Accounting For Loans & Capital Leases SHARELast | Edmonton Bookkeeping
Welcome to another edition of ask the spurtle CPA. Today we’re talking about accounting for loans and capital leases. I have coal here with me again. Uh, so Cole High, you, uh, how you make it out in your studies lately.
Good. Pretty stressful, but
and April, are they going to make it right on April 30th, 27th I said, that’s all right. Okay. Um, so the, the quote here, uh, Michael Gerber called author, author of the e Myth, you know, the fatal assumption is if you understand that technical work of a business, you understand the business that does that technical work. The statistic that will throw at you again is a new one dealing with accounting for loans and capital leases is intuit the makers of quickbooks. They did a survey for financial for business owners on their financial literacy in terms of their business. And what they found was 82% of the business owners got a score of 70% or less, so less than 70%. Um, when it dealt with basic financial statement items. Um, and what we have here is we have business owners, they don’t really know how to account for the loans or capital leases properly. And as a result they have these income statements and they don’t make any sense whatsoever. Um, and it, they, as a result, they’re not gonna understand the cashflow. So cold. What are the questions
is that these business owners should be asking, should each loan account had a separate balance sheet account?
Yeah, hundred percent. So every loan account that we have, you know, we have an operating loan and we have mortgage number one or mortgage number two and equipment loan number one, they should all have separate accounts on the balance sheet. We shouldn’t be commingling those loan accounts at all under any circumstances. Those are always kind of separate.
Should the monthly payment be posted to the balance sheet or income status?
Yeah, so if you have a loan, that monthly payment should be posted to the balance sheet. Most of the time, almost all of that deals with the principal payment. Um, you know, or the majority of it is going to deal with the principal payment. Now there is the interest component does belong on the income statement. Sometimes it’s really obvious from the bank statement how much is the interest and how much is principle. And if case, if that’s the case, you should put the interest payment on the income statement and the principle portion on the balance sheet. If it’s not obvious, you know, this might be something that’s not worth doing a loan amortization schedule every month. Just put that payment on to the balance sheet. Uh, because we were talking about repaying and principal loans to buy capital assets, they don’t belong on the income statement. Um, so we have to understand that they’re, you know, they’re, they’re going to completely overshadow that statement. If we’re looking at, uh, you know, the pay back on alone. Edmonton Bookkeeping is important to your business growth. So, um, you know, if we know the interest component, put it out on the complete it, but if not, if we’re just looking at the payment, the principle payment or the unknown parts of the payment, you don’t put it all on the balance sheet in their individual loan account.
Why do you need enough income to cover these principal payments?
So ultimately because those payments are not on your profit and loss statement, you need enough income to pay it. So if we have a $2,000 a month principal repayment of a loan and we have $0 million in income, we’re going to have negative 2000 and cashflow. But if we have, you know, $2,000 on our income statement and we use that $2,000 to pay back our loan, you know, we’re okay now we, we were kind of cashflow at scratch if you will. So we need enough income to cover the principal payments of those loans.
Are there positive and negative current portion accounts?
So the positive and negative current portion accounts are a factor of most accountants software. So this isn’t the software that will businesses the quickbooks or simply accounting file as you are using. But most, most of the software that accountants use at the year end, um, preparation, they have to separate out the current portion of the loans. So you have a loan in your $100,000 on that loan and you’re going to pay back $10,000 next year. And the other $90,000 in the upcoming years, that $10,000 has to be separated on the financial statements as the current portion of loan. Um, so what happens is there’s almost like a placeholder account that says the $10,000. That’s the current portion. We know the whole hundred thousand is sitting in the account that you use in your, in your quickbooks file that you’re simply accounting file. Don’t put off your Edmonton Bookkeeping. Um, but we have another account, the current portion so we can put it on the, the, the balance sheet, but then we also have to have an offset. Um, so it’s really just a placeholder account. Um, and if you’re just going to have, you know, for example, you know, you’d have one $10,000 account, one negative $10,000 account, and they essentially just cancelled them off the average small business owner. I can almost just disregard those current portion accounts and just, you know, post all the payments, uh, to the main loan account.
Why should you see a consistent decrease to the main loan accounts each month?
That shows that the monthly payment has happened. Okay. So if you have the loan account, you know, in one month it was 100,000, the next month it was 99 a month after it was 98 and the month after it was 97 things are looking good. But then if it sticks at 97, there’s generally one of two things that has, you know, uh, happen. Um, you know, that either there’s, you know, a mistake and it wasn’t posted to that loan account or we didn’t have enough money in the loan account, didn’t get paid. But you know, we should see that decrease every month to reflect the payment.
What are some likely causes if there’s no change in the loan account? One both.
Yeah. It, it’s usually going back to that. It’s usually the, um, you know, it’s been misclassified. So that’s normally what’s happened. I mean there’s, it could be that it didn’t get paid. That is a likely I could serve. Most banks, they have these things on autopilot and it’s automatically coming out of the account unless it bounced from the accounts. So the likely causes, it’s probably sitting somewhere else and it’s probably sitting on your income statements. So which is going to completely skew your income statement and it’s not going to give you an idea of how much you’re actually making in this business. It can also be if you have multiple loan accounts and one of the other common mistakes is it’s in the wrong loan account. Um, so you have loan payment a in, in loan account B, that’s another, you know, very likely cause that happens. So you should just, you know, take a bird’s eye view. Again, we’re always recommending the, the six month comparatives, uh, to review your, uh, your monthly comparative Balance Sheet. And you should see those loan accounts going down by, you know, a set amount or reasonably similar amount of each and every month. Um, and if there’s no change in one month, we either we missed the payments, you know, we have a classification air or we have the wrong payment to the wrong account.
Are there certain types of leases that are accounted for like loans instead of, or rent?
Yeah, so they’re called capital leases. So if you have a capital leases, what that means is, although the legal, uh, structure of the, uh, of the, uh, of the transaction is a lease, really it takes the form, the spirit of the transaction is more ownership in nature and for accounting purposes, you know, we, we basically book and record those, um, those capital leases. The same way we would record a alone is if you had bought an asset and took a loan out to acquire that assets that the recorded, um, in that manner as opposed to just putting the, the rent payment as an expense on the income statements. So they’re recorded as you know, let’s put the acid on, let’s put the liability that’s associated with that asset on and every time you make a payment on it, you know, let’s book that payment against that liability.
What happens if Elise has a discount bio option at the end of the term?
Well that’s one of the, you know, criteria for determining if this is a capital lease or an operating lease. So, you know, you have this hundred thousand dollar piece of equipment and at the end of the term you’re going to use this thing for all five years and at the end of the five years you would expect that that asset is worth 20,000 bucks. You know, I’m off the lot. It was 100,000 used, it’s worth 20,000. But let’s say at the end of the lease, you have the option to buy it for a dollar. Really, you own this thing. You’re not not going to buy this asset for a dollar at end of the lease. It’s a discount purchase option as one of the criteria that if you have that, that a characteristic of the least, this is a capital lease. And you know, it’s really a, an ownership structure at this point.
What happens if the lease term is for more than 75% of the assets lifespan? Yeah. So that’s criteria number
two is, um, you know, if the lease is for 75% or more of the assets, useful economic life, you own this thing. And let’s say you buy this, uh, uh, this, uh, piece of equipment and the, this piece of equipment is really only expected to last, let’s call it eight years and the lease goes for seven years. You own this thing. This is not a a lease. This is not an operating lease. This is a capital lease and you know, we should be recording it on the financial statements as such to give you an accurate picture of what’s happening. So we were recording that that acid is actually yours and that entire liability that that’s going to come as at least is more like a loan than really just a monthly lease payment.
What happens if the present value of the lease payments is 90% of the fair value?
Well, you’re getting technical now. Cool. So, uh, the, the 90% tests of the other fair value. So what we’re saying is, you know, we have this asset and the fair value is, is a hundred, a hundred thousand dollars, and we’re talking about the present value of those lease payments. So the asset’s worth $100,000. We bought it in cash right now. And let’s say the all the lease payments in total are going to be, I’m just going to call it $150,000. Now keep in mind a dollar paid seven years from now is not the same value as a dollar paid today. Uh, you know, there’s the time value of money and that’s what it talks about, the present value. And we can discount that back mathematically. And let’s say if we find that the those hundred and $50,000 worth of lease payments, uh, you know, they have a present value of say, um, you know, $95,000.
You know, we’re really, this is a, this is more like ownership than it is like a monthly lease. Like you go to, um, you know, budget or a rental car and rent a car that’s a, that’s a clear lease. Stay proactive with your accounting and find a great Edmonton Bookkeeping service. You know, you don’t own this thing, but if you’re, the payments that you’re going to fork out a as a, as your contractual obligation are, you know, the present value of them is, is more than 90% of the fair value of the, the acid on it when it’s coming in, you own this thing and it should be recorded as such,
Ken reporting and capital leases properly help a business get more financing.
It can. Yeah. So sometimes we have this, this capital leases, leased equipment and think of what it like let’s say, were the bankers looking at this lease expense every month? Well, what if they were to understand that capital lease and they know that this lease expires in six and in six months they’re going to get the ability to buy this piece of equipment and it discount rate, say a dollar. That changes the entire cashflow outlook of his business. Oftentimes there’s, you know, when we go to the [inaudible], the optometry clinics that you deal with and there’s a lot of upfront costs and acquiring that equipment, but you know, we’re talking five or seven years in and all of a sudden all those lease payments come off the book and they have all that free cashflow now coming in. Whereas if we were just recording it as a month, a month expense, it just looks like that expense is going to occur in perpetuity.
But if you start to understand what that capital Lee’s looks like and the terms of the capital, at least you know, it can make the business look, you know, more or, or, um, often it’s either more or the same, uh, but it can be more favorable for the business owner and the cashflow outlook looks better. Stay on top of your Edmonton Bookkeeping. Um, so I think that’s what we have for you today on accounting from loans and capital leases. Uh, thanks again for tuning in. Please hit the like and subscribe buttons so we can continue to deliver you tips on how to beat the odds at business. And if you have any questions or queries, you’ll feel free to leave them in the comments below and we’ll do everything we can to address some of potentially making a topic on a future video. Thanks very much. Thank you.