to bother people as well because leases and bonds have a lot of similarities in that they�re

present value techniques, they�re 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. We�re 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 you�re

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 we�re 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

you�re 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 you�re 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 you�ll 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 you�re 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 you�re 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. You�re 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, you�ve got to have at least 75, but then there's a special rule that if you�re

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 you�re 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 you�re 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, we�ll 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. They�re 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 said, �100,000

a year for 10 years. I want to borrow the money.� How much? They said, �We�ll

charge you 10%.� So, that is called my incremental borrowing rate. That's the rate that I could

borrow the money from the bank. The other thing is, I go to the guy selling it, right,

lessor, and lessee. So, I�m the lessee. I go to the lessor and go, �Hey, I like

your yacht. How much?� He goes,�100,000 a year for 10 years or $621,000 cash today.�

Whatever rate where a million dollars, 100,000 a year for 10 years, equals 621, whatever

that rate is, that is the rate implicit in the lease. Who makes that rate up? Obviously

the lessor because the lessor makes up the sales price. So, the lessor always knows the

implicit rate, the lessee doesn't. So, here's the deal. I'm going to use one of these 2

rates to present value this. You will use the incremental borrowing rate unless the

implicit rate is both lower...lower than what? The incremental borrowing rate and known.

Known by whom? By the lessee because obviously the lessor knows the rate because they made