Capital Lease Question

On December 31, 2005, Wander Company executed a three-year lease with annual payments of 1,200,000 for machinery for its recycling facility. The economic life of the equipment was five years and its fair market value at the time the lease was signed was 3,750,000. The interest rate implicit in the lease was 6 percent. Wander Company’s incremental borrowing rate was 8 percent. Treating the above transaction as an operating lease, Wander’s income statement for the year ended December 31, 2006 was as follows: (in ) Sales 18,200,000 Cost of Goods Sold (8,100,000) Gross Profit 10,100,000 Depreciation (1,200,000) Lease Expense (1,200,000) Sales and Administration (3,100,000) Operating Profit 4,600,000 Interest Expense (1,100,000) Income taxes (1,500,000) Net Income 2,000,000 After considering whether the machinery lease should be reclassified as a capital lease, Wander’s operating profit will: A) increase from $4,600,000 to $4,730,795. B) increase from $4,600,000 to $5,930,795. C) decrease from $4,600,000 to $4,538,338. D) remain at $4,600,000. From my understanding don’t we just add back the lease expense to operating profit and apply the depreciation expense to operating profit and if so then how would we depreciate the asset, which is not clarified in the question.

B?? my numbers are not coming to $5,930795 value of the capitla lease n-3, i/y 6, pmt 1.2 cpt pv 3,207,614 4600000+1200000-(3207614/5)=5,158,477 am not sure but it starting point

I think the answer is A. Add back rent expense and deduct depreciation over the time of the lease (not the economic life of the asset, so this should be 3,207,614/3).

For the income statement depreciate straight line, for taxes depreciate with an accelerated method.

map1 is the rule to depreciate over the lease term not economic life?

Yes, over the time of the lease. How would you deduct depreciation when you no longer have the asset if the economic life is longer than the period you leased the asset? There is an example on page 521, CFAI text volume 3. Straight line provision is mentioned on page 521 of volume 3 CFAI text.

On a side note, this would not clasify as a capital lease (less than 75% of economic life, PV of lease payments is less than 90% of fair market value, no title transfer, no bargain purchase).

Map1 is correct…since it does not qualify as a capital lease then the correct answer is D…according to schweser answers.

Right…because they are only considering if this is or not a capital lease, they are not taking the decision to make it capital lease…FRUSTRATING!

thank you for that

How can you ask a question like that? It says they ARE considering… Thanks for figuring it out though, these kinds of questions are killing me. I think there was one on the mock exam where fair value was less than the total lease payments. Whole other wrench.

“I’m considering not eating for a month”, that’s not equal to “I will not eat for a month”. Frustrating.

map1 Wrote: ------------------------------------------------------- > I think the answer is A. Add back rent expense and > deduct depreciation over the time of the lease > (not the economic life of the asset, so this > should be 3,207,614/3). Map1 - Can you please verify this: For calculating Depreciation expense for Capital leases, we should use (PV-Salvage Value)/Lease period. Also, Salvage value is corresponding to value at end of asset’s life or value that remains at end of leasing period ?

In this case, there is no salvage, because the asset is not yours to get some salvage value out of it. You have an yearly expense, with a PV is what it is, and you depreciate it over the time you have it. As if you would have bought the asset, for 3,207,614, and used it for 3 years, but at the end you don’t take posession of it, it is returned to the lessor. But, in a capital lease, if you have a guarantee of a salvage value given, then yes, the annual depreciation formula would include that salvage value, (PV-Salvage Value)/Lease period.

Thanks a lot Map1.

The Q doesn’t say Wander is considering capitalizing…they are asking YOU to consider and make any necessary adjustments. In this case there aren’t any so the answer is D.