Need to know about Capital Leases? Join Roger Philipp, CPA, CGMA, as he discusses capital leases to prepare you for the daunting CPA Exam. FAR is arguably the toughest section of the exam...so stay focused!
Connect with us:
Are you accounting faculty looking for FREE CPA Exam resources in the classroom? Visit our Professor Resource Center: https://www.rogercpareview.com/professor-resource-center/
Video Transcript Sneak Peek:
Let's move on to something uglier, capital leases. Alrighty. With a capital lease, it's not an operating. We did operating. Done, done, bye, bye, bye, bye. Capital lease.
With a capital lease, this is where the rights and risks ownership are transferred from the lessor to the lessee. In other words, in this case, substance over form, and substance is really a purchase and sale even though it looks like a rental. It looks like a lease. So, what we're saying here is, how do you know if the rights and risks of ownership are transferred.
I kind of alluded to it back when I taught you FAR 1 and I was showing you about the conceptual framework for accounting and why we do what we do, but basically, how do you know if it’s capital lease? T-T-B-P-O-75 or 90, T-T-B-P-O-75 or 90. TT. What’s that? Title transfer. If you get the pink slip to the Porsche by the end of the lease, debit asset, today capitalize it. That’s why it’s called a capital lease. You capitalize it, debit asset. BPO says bargain purchase option.
If you can buy the asset for less than its expected fair value at the end of lease. If you can buy it for $15,000, and we expect the Porsche to be worth 30, would you buy it? Don't take too long. You give me 15, I give you 30. Would you do it? Yeah. Debit asset today. 75 says that the lease term is greater than or equal to 75% of its useful life. That means you're getting most of the economic benefit, debit asset today. The last one is that if the present value minimum lease payments is greater than or equal to 90% of the fair market value. So, if your present value, what you're going to pay over the life of the lease is greater than or equal to 90% of the fair market value at inception, then you're going to pay most of the value, debit asset today.
So, in all of these cases, the lessee will capitalize the asset, which means, instead of debiting rent expense, crediting cash, they’re going to debit leased asset and obligation under capital lease, lease liability. You’re going to debit asset, credit liability. For how much? Present value of minimum lease payments. You’re going to pay present value minimum lease payment, never more than fair value. So, what you're going to do is debit asset, credit liability. Who do you think is going to depreciate the asset? Lessee.
Who pays executory cost? Tax, insurance and maintenance...it’s like you bought it. Who would depreciate if you bought it? The lessee. Who would pay executory tax, insurance and maintenance? Lessee. So, the lessee would pay all of those costs because substance over form, and substance...it's a purchase and sale, even though in form it looks like a rental. That’s called substance over form.
Remembering back, the conceptual framework for accounting, why we do what we do? Why do we do this? Because we met the definition of an asset, met the definition of a liability. These are elements that are useful, relevant, reliable...for meeting our objectives of the financial statements.
The key is study hard. Don't get discouraged. Woo! Little Michael Jackson walk. Come on down! I've been teaching almost 20 years after I left Deloitte and Touche. I've done it for many, many years, helped thousands and thousands of people accomplish their goal, which is to get through the exam.