On April, 10 th 2018 two identical companies, ABC, and XYZ., lease similar asset

Question

On April, 10th 2018 two identical companies, ABC, and XYZ., 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%.

ABC capitalizes the lease for financial reporting purpose, whereas XYZ 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.

(Required)

Determine the amount of capital lease (PV of the minimum lease payments) ABC should record at the beginning of 2018.

Determine the amount of lease-related interest & depreciation expenses ABC should recognize for 2018.

Determine both income tax expenses and income tax payable of ABC for 2018.

Determine both income tax expenses and income tax payable of XYZ for 2018.

Determine the amount of 2018 deferred income tax (asset or liability) for XYZ.

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 XYZ for 2018, if XYZ used capital lease instead of operating lease. Briefly explain why.

Explanation / Answer

Part I

The present Value of the Minimim Lease payments is calculated as:

18000/(1+10%) + 18000/(1+10%)2 + 18000/(1+10%)3 + 18000/(1+10%)4 + 18000/(1+10%)5 .

The PV Factor used for 5years is 3.790787.

Hence the amount of the capital lease is 18,000 X 3.790787 = $68,234.16

Part II

The interest expense to be recorded is $68,234.16 X 10% = $6,823.4

The Depreciation expense to be recorded is $68,234.16/5 = $13,646.83

Part III

The income tax expense for ABC would be (75,000 - 6,823.4 - 13,646.83) X 35% = 19085.41

Part IV

The income tax expense for XYZ would be (75000 - 18000) X 35% = $19,550

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