On January 1, 2017, two identical companies, POLY, and YNUS, lease similar asset

Question

On January 1, 2017, two identical companies, POLY, and YNUS, lease similar assets with the following characteristics: Lease term is for five years. Lease payments of $18,000 per year are payable at the end of each year, with the first payment due on December 31, 2017. Each firm has an incremental borrowing rate of 10% and a tax rate of 30%. Nike capitalizes the lease for financial reporting purpose, whereas Adidas uses the operating lease method. Both firms use straight-line depreciation method for all assets including leased assets on their financial statements and for income tax purpose. Assume that both firms treat the leases as capital lease on their tax returns. Assume also that each firm generates $75,000 for income before lease-related expense and income tax in 2017. 1. Determine the amount of capital lease (PV of the minimum lease payments) Nike should record at the beginning of 2017. 2. Determine the amount of lease-related interest & depreciation expenses Nike should recognize for 2017. 3. Determine both income tax expenses and income tax payable of Nike for 2017. 4. Determine both income tax expenses and income tax payable of Adidas for 2017. 5. Determine the amount of 2017 deferred income tax (asset or liability) for Adidas. 6. State the effect (increase, decrease or no effect) on (i) debt to equity ratio, (ii) interest coverage ratio, (iii) operating cash flows, and (iv) net income of Adidas for 2017, if Adidas used capital lease instead of operating lease. Briefly explain why.

Explanation / Answer

Ans 1 Nike's Books of accounts Lease Payment dates Dec-17 Dec-18 Dec-19 Dec-20 Dec-21 Total Lease payments per year ($) 18,000 18,000 18,000 18,000 18,000 90,000 Borrowing rate / Discount rate 10% 10% 10% 10% 10% Present value factor for Lease payments 0.9091 0.8264 0.7513 0.6830 0.6209 Present value of lease payment ($)     16,363.64    14,876.03    13,523.67    12,294.24    11,176.58    68,234.16 The amount of capital lease (PV of the minimum lease payments) for Nike to record at the beginning of 2017 is $ 68,234.16 Ans 2 The amount of Lease-related interest and Depreciation expense for Nike for the year ended December 31, 2017 are as under : Lease related interest being 10% of capitalisation i.e. $ 68,234.16 = $ 68,234.16*10% = $ 6,823.42 Depreciation on Leased assets (Straight-line for 5 years on Capital Lease asset) = $ 68,234.16 / 5 = $ 13,646.83 Ans 3 Income Tax expense and income tax payable of Nike for 2017 Income ($)     75,000.00 Less : Lease interest expense ($)     (6,823.42) Less : Depreciation on Lease assets ($) (13,646.83) Net income chargeable to income tax ($)     54,529.75 Income tax rate 30% Income tax expense / payable ($)     16,358.93 Ans 4 Income Tax expense and income tax payable of Adidas for 2017 Income ($)     75,000.00 Less : Lease expense ($) (18,000.00) Net income chargeable to income tax ($)     57,000.00 Income tax rate 30% Income tax expense ($)     17,100.00 Income ($)     75,000.00 Less : Lease interest expense ($)     (6,823.42) Less : Depreciation on Lease assets ($) (13,646.83) Net income chargeable to income tax ($)     54,529.75 Income tax rate 30% Income tax payable ($)     16,358.93 Ans 4 The amount of deferred tax asset for Adidas for 2017 is as under : Income tax expense ($)     17,100.00 Income tax payable ($)     16,358.93 Difference / Deferred Tax asset ($)           741.08 Ans 5 (i) If Adidas treat the lease as capital lease, the asset would be created in the books of account. The interest and depreciation expense impact would be higher in 2017 compared to Lease expense under Operating lease. This would reduce the equity capital of Adidas. The debt to equity ratio of Adidas would increase. (ii) Due to higher interest expense in 2017, Adidas would have reduced profit for 2017 if lease would be treated as capital lease. This would reduce interest coverage ratio. (iii) The interest cost is added back in Operating cash and disclosed as financing cash flow. Depreciation is added back being non-cash expenses. Accordingly, under capital lease treatment Operating cash flow would improve. Under Operating lease, lease expenses are treated as operating cash flow and adversely impact operating cash flow. (iv) The net income of Adidas would reduce under capital lease as lease interest expenses would have been higher in year 2017.

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