operating lease. We also have a

  • non-operating lease. From the lessee�s standpoint, we have an operating lease and a capital lease

  • and now, notice, we don't call it operating and capital here, it�s operating and non-operating.

  • Here, from the lessee, it�s operating and capital. Now, on the exam, they love to test

  • capital lease a lot, a lot, a lot because in the real world, what's happening? Well,

  • in the real world, usually you are leasing an asset. So, is it operating lease, like

  • a true rental, or is it a capital lease versus, it's not normal or not usual that youre

  • auditing the leasing company because the leasing company would be more on this side. So, that's

  • what we're looking at, lessor, and lessee. Now, let's start out with an operating lease

  • because it�s easy and it matches both of them. An operating lease is just a true rental.

  • It's like your apartment. Every month what do you do? You debit rent expense, credit

  • cash, you debit rent expense, credit cash. Do you debit the building on your balance

  • sheet? No. Do you pay executory costs called taxes insurance and maintenance on the building?

  • No. Do you depreciate the building? No. So, all you really have is rent expense. Now,

  • you could have prepaid rent, an asset. You might be late on your rent, called a rent

  • liability, rent due. So, you could have a prepaid or a payable, but you don't show the

  • asset on your balance sheet. You're not depreciating the asset. Basically, it is a true rental.

  • So, if you look in your notes, for an operating lease, it says the lease with the rights and

  • risks ownership do not transfer, it is considered a true rental. Alright, from the lessor standpoint,

  • the lessor's the guy that owns it. They depreciate the asset. They paid the direct lease cost,

  • like commissions, legal fees. They pay executory cost, yellow in this word because you need

  • to remember them. They are known as taxes, insurance and maintenance. Those are executory

  • costs. So, in an operating lease, the lessor's paying these. A lease bonus...if you paid

  • one up front, then that would be deferred and amortized over the life of the lease.

  • Rent received in advance is considered unearned, so, in other words, if there's any rent in

  • advance, that would be unearned until it's actually earned. Security deposits...if they're

  • non-refundable, refundable. Unearned rental payment to recognize, yellow in the word,

  • uniformly over the lease term. What does that mean? It's kind of like free rent. Let's say,

  • for example, we have a 5-year lease, and they want to charge us $10,000 a year, but what

  • they say to us is, they say, �Look, if you move in and sign a 5-year lease, I'll give

  • you 6 months free rent?� Okay. Then what is this really costing us? Well, it's really

  • costing us what? In the first year, 5,000 then 10, then 10, then 10, then 10. It's costing

  • us $45,000. So, our cash payments are going to be 10, 10, 10, 10, 5, but were supposed

  • to recognize it uniformly, which means equally. So, what we have to do is you say 5 into 45

  • is 9000. So, we're going to recognize 9, 9, 9, 9, and 9...that's 45. Sounds German...nein,

  • nein, nein, nein, nein, right? So were going to hit 9, 9, 9, 9, 9...there�s your

  • 45,000. That's what I mean by uniformly, and that goes on both sides. The person recording

  • the income 9, 9, 9, 9, 9. That's what GAAP says. The person paying it, same thing, 9,

  • 9, 9, 9, 9. So, that's going to be uniformly. From the lessee�s standpoint, it says lease

  • rent expense is recognized uniformly, which I just said. Lease bonus is considered an

  • asset, an amortized straight line over the lease term. Any leasehold improvements, we

  • talked about that in the PP fixed assets section and also in the intangible section. I said

  • there if you leased a building, and you built the closet, that household improvement would

  • be amortized over the shorter of the lease term, 8 years or the legal life, 10 years

  • or the useful life. So, let's say the closet�s going to live 10 years, but I'm only leasing

  • it for 8, do it the shorter 8. But let's say there's a 4-year bond...renewal option, likely

  • youre going to renew. So, 8 plus 4 is 12 versus 10, do it the shorter, 10. Alright,

  • disclosure. What do you have to disclose? The financial statements, general description

  • the lease, the amounts that are due each in the next 5 years and the aggregator total

  • beyond 5 years. Okay. So, that is called a what? That�s called an operating lease.

  • So, as you look at that operating lease, notice operating, operating, that�s from both sides,

  • lessor, lessee, talked about it here, buh-bye, buh-bye. Now, let's talk about what�s heavily,

  • heavily tested, which this one is called the capital lease. Now, what is a capital lease?

  • Substance over form, and substance...it's a purchase and sale, even though in form it

  • looks like a rental. So, with substance over form, it is where it looks as if it�s a

  • purchase even though it's called a lease. So, substance over form says, �Hey, in this

  • case, you're going to recognize both an asset and a liability at the present value of the

  • payments.� So, if I'm going to lease this building for the next 5 years, then, as we

  • learned in bonds, I'm going to have to present value those payments. Well, how do I know

  • if it�s a capital lease? There's 4 requirements under GAAP. What are they? T-T-B-P-O-75 or

  • 90, T-T-B-P-O-75 or 90, T-T-B-P-O-...Woo! What does that mean? T-T, T-T means title

  • transfers. If title transfers, if you get the pink slip to the Porsche by the end of

  • the lease term, you're going to own it, you have an asset today. If there's a B-P-O, what

  • is that? If there's a bargain purchase option, you can buy the asset for a bargain at the

  • end of the lease term, less than its expected fair value. Then, the Porsches were 30 grand

  • at the end of the leas, you can buy it for 100 bucks. You think you're going to buy it,

  • GAAP, if youre going to own it, that�s called a BPO, bargain purchase option. You've

  • got T-T-B-P-O-75 and 90. What�s 75? That says that the lease term is greater than or

  • equal to 75% of its useful life. Now, that�s useful life at inception of the lease. And

  • then 90 says the present value minimum lease payments greater than or equal to 90% of the

  • fair market value at inception. Let me write that so you can read it. What does at inception

  • mean? It means at inception of the lease, when you first start the lease. So, what are

  • they? T-T-B-P-O-75 or 90, T-T-B-P-O-...and I run into people years later and they go,

  • Hey, Rog Philipp! T-T-B-P-O-75...�, so it's something youll remember forever,

  • for the rest of your life, for the rest of your days on this Earth. So, that�s T-T-B-P-O-75

  • or 90. Those are the requirements. You just have to meet 1 of the 4, and you debit asset.

  • If you don't meet any these, then what? It�s an operating lease. So if you don�t meet

  • these, it�s an operating lease, which means all you have is rent expense. If you meet

  • one of these 4, you, the lessee, will debit asset and credit liability obligation under

  • capital lease. So, that's what we're doing here as far as looking at all these items.

  • Alright. So, as we go through it T-T-B-P-O means title transfers, bargain purchase, 75

  • means three quarters of its life, 90% of the value. Now, if it�s TT or BPO, you're going

  • to own it. Who should depreciate the asset? Well, in all of these cases, who depreciates

  • the asset? The lessee. But let's see how long. If it's TT or BPO, you're going to depreciate

  • it since youre going to own it over the useful life. If it�s 75 or 90, you're not

  • going to own it. It says lease it for three quarters, then give it back. So, in that case,

  • you're going to do it over the shorter of useful life or legal life. So, the shorter

  • of useful life, legal, useful life, it�s going to live 10 years but it�s an 8-year

  • lease, then do 8 years. So, here, if it�s TT or BPO, useful life. So, let's say it�s

  • an 8-year lease but it can live 10. If it�s going to live 10, you're going to own it,

  • do 10. Here, it's a 10-year asset, but youre leasing it for 8. At the end of 8, you give

  • it back, then you only depreciate it over 8. So, that's what we're looking at. If you

  • meet any one of the 4. What if you meet all 4? You're going to own it. Then do these.

  • So, that T-T-B-P-O-75 or 90. Now, TT makes sense...title transfers, you get the pink

  • slip, debit asset. BPO makes sense. Youre going to buy it for a bargain, get the pink

  • slip, debit asset. 75, three quarters of its life. Makes sense. Now, I mentioned at inception.

  • So, youve got to have at least 75, but then there's a special rule that if youre

  • in the last 25% of its useful life, you cannot use criteria 3 or 4? Why not? Because, let's

  • say, it�s a 10-year life, but youre in year 8. So, if you're in year 8 that means

  • there's only 2 years left. Let�s say I�m going to lease it for 2 out of the 2 years.

  • I�m leasing it for a 100% of its remaining life. But guess what? I�m in the last 25%

  • of life, you can�t use it. So, again, if youre in the last 25% of life, you can

  • only use T-T-B-P-O, not 75 or 90 because there's really not much left. Why not? They figure

  • most of the economic benefits have already been used up, so just use TT or BPO. Alright.

  • Now, what does this mean? 70...n-n-n-n-n-...75...l...makes sense... present value MLP. What�s MLP?

  • Minimum lease payments. So, if you are paying at least 90% or more of its minimum lease

  • payments, then you debit asset. So, let us look at our notes, and you'll see here it

  • says, capital lease lessee. What are the 4 criteria�s? We've got T-T-B-P-O-75 or 90,

  • T-T-B-P-O-75 or 90. It says, �If the beginning of the lease falls in the last 25%, then don't

  • use criteria 3 or 4.� Now, as far as hitting this, it says, �The lessee will record the

  • lease at the lower of.� So, when we record the lease, we're going to record the new asset

  • at the lower of, and we have a couple of options. So, record the new asset at lower of either fair market value or present

  • value minimum lease payments. So, it�s present value minimum lease payment never to exceed

  • fair market value. Now, what does the minimum lease payment include? It includes, let's

  • say, for example, you have a beautiful 80 foot yacht, and I want to lease it. So I go,

  • How much for that yacht?� And you go, �Well, it�s a million dollar yacht. I�ll

  • lease it to you for the next 10 years for a $100,000 a year.� So, what is my annual

  • payment? My periodic payment. That would be my annual payment. So, well present value

  • 100, 100, 100, 100 plus any bargain purchase option. If there was a BPO, a bargain purchase

  • option, you present value that as a lump sum plus any kind of guaranteed residual value.

  • Now, guaranteed residual value means that I'm guaranteeing at the end of the lease it's

  • going to be worth something. That's called a guaranteed residual value. That's how much

  • I am saying that it's going to be worth. You do not include executory cost. Huh? Not executory

  • costs. What are executory costs? Taxes, insurance and maintenance. You do not include those.

  • Why not? Because those are expensed as paid. Debit lease, debit insurance expense, credit

  • cash, right, because, what is it? Executory costs are taxes, insurance and maintenance.

  • Tax, debit expense, credit cash. Maintenance, debit expense, credit cash. Insurance, debit

  • expense, credit cash. So, those are not present value. Theyre expensed as incurred. So,

  • what do we have to do? We're trying to figure out what to debit our asset for present value

  • minimum lease payments not to exceed fair market value. What are the present value payments?

  • Minimum lease payments are what? Annual payment, bargain purchase option, a guaranteed residual

  • value. Now, when I say present value, what rate do you use? You have 2 choices. It�s

  • either called the incremental borrowing rate or the implicit rate. Okay, those are your

  • 2 choices, to do what? You use one of these 2 rates to present value this. So, what's

  • the incremental borrowing rate? Let's say I wanted to lease that boat, and I went to

  • the bank and I said, �Hey, I want to lease this yacht. How much?� They