On May 1, 2018, Isachsen Inc. (Isachsen) signed a four year lease with an office supply company to supply Isachsen with all required office equipment over the lease period. Had Isachsen purchased the office equipment, it would have cost about $250,000. The lease requires Isachsen to make annual lease payments of $75,000 on April 30 of each year. Isachsen made the first payment on April 30, 2019. At the end of the lease, Isachsen will own the equipment. Isachsen's management believes the office equipment will be useful for between six and eight years. The interest rate appropriate for this lease is 11 percent.
On April 30, 2019, Isachsen had total liabilities (before accounting for the lease obligation) of $1,375,000, common shares of $750,000, and retained earnings of $450,000. Isachsen's income before lease related-expenses and taxes for the year ended April 30, 2019 was $275,000. Isachsen's tax expense for fiscal 2019 is estimated to be $80,000 (including the effect of the lease).
a. What are some of the reasons that Isachsen might have leased rather than purchased the office equipment?
b. Should the lease be accounted for as a capital (finance) lease or an operating lease? Explain.
c. What journal entry would be required when the lease agreement was signed if the lease was considered a capital (finance) lease? What entry would be required if it were classified as an operating lease?
d. Prepare a schedule showing the principal and interest components of each annual payment over the life of the lease, assuming the lease is treated as a capital (finance) lease. Prepare the journal entries that Isachsen would make on April 30, 2019 and April 30, 2021 to record the lease payment. What would the entries be if the lease was classified as an operating lease?
e. What amount would be reported on Isachsen's balance sheet for the equipment when the lease was signed in May 1, 2018? What does this amount represent?
f. Over what period of time should the equipment be depreciated? Explain. Prepare the journal entry to record the depreciation expense for the year ended April 30, 2019. Assume Isachsen uses straight-line depreciation.
g. How would Isachsen's debt-to-equity ratio be affected by accounting for the lease as a capital (finance) lease? Compare the debt-to-equity ratio on April 30, 2019 when the lease is classified as a capital (finance) lease versus an operating lease.
h. Compare the effect on the income statement of classifying the lease as a capital (finance) lease versus an operating lease. Make the comparison for the years ended April 30, 2019 and 2021, and in total over the term of the lease.
i. What steps could Isachsen take to have the lease classified as an operating lease? Why might Isachsen prefer that classification?
j. Suppose you were considering buying all the shares of Isachsen. Which balance sheet and income statement would be more useful to you in assessing the company- statements where the lease was classified as a capital (finance) lease or as an operating lease?