Question

On January 1, Caroline Electronics Inc. leased a fleet of 20 trucks at an annual lease payment per truck totaling $10,000 per year for a five-year period. The interest rate implicit in the lease is 6 percent.

A.	If the truck lease is accounted for as a capital lease, what value should be capitalized to Caroline's balance sheet for the leased assets and lease liability on January 1?
B.	Assume the trucks will be depreciated on a straight-line basis with no salvage value. Compare the financial statement effects over the five-year lease period assuming the lease is accounted for as (1) an operating lease, and (2) a capital lease. Provide numbers for depreciation, lease expense and, if applicable, interest expense. Which approach provides the greatest tax benefits? Why?

Answer 1

A. If the truck lease is accounted for as a capital lease, the amount that Caroline Electronics would capitalize would be the present value of the lease payments at 6 % for 5 periods.

Annual payments = 20 x $ 10,000 = $ 200,000.

PVA _{6%, n=5 years} = [ { 1 - ( 1 / 1.06) ⁵ } / 0.06 ] = 4.21236

Present value of the lease payments = $ 200,000 x 4.21236 = $ 842,472

Therefore, the leased asset and the corresponding lease liability would be capitalized on Caroline's books at $ 842,472 on January 1.

B. If the lease was a pure operating lease, lease rent of $ 200,000 would charged to the Income Statement, and that's about it. The transaction would not affect the balance sheet.

On the other hand, if the lease is treated as a capital lease, there are multiple implications. The leased asset would be carried on the asset side of the balance sheet, with a corresponding lease liability on the liabilities side, which would be amortized over the lease term as per the following schedule:

Lease Amortization Schedule:

Date	Amount Paid	Interest Expense	Reduction in Lease Liability	Carrying Value of the Lease Liability
January 1, Year 1				842,472
December 31, Year 1	200,000	50,548.32	149,451.68	693,020.32
December 31, Year 2	200,000	41,581.22	158,418.78	534,601.54
December 31, Year 3	200,000	32,076.09	167,923.91	366,677.63
December 31, Year 4	200,000	22,000.66	177,999.34	188,678.29
December 31, Year 5	200,000	11,321.71	188,678.29	0

Therefore, interest expense would be recognized each year on the Income Statement, as well as depreciation expense of $ 842,472 / 5 = $ 168,494 each year of the lease term.

Accounting for the lease as a capital lease would result in the greater tax benefits for Caroline Electronics Inc. because, by opting to do so, it can enjoy the tax shields of both depreciation expense, and interest expense.