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Learn "Leases" with a mnemonic you'll never forget….ever

Learn "Leases" with a mnemonic you'll never forget….ever

Pulled straight from the FAR section of our CPA Review Course, Roger teaches you a fun and easy-to-remember mnemonic to help recall the four requirements under GAAP used to determine a capital lease.

Roger Philipp, CPA presents:

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 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 gotta 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, 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, 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, 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 bon...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 is this one called the capital lease. Now, what is a capital lease? Substance over form, and'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 criterias? 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, 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 it up. So, that's when you will present value. So, if you look on page 3, it says, "The lessee records the lease at the lower of fair value. The perio...or the present value minimum lease payments, which is the periodic payment, BPO, the guaranteed residual value. Don't include executory cost. To present value, use the incremental or unless both. Use the implicit if it's both lower and known. Note: the lessor always uses the implicit rate." So, the lessor always uses the implicit rate. The lessee will only use it if it's both what? Lower and known. Okay. So, what we need to do is, we need to then figure out what we're going to record as the lease. Now, when we go through this, there's a couple of journal entries that relate to all types of leases. Let's look over here. On day 1, we're going to lease the asset. Day one. Journal entry is leased asset and credit obligation under capital lease or lease liability. And you're going to record that for how much? The present value minimum lease payments not to exceed fair value. Then, usually on day 1, you make the first payment. Now, this isn't always the case, but remember when I taught you bonds, I said you haven't earned any interest till the end of the year? But with a lease, you might make a payment right away. So, they might say, ìI want you to make a payment up front.î So, in that case, the first payment is on what? Let's say you buy a house and they want 20% down. Isn't the first payment all principal? Yeah. So, therefore, it should all come out of lease liability and credit cash because it's all principal. Then we're going to depreciate the asset. Now, who depreciates the asset? Since it's a capital lease, the lessee depreciates the asset. So, we're going to debit depreciation expense and credit accumulated depreciation. And you're going to depreciate it by what method? Whatever method you currently use for those similarly type owned assets. So, in other words, if it's a piece of equipment, usually use straight line, do straight line. Finally, this is the tricky part, all of the additional payments, payment one plus, all of these, you're still going to be paying cash, but some of it is coming out of lease liability and some of it is going to be interest expense. Now, think about this. When you're amortizing this out, what method are we going to use? Same thing we did earlier, which is what? The effective interest method. The same thing we learned for bonds. Oh! That's why it's such an important concept. So, you can see here, here is day 1, and here's the first payment depreciation. This is where we have to use our effective interest table that I taught you in bonds. So, we're going to have to go through and learn that again. Okay? So, that's what you're going to see as far as what we're doing. Let's look at this example in your notes about page 4. It says, "Example. We have an 8 year lease of 75,000 a year. The present value of the minimum lease payments is 428,415." What is that? That's the present value of our 75,000 a year for 8 years because the gross amount is what? If we're paying 75,000 a year for 8 years, we're paying...What's that? $600,000, but the present value of 75, 75, 75, 75, 75, 75, 75, 75 is 428,415, which means, again, if you put for 428,415 in the bank, it would gr...So, alright, it says, "The first payment is 75,000 on day one." It says, "The implicit rate is 11%, which is known by the lessee. The incremental borrowing rate is 12%." So, which rate are we going to use? You use the incremental unless the implicit is both lower and known. This is both lower and known. We have a 10-year useful life and it includes a title transfer at the end of the lease term. So, you tell me what kind of lease is this? Well, we've got T-T-B-P-O-75 or 90. Well, there's a couple things. It's an 8-year asset, it's going to live 8 years and you're it for 10 years. So, that tells you that its 8 over 10 is 80%. So, that. But it also has T-T, which means, boom, we're going to own it. So, what do the rules say? It says if you meet TT, you're going to own it. Are you going to depreciate it? Yes. Since it's TT or BPO, you depreciate it over its useful life. Remember, useful life is 10 years, and the legal life, or the lease term, is 8 years. So, if it's TT or BPO, it's 10 If it's 75 or 90, 8. If it's both, which it is, do 10. So, we're going to have to then depreciate it over 10 years. What method? Whatever method they tell us. Luh luh luh luh luh luh luh. Alrighty. So, let's go through and do our journal entries because we need to see what we're trying to accomplish, what we're trying to accomplish. Alright, so let's go through and see what's happening. We start out and we go, let's lease the asset, and we're going to debit the asset for how much? We're going to debit the asset for present value minimum lease payments not to exceed fair market value 428,415, 428,415. Then, when do we make the first payment? It said day one. So, 75,000, 75,000. Why? Because it's all up front. It said the asset is going to live 10 years. Straight line depreciation 428,415 over 10 equals 42,841, 42,841. Okay? This is the hard part. Now, we've got to figure out all these other payments and all these other payments are going to be what? They're all going to be still 75, 75, 75, but we've got to figure, of the 75, how much is principal, how much is interest. How much is principal? How much is interest? What method are we going to use? The effective interest method. What is the effective interest method? The same method that we learned earlier in bonds is the effective interest method. So, what I need to do now is, I need to kind of set up an effective interest table, kind of like what we've dealt with earlier in bonds. So, as we go through this, let's set up our effective interest approach, our effective interest method. Now, you'll see this in the notes. I set up a lease liability times the incremental or implicit interest rates, so I'll say times the interest rate equals interest expense or interest income, because remember, one guy's expense is the other guy's income because we're leasing the asset...minus the cash payment, that's how much we're paying a year, equals amortization of your lease liability. So, we're going to amortize it out. So, we have a lease liability times the interest rate is your interest expense, your interest income, minus the cash, 75, 75, 75, 75, equals amortization of your lease liability. Alright. So, when we look at this, let's start out...Journal entry. Let's look over here again, journal entry. So, we've got debit leased asset, credit leased liability boom, boom, boom...that's how much we're going to set up our asset for, that's what we owe. What we have to do is amortize this out, but don't forget, we're going to make the first payment up front. So, we don't owe this, we really owe the net of these two. The asset is still this, but this is our liability. That's record. That's report, net. So, we're going to have to go through and figure out what are we recording, what are we reporting. So, in this particular case, we start out with what? 428, 415. What's the effective interest? It is 11 and 12%. The 11% was the implicit, 12% was incremental. Use implicit if it's both what? Lower and known. So, it's 11%. That, no...What did I do wrong? No...because you've got don't owe 11% interest on 428, you owe 11 on 428 minus 75 because that's your first payment. So, minus the 75. Now, what we have to do is take that amount, which is 353,415 times the 11%...that gives us our 38,876 minus the cash payment, which was given as 75,000 equals 36,124. Then, 36,124 comes down to 317,291 times 11% equals 34,902 minus 75 equals 40,098 minus 40,098 is 277,193, and you could keep going. Notice, in a lease, this eventually has to go to 0. Why is it going smaller, smaller, smaller. Because at the end when you paid off your home, how much do you owe? 0, zilch, nada. You paid it off, you don't owe anything. So, this is getting smaller, smaller, smaller, smaller, smaller, down to 0. Notice, just like with bonds, here's your journal entry. So, my journal entry is what? I'm going to credit cash of 75. Remember we have to get rid of the liability debit lease liability and lease liability amortization 36,124 and your interest expense is going to be 38,876. And the next year, what is it? 75. And this lease liability is going to be 40,098, and your interest expense goes down to 34,902. Notice every year as this gets smaller times 11%, this get smaller 75, 38, 75, 34, 75, 30, 7...Notice the amortization gets bigger every year. So, you can see the amortization is getting bigger every year as the liability gets smaller because you're making the same payment. That's why, like, when you buy a home, in the first few years, it's all interest, and the last 5 years, it's all principal because the interest is pretty much paid off. So, you can see how the principal balance that you owe goes smaller, smaller, smaller...that's how it's happening. So, as we do that, this is our journal entry which will carry on over to here so our journal entry over here is credit cash, 75, debit lease liability, 36,124, which we'll see in that table 38,876 and then again 75 and so on. So, that's your journal entry year after year after year as far as how much you're going to be amortizing out. So, you can see that there's some similarities between this and also with bonds as well because there is some overlap in the accounting for that. So, you'll see that. Look in your notes there. Now, a couple other things I want to mention going back to my A-B-C-D-E-F-G. Let's see that. A-B-C...record, I'm recording it at 428, but I report yet at 353. CDP. Record journal entry, report net of the first payment. Report, report. The other thing that's really important to understand. They've asked you to prepare a balance sheet between current and non-current. So, one of the things that you have to understand much do I currently owe here? 353,415. But how much of that is current? That's this, current. How much is non-current? That's this. So, whenever they want to know current or non-current, you have to go one more year to break it down. I owe you this. That's current, that's non-current. Because this plus this is this. So, if I'm standing here but they want to know how much is current, you've got one more year because that's due within 12 months of the operating cycle, that's the non-current amount. So, if you're breaking down...remember, with bonds, it was all due in the term bond all at the end of 10 years. It was all non-current. If it was a serial bonds, some could be due currently. Here, you always have some current and non-current, current and non-current. So, that's important to understand as far as how those amounts set up. In your notes, you'll also see depreciation. What's it say there? It says criteria 1 or 2, T-T-B-P-O, 3 or 4 75 or 90. If itís TT or BPO, you're going to own the asset. Since you're going to own the asset, what does that mean? Well, since you're going to own the asset, you're going to get the salvage value, so take it out. If it's 75 or 90, you're not going to own it, therefore, you ignore the salvage value. So, take it out, ignore it. Again, useful life versus the shorter of useful or lease term legal. Alrighty. Next page, note the liability 353, 36 is current and 317 is non-current. That's what I just said over here. Of the 353, that's current, that's non-current. What do we have to disclose in the financial statements? A description, the gross amount and the minimum lease payments for each of the next 5 years and the aggregate beyond 5 years. Alrighty, let's do a couple questions on that. Question number 1. Question number 1 says, ìLease M does not contain a bargain purchase option, but the lease term is equal to 90% of the estimated economic life. Lease P does not transfer ownership of the property by the end lease term, but the lease term is equal to 75% of its life. How should we classify these leases?î I already forgot. What is the rule? Let's see right here. Let's sing a little bit again. Hmm hmm hmm hmm hmm hmm. Let's sing. What is it? T-T-B-P-O-75 or 90. T-T-B-P-O-75 or...Title transfers? No. Bargain purchase? No. 75 lease term? Yeah, that's of the life. 90% of what? The dollars. So, remember, 75% of the life, 90% of dollars. So, what they're saying here is, in the first one, it's 90% of the life, 90% of the life. Yeah, 75. Second one is 75% of the life. Yes. 75%. So, they're both what? They're both capital leases. Number says, last sentence first, "At the beginning of a lease term, Day should record a lease liability of how much?" And, again, we're using the word record versus report, how much should they record...sorry...yeah, record. Alrighty. "On December 31st, Day Co. leased a new machine from Pear with the following pertinent information: The lease term 6 years, annual rental payable at beginning of the year 50,000, useful life 8 years, incremental borrowing rate 15, implicit rate known by Day 12, present value of annuity advance at 6% for 6 periods at 12% is 4.61, at 15% is 4.35. The lease is not renewable and the machine reverts to Pear at the termination of the lease." So, they don't own it at the end. "The cost of the machine on their accounting records is 375,500. At the beginning of the lease term, Day should record a lease liability of how much?" Alright. So, they want to know how much is our liability? Now, what kind of lease is it and why? Is there a TT? No. It reverts back to them. Is there a BPO? No. So, we've got to see if we meet 75 or 90. Now, it says the lease term is 6 years, and the useful life is 8, but see here...What is 6 over 8, is three-quarters, is 75% greater or equal to...yes. So, we qualified here at 75. Alrighty. Now, we're going to be making payments. Now, how many years are we making payments and how many years are we depreciating? Let's this case, we're making payments for term is 6 years, 50,000 a year. So, the gross amount we're going to be paying is 6 times 5 or $300,000 and that's 6 years at 50,000 a year. Alright. It says useful life 8 years, incremental borrowing rate, 15, implicit. Which rate do we use? 12%. Why? Because it's both lower and known. We're going to use the 12% in order to present value. It says the present value of an annuity of a dollar for 6 periods at 12% is 4.61. So, 4.61 times 50. So, we're going to have $50,000 times 4.61, which gives me something like 230,500, 230,500...da, da, da...the lease is not renewable...So, basically, we debit lease asset, credit lease liability. For how much? Leased asset 230,500, lease liability 230,500. That's how much we're going to record. What do you report it at? Then you're going to make the first payment, debit lease liability for 50, credit cash for 50 because we're going to pay that off...but they're not asking to report, they're saying record, record, record 230,500. Alrighty. In a moment, we're going to talk about another exciting area called non-operating leases, and we're going to look at that from the lessor standpoint. Because what did we just look at? We just looked at capital leases from the lessee standpoint. We talked about operating, operating, talked about capital. Now, we've got to look at what we call non-operating from the lessor standpoint. We'll do that in just a minute. Okay, now let's look at a task based simulation on leases. Now, remember on the FAR exam you've got 90 multiple choice 30, 30, 30 and you have 7 task based simulations of which 6 are graded. One is pre-tested. Of course, you never know which one is pre-tested. Also, you've got about 12 to 15 minutes per task based simulation. Some will take longer, some will take shorter. What is a task based simulation? It's kind of like taking a bunch of multiple choice like we just did, putting them together into one bigger problem. If you look at TBS 1, last sent...I would say read the question first. Requirements. It says, "Prepare the necessary journal entries without explanation to be recorded by Nesbitt for entering into the lease on January 2nd, x2, making the lease payment on December 31st, x3, which is the end that first year, expenses related to the lease for the year ended December 31st, x2." Alright, let's read the background and kind of remembering all the good stuff we just talked about, that we just learned. It says, "Situation: On January 2nd, Nesbitt Co. leased equipment from Grant. Lease payments are to be a $100,000 payable annually every December 31st for 20 years." So, we're going to make the payment not at the beginning but the end of the year. Also, it's for 20 years. "Title to the equipment passes to Nesbitt at the end of the lease term. The lease is non-cancelable." So, let's review. What is it? T-T-B-P-O-75 or 90, T-T-B-P-O-75 or...a little dancing. So, what is it? T-T, title transfers, sounds like a capital lease. Title transfers. The lease is non-cancelable. "The equipment is at a 750 carrying amount on Grant's books. It's estimated economic life is 25 years". So, they're giving us 20 and 25 years. This gets tricky. So, we're going to depreciate the asset over what? Remember what we said, if it's criteria 1 or 2, over the useful life. If it's 3 or 4, the shorter of useful or legal. In this case, it's TT. So, we're going to depreciate it over what? Its useful life. Useful life is what? 25 years. But careful...when we're making payments, we're making payments for how many years? It's a 20-year lease. So, the asset lives 25, we're only leasing it for 20. So, at the end of the 20th year, we've paid it all off. Basically, we're going to own it, but we're going to depreciate it over 25. We're going to have to present value the payments over 20. ìThe rate implicit in the lease, which is known to Nesbitt is 10%. The incremental borrowing rate is 12.î What do we use? We use the implicit rate unless the incremental borrowing rate is both what? Lower and known, lower and known. Known by whom? By the lessee, Nesbitt, which it is. So, we'll use 10%. "Nesbitt used a straight line method of amort...of depreciation. Straight line. 25 years for the depreciation and the round of present value factors for the ordinary annuity for 20 years are as follows..." Now, an ordinary annuity. We have an annuity in advance, which is annuity due now. That's when you make the payment in the beginning. Ordinary annuity. Where is your arrears? Your rear is at the end, at the end of the year. That is ordinary annuity or annuity in arrears. It says here, for 20 years 12%, 8%. Now, if I wrote this question, what would do? I'd give you the present value at 12% and 10%, and I'd give it to you for 20 and 25 years, because you know someone would have picked the 25-year present value factor, but we want the 20 because we're going to make payments for 20 even though we're going to own it for 25. Alright. Now, which rate, which rate is lower and known? 10%, 10%, 8.5. ìPrepare the necessary journal entries with an explanation.î Alright. So, when we look at this, first of all, we've got $100,000 a year, the present value factor is a 8.5. So, we've got 100,000 a year times 8.5 is $850,000 is the present value, the minimum lease payments, not to exceed fair market value. So, that's going to be the 850. So, on day one, what do we have? We're going to lease the asset. We have leased asset 850, and, let's say, obligation under capital lease or I'll just say lease liability. 850. Okay. So, that's our first journal entry. The other thing we're going to do, remember we said the asset's going to live how many years? 25 years. So, if I take the asset, which is 850 over 25 years is $34,000 a year. So, I'll have some depreciation expense of 34,000 and credit accumulated depreciation, 34. Remember, you learned this back with fixed assets, straight line, sum of the year's digits, declining balance, different types of depreciation. In this case, we've got our straight line depreciation. Now, make the journal entry entering the lease...boom.. Make the lease...expenses related. There's one of them. Another one, it says, ìMaking a lease payment at the end of the year and here is at the end of x2.î So, on day one, we make this journal entry. Now, what do we have to do? Let's go back to our present value...remember our table over here...the effective interest, the amortization table. So, what do we do? We start with our lease liability of 850. Now, remember, we're going to pay it off. It's like your mortgage. You buy a home. You're going to pay it off over 30 years. What happens? Eventually this goes down, down, down, down, down, down to 0. So, we've got 850 times the interest rate. Which rate are we using? Implicit or incremental? We're using implicit, because it's both lower and known. So, that's going to be our 10% equals 85,000. The cash payment is we're paying 100,000, 100,000, 100,000 so, we're paying 100,000 a year equals $15,000. Now, remember, this has to get smaller. So, take out the 15, gives us 835...oops...a little dyslexia there, 835 times 10%, equals 83,500 minus 100,000 equals, that looks like what, about 16,500. So, if we take out 16,500, then, again, we just keep getting smaller, smaller gives us, what? Like, 67,000. 6 and 7 is 13, 5. Yes. So, you can just keep going and do the whole thing. Notice, the journal entry comes out of here. Now, as I showed you earlier, here it starts big, smaller, smaller, smaller, smaller, smaller. As this get smaller times the same interest rate, this get smaller. It's a 100, 85, 100, 83, 100, 79, 100...This difference every year gets what? It gets bigger. The amortization gets bigger. That's why when you pay off your home, everyone says, "Hey, you want to save money in taxes? Buy a home because your interest expense is tax deductible." So, your interest expense is tax deductible. Notice the first year you buy the home, it's all interest. very little principal. At the very end, what happens? So, the beginning it's interest expense is high, at the very last year of your mortgage, there's no interest, right? It's very little. So, this starts big and gets smaller, but as your interest gets smaller, you're paying the same amount, more of it comes out of the principal. Alright, what's our journal entry? Journal entry comes right out of here. So, we've got what? The amortization of that amount. So, every year, as we make our cash payment, we're going to pay cash of 100,000. Then we're going to take it out of interest expense and lease liability. So, our lease liability is going to go down. Here's our lease liability. In the first case, amortization, liabilities are come down by 15,000, and your interest expense is going to be 85,000. The next year, and all your entries just come right out of this table, so, the next year, we're going to pay 100,000. They didn't ask for this, but we're going to do it anyway. The next year, this is going to go 16,5, this is going to go down to 83,500. So, every year, notice this payment 100,000 still stays the same, but these this number goes up, this has to go down. This goes up, this goes down, because we're still paying the same amount every year. So you can see right here how that kind of flows together. So, those are the journal entries are looking for. In a question, on today's exam, what would they do? They'd basically ask you to go through and either drag and drop the amounts...also they'll ask you for the categories. So, they'll give you a whole list lease asset, lease liability and so on and so forth. You drag and drop. If you look at the next question, they just want you to go through and kind of match things up. So, for example, you have 2 different columns. Here, it says, "A. The substance of this transaction is that it consists of 2 separate and distinct transactions." We haven't talked about that yet. You may have in class, but it's called a sale-leaseback transaction where basically I have an asset, I sell it but I still need the asset. So, I sell it to you, then I immediately lease it back. When I lease it back I'm now the lessee. It could either be and operating or capital lease. I know we'll talk about the deferred gain what to do about it, which we'll cover that down the road or you can watch my lecture as well. If you want to watch my lease lecture, just contact my office. You can watch the whole lecture again. "Rental payments are recognized on a straight line basis, even though the lease calls for payment that increase over the term." Remember, you want to recognize your rents uniformly. That's an operating lease. "C. Depreciation expense related to the leased asset is reported on the lessee's income statement over the lease term." Well, when you depreciate it, you pay executory costs, taxes, maintenance...all of those are going to be in a capital lease as opposed to an operating lease. "Sales revenue. The present value of minimum lease payments unless the carrying amount of leased asset is reported on the lessor's income statement." This is called a sales-type lease, which, again, I haven't talked about so far, but I would in my regular class and it's in the notes...called the sales-type lease or a direct financing lease. That is from the lessor's standpoint, and we talk about how do you know if it's a sales-type or a direct finance. It has to be 1 of the 4 criteria. T-T-B-P-O-75 or 90. It also has to be collectible and measurable in order for the lessor to take it off their books as if it's a sales-type lease...but anyway, those are just a couple of areas just to show you an example of how and the types of questions you would see at the actual CPA exam. Remember, this just one piece of all of financial accounting. Remembering, that again, this is a 4 hour exam. It includes all your intermediate I, intermediate II, advanced, government, non-profit. If there's stuff like governmental accounting, you've never seen, don't worry about it because I'll walk you through it so you can see it step by step by step. Again, hopefully you learned a lot from my presentations. Study hard, and you too will not only pass this intermediate class, but you'll also pass the CPA exam.