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
$5,000.00 $ 0.00 Total
$ 0.00 Capital lease
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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- Fall '08