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Consequently the effective rate is greater than the

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Unformatted text preview: ccounts are affected under the two approaches. With a capital lease, the $150,000 is allocated between interest expense and depreciation expense, while with an operating lease, the entire $150,000 is allocated to rent expense. P11–15 a. If the lease is treated as an operating lease, Thompkins Laundry would not have to report any liability associated with the lease. Therefore, its debt/equity ratio would be as follows. Debt/Equity Ratio b. = = = = Total Liabilities ÷ Stockholders' Equity (Current Liabilities + Long­Term Liabilities) ÷ Stockholders' Equity $30,000 ÷ $40,000 0.75 If the lease is treated as a capital lease, Thompkins Laundry would have to report a liability equal to the present value of the future lease payments. Therefore, its debt/equity ratio would be affected. Present value of lease payments Debt/equity ratio = $5,000 Present value of an ordinary annuity factor for i = 12% and n = 5 = $5,000 3.60478 (from Table 5 in Appendix A) = $18,023.90 = ($30,000 + $18,023.90) ÷ $40,000 = 1.20 P11–15 Concluded c. Rent Expense Operating lease $5,000.00 Interest Depreciation Expense ___Expense_ $5,000.00 $ 0.00 Total Expenses $ 0.00 Capital lease 3,604.78 d. 0.00 5,767.65 2,162.87 There are two primary reasons why Thompkins Laundry might want to arrange the terms of the lease agreement so that the lease would be classified as an operating lease rather than as a capital lease. First, lease obligations under an operating lease are not disclosed on the face of the balance sheet. Consequently, operating leases are essentially off­balance­sheet financing and will not affect any existing debt covenants that are based on reported liabilities. Second, in this case the capital lease classification results in higher expenses and, hence, lower net income in 2012 than the operating lease classification. Decreased net income would adversely affect any contracts, such as the manager's incentive contract, written on the basis of reported net income. To avoid classifying thi...
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