1. Magnet Beauty leases all of its stores from the same lessor. They have determined that leasing makes more sense than buying properties. Describe the process that most companies undertake to make lease-versus-buy decisions.
A company attempting to differentiate and decide between lease-versus-buy should first consider how long it plans to have the facility. This is an important point/factor when deciding between the two options because a company may opt to lease a facility, for instance, for a short time if the company is aware that it will move to a new location in the near future whereas a company will be more likely to purchase if the company knows that it will continue business in ...view middle of the document...
2. Once a company decides to lease, there are a number of different ways a lease may be classified for accounting purposes. Identify and describe the different classifications, including (1) how to determine the right classification, and (2) the different ways they would be presented in the company’s financial statements.
(1) FAS 13 provided 4 criteria to test the right classification whether a lease met the “substantial transfer of risks and rewards”
1. The lease transfers ownership of the property to the lessee by the end of the lease term.
2. The lease contains a bargain lease option.
3. The lease term is equal to 75 % or more of the estimated economic life of the leased property.
4. The present value of the minimum lease payments equals or exceeds 90 percent of the fair market value of the property.
(2) Leases classified as capital leases were treated as similar to a purchase of the underlying asset with a loan. Consequently, the lessee recognized in its balance sheet the leased item as an asset and an obligation to pay rentals as a liability. Over the term of the lease, the lessee depreciated the leased item and apportioned lease payments between a finance charge and a reduction of the outstanding liability. The lessee recognized no similar assets or liabilities when the lease was classified as an operating lease. Instead, the lessee recognized the annual lease payments under an operating lease as rental expense.
3. Using the information in the exhibits, compare the impact of Magnet Beauty’s two lease options on their income statement, balance sheet, and cash flow statements.
| Capital Lease | Operational Lease |
Income Statement | Recognized as depreciation and amortization | Recognized as rental expense |
Balance sheet | Recognized as an asset and an obligation to pay rentals as a liability | Not recognized as assets and liabilities |
Cash flow statement | Recognized as asset amortization and lease obligation | Not recognized as amortization and lease obligation |
4. Which option should the CEO select, and why?
The lease option that Janette Clark should choose to pursue in our opinion is the ‘3 plus 2 year lease.’ We are choosing this lease based on the assumption the Clark will operate the company for the duration of the 5 year period projected in the financial statements provided in the case. Reasons for this conclusion are that Magnet Beauty Products would be locked into a 5 year agreement as a result of the 3 plus 2 year lease. This lease enables Magnet to stay in their current locations thereby maximizing their ability to retain their loyal customer base. Maintaining their store locations is an important...