FAR Exam Mnemonic for Capital Leases - YouTube

All right, we�re on a roll now, let�s continue talking about leases. It says here

capital lease. Now this is from the lessee standpoint not the lessor but the lessee,

the person who is leasing the asset from the lessor. Now, in a capital lease, we just talked

about operating, true rental, here in a capital lease, really it�s substance over form,

and substance is really like you�re buying the asset, even though in form, it looks like

just a rental. So it talks about substance over form, rights and risks of ownership of

transfer. So that�s one of the main things that we're looking at is, have the rights

have the risks of ownership of this asset actually transferred from one person to the

other? And we�re going to talk about rights and risks of ownership under IFRS as well

later on, but those words are important. Again, the rights and risks of ownership. Now, in

looking at this, there are four criteria to determine if it is considered a capital lease.

If you meet one of the four criteria, it's a capital lease. If you don't meet one of

the four, what is it? An operating lease. You don�t have to meet all four, just any

one of the four. So, this is to see if it's a capital lease. And a good way to remember

this, and I have a song that I'm famous for is...T-T-B-P-O-75 or 90, T-T-B-P-O-75 or 90...Title

Transfers Bargain woo-hoo! Right? Its a little dance song T-T-B-P-O-75 or 90. Woo-hoo! Doing...what�s

that word? Twerking? What�s the word? Twerk? Twerkin�? T-T-B-P...anyway...So, what does

this mean? T-T means title transfers. That means by the time the lease ends, the title

transfers from the lessor to the lessee. T-T. That means that the lessee is going to own

the asset. They�re going to have the pink slip to the Porsche, they're going to own

it. If they�re going to own it in five or ten years, wouldn�t it make sense to just

debit the asset today as if they purchased it? Wouldn�t it make sense to just debit

and start d-d-depreciating it? Wouldn�t it make sense that you should pay executory

taxes, insurance and maintenance? Yeah! Because in substance it�s a purchase, even though

in form it looks like a rental. In reality, the rights and risks of ownership have transferred.

In other words, the rights and risks have transferred from the lessor to the lessee...title

transfer. B-P-O is a Bargain Purchase Option. Bargain purchase option. What that means,

is you can buy this asset at the end of the lease term for a bargain. At the end of the

lease, if the asset�s worth thirty grand, you could buy it for three grand. So, let�s

think about it. If you give me three, I�ll give you thirty. If you give me three, I�ll

give you thirty. Would you do it? Don't think too long. Yeah! So, therefore, if you buy

it, you�re going to own it. That�s a capital lease. The next one is 75% and 90%. Now the

75% says that if the lease term, and this important, greater than or equal to 75% of

its useful life. That means that you�re leasing it for at least three quarters of

its life. That means you�re getting most of what we call economic benefit. Since you�re

getting most of the economic benefit that means that we�re going to debit the asset.

Here says that the present value minimum lease payments of the [blah] is again greater than

or equal to 90% of the fair market value at inception. So what that says is, if you�re

paying the present value of the future payments that you're going to be making are greater

than or equal to 90% of the value, you�re paying most of the value...we consider that

a capital lease. Now, T-T-B-P-O-75 or 90, T-T-B-P-O-75 or 90...woo! Anyway, so that�s

the mnemonic for memory. How many do need to meet? Any one of the four: capital lease.

Now, in all these cases, who is going to depreciate it? Well, it�s as if it�s a purchase and

sale...the lessee will depreciate it. Now, here�s a little trick too, which I'll show

you later. If it�s T-T or B-P-O, let�s think. Who�s going to own it? The lessee

will actually own it because either you get the title transfers, you get the pink slip,

or you�re going to buy it for a bargain purchase, you�re going to own it, you're

going to get the pink slip. Therefore, since you�re going to own it, you're going to

live with it until the end, depreciated over its what? Useful life. So, the useful life.

If instead it is 75 or 90, did I talk about owning it? No. I said you�re going to lease

it for three quarters of its life, you�re getting most of the economic benefit, but

at the end of the lease term, what do you do? You give it back. What about 90? You�re

paying 90% of the value. That�s how much you�re paying, but at the end, what do you

do? You give it back. Therefore, you�re going to depreciate it over the shorter of

what two lives? How about useful life for legal life? The asset�s going to live ten

years, you�re leasing it for eight, and it�s going to be...at the end of eight,

you give it back, what�s shorter? Eight. You�re leasing it for eight years, but it�s

going to live ten, you�re going to own it, do ten. So that�s where it's important to

know, okay, the lessee�s going to depreciate it. Over what? Here, useful life if it�s

T T B P O, here 75 or 90, shorter. What if you meet all four? Then you own it, so do

the top. Mmmkay? How many do you need? One of the four. Now, what if you don�t meet

one of the four? T-T-B-P-O-75 or 90. What is it? It�s an operating lease, so the fallback

is operating lease. If it�s not a capital what is it? It�s an operating. If it�s

not good what is it? It�s bad. Alright? So that�s what we�re looking at as far

as the lease. So you�ll there one of these terms. Now, if the beginning of the least

term falls in the last 25% of the life, criteria three and four shall not be used for purposes

of classifying the lease. What that means is, then let�s say the asset is going to

live ten years and I�m leasing it in year eight. Okay, now how many years are left?

Two. I�m going to lease it for two of the two which is 100%, but because I�m in the

last, what, it says, in the last 25%, I�m in the last 80%, right? There's only 20% left,

so if you�re in the last 25% of its useful life, then it says you cannot use the third

or fourth criteria. So the only way you would capitalize it is if you're going to own it.

T T or B P O. But, if you�re in the last 25% or more of its life, then what? Then you

can�t use criteria three or four. Why not? Because we figure most of the economic benefits

have already been used up. It�s a ten year asset. You�re not going to lease it until

your eight, nine and ten. You�re getting the very end of it. You know what? Unless

you�re going to own it, don�t capitalize it. So that�s a special little rule the

talks about T-T-B-P-O-75 or 90. Now, it says non-cancellable lease term because we're talking

about, we're entering into what we call this non-cancellable lease. It says non-cancellable

lease term is the minimum period of time which the lease is expected to be enforced, so it's

non-cancellable for that time that it is enforced. It includes an initial lease term. That's

the original term that does not include any renewal. A bargain renewal period. It says

there�s an option to renew and it makes it likely that the lessee will renew it. Penalty

for non-renewal. There's a penalty that if you don't renew it, it is a significant penalty,

so you�re not going to want to do that. And the lease contains a bargain purchase,

and the B P O, it�s assumed, if it�s a good bargain purchase that it�s going to

be exercised. So, that's what we mean by non-cancellable term. Now, we talked about the minimum lease

payments, and remember, the minimum lease payments that over here we said that present

value minimum lease payments is MLP, minimum lease payments, which we�re going to expand

on. But here, let's see it says, minimum lease payments represent the minimum amount that

the lessee will pay or that the lessor will receive under the terms of the lease during

the non-cancellable lease term. The minimum lease payments include...so when we talk about

90% of what? Present value minimum lease payments greater than 90%, what does minimum lease

payment include? The base rent, the B P O, which is the present value of the lump sum,

the bargain purchase, any penalties that are part of the minimum lease, residual value.

Now a residual value is like a salvage value that we talked about. So let's say at the

end I say, �Okay, I�m going to lease it� and at the end there is some sort of guaranteed

value. If it is a guaranteed residual value by the lessee, then the lessee and the lessor

both will include that amount as part of the minimum lease payment. If it is guaranteed

by a third party or it is unguaranteed, than the lessee does not include it, only the lessor

would include it. It says minimum lease payments would not include, so these are certain things

that they exclude, certain things like contingent rent. If there�s a contingent rent, which

would be an additional rent based on things like sales in excess of certain amounts or

executory cost. What are executory cost? Taxes, insurance and maintenance. Those are not part

of the present value minimum lease payments. They're not part of the minimum lease payments.

Those are expensed as incurred. So, in that case, if I'm paying taxes, insurance and maintenance,

I don�t put that as part of the leased asset. Instead I just debit expense, credit cash,

debit expense, credit cash. So these two elements, contingent rents and executory cost are not

considered as part of what? The minimum lease payments. So, as we move forward, what are

we saying? We�re saying that there�s a lessor leasing it to a lessee. On the lessee

standpoint there�s operating lease, lessor operating, and operating, operating, true

rental, pretty straightforward. From the lessee�s standpoint, there�s a capital lease or operating.

How do you know if it�s a capital lease everybody? T-T-B-P-O-75 or 90. Title transfers,

bargain purchase lease term grade above 75% of its life and minimum lease payments 90%

or more. Now as we look at these, they make sense. T T title transfers, yeah, you're going

to own it. B P O, you can buy it for a bargain, you�re going to buy it. 75%, you�re leasing

it for at least three quarters of its life unless you�re in the last 25% of its life.

Present value minimum lease payments greater than 90% of the fair value at inception, unless

you�re in the last 25%, but this one needs a little bit more explaining because it says

present value minimum lease payments is greater or equal to 90% of the value. What is this

[bleh] minimum lease payments? So it says minimum lease payments. That�s what we need

to know, and we need to figure out how the heck to present value. So when we look at

this, you�ll see here the lessee records the lease at the lower of, so we�re going

to record this Lease at the lower of what? We�re going to record it at the lower of

either fair market value or the present value of the minimum lease payments. So let�s

talk about present value minimum lease payments, MLPs. Now, what are the minimum lease payments?

That would be for example the annual payment that you�re making, what we call the periodic

payment. So, if I�m going to be paying you...let�s say I want to lease your beautiful yacht,

okay? You have a gorgeous yacht over in the marina, and I go, �How much for that yacht?�

And you go, �Um, I�ll lease it to you for ten years at 100,000 dollars a year.�

So, I�m going to present value a hundred thousand. Now, remember we talked about present

value with bonds? We started to introduce you to the concept. We looked at present value

tables at the time. We said, �What is the present value?� It means a dollar, you know,

a dollar a year from today is really worth 90 cents today. A dollar two years today is

really not a dollar, it�s really worth 82 cents today. A dollar three years is 75 cents,

so when you add all that, that�s a present value of the annuity. Now, if I�m paying

you a hundred thousand a year for the next 10 years what did we say an equal stream of

amounts to be received or paid is an a-n-n-n-n-unity. An annuity: an equal amount to be received

or paid. So, we�re going to present value what? The periodic payments, so that's the

annual payments. We�re going to present value the bargain purchase option as a lump

sum. We�re going to present value any kind of guaranteed residual value. So all of these

are going to be present value. What things do we not present value? We�re not going

to present value contingent fees or contingent rents. We�re not going to present value

executory costs. So I�m going to put non-executory costs. Remember, what are executory costs

everybody? Taxes, insurance and maintenance. What do we do with those? Debit expense, credit

cash as you incur those. So, those we are not going to present value. Says here, penalty

for failure to renew which we mentioned and defined what it was earlier. You would include,

don�t include executory cost since they are expensed as incurred. Now, we're starting

to understand this. I�m going to debit an asset, credit an obligation under capital

lease or a lease liability. In an operating lease I don�t debit the asset instead I

just debit expense cash as I make payments. But in a capital lease, you capitalize it.

You debit an asset at how much? At the fair market value not to exceed present value minimum

lease payments not to exceed fair market value and what does present valuing mean? You present

value the payments the annual payment, the bargain purchase, the guarantee, non-executory.

The question is, what rate are we going to use to present value it? You will use one

of two rates. You are going to use what we call the incremental borrowing rate. Now what

is the incremental borrowing rate? That means that I go to the bank, and I go, �Hey, Mr.

Bank! I would look over to lease this beautiful 75 foot yacht for 100,000 dollars a year for

the next ten years. I need to borrow some money. How much are you going to charge me?�

11%. Ooo, okay, so what is that? Incremental borrowing rate. That is the rate that I could

go out and borrow the money on these terms. Or we�re going to use the implicit rate.

And the implicit rate, that is the rate implicit in the lease. So for example, what they�re

saying to me is they say, the owner, I say, �Hey! How much for your yacht?� He goes,

�I�d like 100,000 a year for the next 10 years.� A hundred thousand a year is

a gross of a million dollars. We know it�s not worth that much, however, or 673,000 cash

today. So whatever the rate is where present value of the 100,000 a year for ten years

equals 673, then that is the rate implicit in the lease. Who makes that rate up? Who

makes up the sales prices of the asset? The owner, the lessor. So, therefore, that would

be the rate implicit in the lease. That�s called the lessor�s rate. So that rate would

be used. So when does the lessee use that rate to present value the payments? They use

the implicit rate only if it is both lower and known. Now what does that mean? Lower

and known? Lower than what? Incremental borrowing rate. Known by whom? Known by the lessee.

The lessor knows the rate. They made it up. The lessor said, �Hey! I�m going to sell

you my asset for 100,000 here for 10 years, or 673,000 dollars cash today.� Whatever

that rate is, that�s the lessor's rate. The lessee would also use that rate if it's

both what? Lower and known. It says here, lessee knows the lessor�s implicit rate

and the implicit rate is lower than the incremental borrowing rate. That�s the rate they�re

going to use. Note: the lessor always uses the rate implicit in the lease. So, the lessor

always uses the implicit rate. We�re just trying to figure out what rate should the

lessee use. So again, so you don�t get lost, what are we using this rate for? To present

value all of these payments. That is the rate we�re going to use. So, as you're going

through it, we use it if the rate is lower than this rate. What I mean by that is that

if this incremental rate is 11%, and this is 10%, and it�s known, we�re going to

use that. Now, the lower rate means less interest, means a higher carrying value, so the dollar

amount may be more. But just look at the rates. So remember, it�s the rate that�s lower,

not the dollar amount. And I'll explain that more later, but I just want to plant that

seed now so you start to understand it. Alright, so those are some of the basics in stepping

into it. What I want to do though is we have to figure out, okay, what is the accounting

for this capital lease? How do we set that up in the books? We�ll do that in just a

second.