On January 1, 2018, two companies, Luxor Ltd. and Cale Inc., were incorporated. Each company operates a restaurant and had identical revenues during the year of $3 million but Luxor bought its building for $1.7 million and the related land for $800,000. The company estimated that the building would have a useful life of 20 years with no residual value. Luxor uses the straight-line method of depreciation. Because of the building purchase, Luxor had an outstanding 4% bank loan during the year amounting on average to $2.8 million.
Cale, however, did not buy a building. Instead it rented a building under a five-year operating lease starting on January 1, 2018, for $17,000 per month. Because of this, the company had to install leasehold improvements for $100,000, which were completed in the first few days of January. Because Cale did not have to buy a building, its outstanding 4% bank loan during 2018 averaged only $350,000.
The income tax rate for both companies is 22%. Assume both companies had identical revenues and expenses except for the items noted above.
Instructions
(a) If Luxor had net income of $175,000 for the year ended December 31, 2018, what net income did Cale have?
(b) If Luxor had total assets of $3,025,000 as at December 31, 2018, and the only differences between the assets of Luxor and Cale related to land, buildings, and leasehold improvements, the latter being depreciated over the term of the lease, what are the total assets for Cale at the end of 2018?
(c) Calculate the asset turnover ratio for both companies for 2018. (Hint: Because this is the first year of operations, you can use the year-end asset balance rather than the average asset balance for the denominator.) Explain why the ratios are different.
(d) Calculate the profit margin ratio for both companies for 2018. Explain why they are different.
(e) Calculate the return on assets ratio for both companies for 2018. (Hint: Because this is the first year of operations, you can use the year-end asset balance rather than the average asset balance for the denominator.) Explain why the ratios are different using your answers in parts (c) and (d) above.
(f) What information relating to Cale is not reflected in the financial statements that may be relevant to assessing its financial position and profitability?
(g) Would adopting the revaluation method under IFRS change the values of any of the three ratios covered above? Would those ratios improve or not?
(h) If new rules for treating operating leases beyond one year as capital leases are adopted in 2019, what impact will this have on Cale's asset turnover ratio?