On December 31, 2014, Thomas Henley, financial vice president of Kingston Corporation, signed a noncancelable three-year lease for an item of manufacturing equipment. The lease called for annual payments of $41,635 per year due at the end of each of the next three years. The leased equipment’s expected economic life was four years. No cash changed hands because the first payment wasn’t due until December 31, 2015.
Henley was talking with his auditor that afternoon and was surprised to learn that the lease qualified as a capital lease and would have to be put on the balance sheet. Although his intuition told him that capitalization adversely affected certain ratios, the size of these adverse effects was unclear to him. Because similar leases on other equipment were up for renewal in 2015, he wanted a precise measure of the ratio deterioration. “If these effects are excessive,” he said, “I’ll try to get similar leases on the other machinery to qualify as operating leases when they come up for renewal next year.”
Assume that the appropriate rate for discounting the minimum lease payments is 12%.
Also assume that the asset Leased equipment under capital leases will be depreciated on a straight-line basis.

1. Prepare an amortization schedule for the lease.
2. The effect of lease capitalization on the current ratio worried Henley. Before factoring in the capital lease signed on December 31, 2014, Kingston Corporation’s current ratio at December 31, 2014, was:

Once this lease is capitalized on December 31, 2014, what is the adjusted December 31, 2014, current ratio?
3. Henley was also concerned about the effect that lease capitalization would have on net income. He estimated that if the lease previously described were treated as an operating lease, 2015 pre-tax income would be $225,000. Determine the 2015 pre-tax income on a capital lease basis if this lease were treated as a capital lease and if the leased equipment were depreciated on a straight-line basis over the life of thelease.

  • CreatedSeptember 10, 2014
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