Review the Consolidated Balance Sheets (page 41), and Note 17 – Leases (page 72)

Question

Review the Consolidated Balance Sheets (page 41), and Note 17 – Leases (page 72). As part of its incentive plan for senior executives, Sherwin-Williams pays a bonus for a metric called RONAE (Return on Net Assets Employed). The metric is defined as Net income divided by average net assets employed, which is the sum of net accounts receivable, total inventory, net fixed assets, total intangible assets and goodwill, less accounts payable. Given this incentive structure, would a bonus-maximizing manager prefer (1) operating leases or (2) capital leases? Explain.

Consolidated Balance Sheets December 31 Current assets: Cash and cash equivalents . . .. .. . Accounts receivable, less allowance-. Inventories: $ 889,793 S 205,744 $40,732 1,130,565 1,230,9871,114,275 Finished goods .. Work in process and raw 898,627 840,603 177,927 191,743 1,033,527 109,087 251,655 3,627,298 2,657,180 2,565,566 87,883 230,748 Other current assets 381,030 Total current assets 1,126,8921,143,333 255,010 Deferred pension assets Other assets Property, plant and equipment: 244,882 119,530 696,202 125,691 2,153,437 2,026,617 ,952,037 117,126 3,100,9332,923,431 2,005,045 1,881,569 1,814,230 1,095,888 ,041,862 1,021,030 Total Assets . Liabilities and Shareholders' Equity Current liabilities: $6,752,521 5,778,937 5,699,333 Short-term borrowin S 40,739 1,034,608 39,462 679,436 57,561 1,042,182 338,256 Accrued taxes Current portion of long-term debt... Other accruals 578,547 522,280 Total current liabilities 2,829,1792,141,859 2,680,666 1,115,996 277,892 1,211,326 Postretirement benefits other than pensions . .. . . . 248,523 Shareholders' equity Common stock $1.00 par value 93,013,031, 92,246,525, and 94,704,173 shares outstanding at December 31, 2016, 2015 and 2014, respectively 115,761 114,525 2,330,426 2,079,639 4,049,497 3,228,876 2,424,674 (4,235,832) 4,220,058) 3,150,410) Retained earnings Treasury stock, at cost .. Cumulative other comprehensive loss Total shareholders' equity Total Liabilities and Shareholders' Equity. . 1,878,441 867,910 996,470 $6,752,521 5,778,937 $5,699,333 See notes to consoidated financial staternents.

Explanation / Answer

Operating lease-rentals reduce the net income to the extent of the full amount of the periodic lease payments & also the resultant tax benefit -- the effect is felt in the retained earnings balance on the liability side of the balance sheet ---other than which ,there is no direct impact on the balance sheet . Whereas, in case of capital leases, it affects both the Income statement and the balance sheet Periodic lease payments include payments both towards interest and principal repayment ,the former goes through the income statement and reduces the taxable income(though comparatively less than under operating lease) . Principal repayment reduces the capital lease liability carried on the liability -side of the balance sheet . There is also the advantage of cash flow increase within the business due to charging of non-cash expense of depreciation--- to the extent of the tax rate percent times the depreciation amount. But depreciation also reduces the net income after-tax (Calculated for bonus purposes) In addition, the lessee can also elect Sec. 179 deduction for the asset, wherr by the full PV of the lease can also be claimed ,in the income statement. And the leased asset appearing on the asset side of the balance sheet of the lessee shows the carrying value of the asset.So, there are matching debits & credits on both sides of the balance sheet. Summing up, given this bonus structure, Under operating lease, numerator(Net Income) reduces by the full lease amount.But the denominator(assets) remain untouched. But, under, capital lease,the numerator (net income) also reduces (both by interest & depreciation) & there is also addition to the value of the denominator(assets) (though,reduced by the amount of accumulated) depreciation So, in all possibility, the metric, Net income divided by average net assets employed will be less under Capital leases as the asset base is bound to be larger than under operating lease. So, a bonus-maximising manager, will prefer only the operating lease,under this type of incentive-structure.

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