Question 9.18: Comparison of Accounting and Financial Statement Effects of ......
Comparison of Accounting and Financial Statement Effects of the Buy versus Lease Decision
Bi-ly Company is considering the following alternatives in obtaining the use of a new piece of equipment at the beginning of Year 1:
Alternative 1: Buy the equipment and finance the purchase with new debt.
Alternative 2: Lease the equipment under an operating lease (the equipment is not reported as an asset, the lease payments each period are treated as an operating expense on the income statement).
Alternative 3: Lease the equipment under a finance lease (the equipment is reported as an asset and an obligation is recorded equal to the present value of future lease payments).
The fair value of the equipment, having a five-year useful life and no salvage value, is $1,000. If Bi-ly leases the equipment, annual lease payments would be $264 due at the end of each year. Bi-ly’s discount rate is 10 percent. The company uses straight-line depreciation. (For illustration, assume the company can record the lease as either operating or financing.)
1. For each alternative under consideration, determine the effect on assets and liabilities at the beginning of Year 1.
2. For each alternative, determine the effect on the income statement in Year 1.
3. For each alternative, calculate Bi-ly’s return on assets and debt-to-asset ratio at the end of Year 1. For simplicity, assume that—excluding any effects of Bi-ly’s choice among the three alternatives for obtaining the assets—total assets at the beginning and end of the year are $4,500, total liabilities at the beginning and end of the year are $3,000, and net income for the year is $800.
to 1: At the beginning of Year 1, Bi-ly would show the following assets and
debt: (Table 1)
to 2: For Year 1, Bi-ly would show the following expenses related to the
equipment: (Table 2)
For Alternatives 1 and 3, depreciation expense is the acquisition cost of $1,000 divided by the 5-year useful life. Salvage value is 0.
For Alternatives 1 and 3, interest expense is the beginning balance of debt, $1,000 times the discount rate of 10 percent. Each year the interest expense will decline.
For Alternative 2, rent expense is the lease payment of $264.
to 3: To calculate the return on assets: (Table 3)
In this example, the highest return on assets is found when the equipment is leased under an operating lease which is expected because net income is highest and the asset base is lowest. Buying an asset and seeking to finance it with new debt and leasing it under a finance lease result in the same return on assets.
To calculate the debt-to-asset ratio at the end of the year: (Table 4)
In this example, the lowest debt-to-asset ratio is found when the equipment is financed through an operating lease. Buying an asset and seeking to finance it with new debt and leasing it under a finance lease result in the same return on assets.
| Alternative | 1 | 2 | 3 |
| Buy/Lease | Buy | Lease | Lease |
| Finance/Accounting | Issue new debt | Operating | Finance* |
| Long-lived asset | $1,000 | $1,000 | |
| Debt/lease obligation | 1,000 | 1,000 | |
| (Table 1) | |||
*Under a finance lease, the present value of five future lease payments of $264 discounted at 10 percent is reported on the balance sheet as a lease obligation and an asset of $1,000 (rounded).
| Alternative | 1 | 2 | 3 |
| Rent expense | $264 | ||
| Depreciation expense | $200 | $200 | |
| Interest expense | 100 | 100 | |
| Total expenses | $300 | $264 | $300 |
| (Table 2) | |||
| Alternative | 1 | 2 | 3 |
| Net income, excluding new asset | $800 | $800 | $800 |
| Add additional expenses (solution to 2) | $300 | $264 | $300 |
| Net income, adjusted | $500 | $536 | $500 |
| Total assets, beginning, excluding new asset | $4,500 | $4,500 | $4,500 |
| Add additional asset (solution to 1) | 1,000 | 1,000 | |
| Total assets, beginning, adjusted | $5,500 | $4,500 | $5,500 |
| Total assets, end, excluding new asset | $4,500 | $4,500 | $4,500 |
| Add additional asset* | 800 | 800 | |
| Total assets, end, adjusted | $5,300 | $4,500 | $5,300 |
| Average total assets | $5,400 | $4,500 | $5,400 |
| Return on assets, adjusted | 9.3% | 11.9% | 9.3% |
| (Table 3) | |||
*The book value of the new asset at the end of the year is its beginning balance of $1,000 less $200 accumulated depreciation.
| Alternative | 1 | 2 | 3 |
| Total assets, end, excluding new asset | $4,500 | $4,500 | $4,500 |
| Add additional asset | 800 | 800 | |
| Total assets, end, adjusted | $5,300 | $4,500 | $5,300 |
| Total liabilities, end, excluding new asset | $3,000 | $3,000 | $3,000 |
| Add additional debt* | 837 | 837 | |
| Total liabilities, end, adjusted | $3,837 | $3,000 | $3,837 |
| Debt-to-asset ratio | 0.724 | 0.667 | 0.724 |
| (Table 4) | |||
*Additional debt at the end of the first year is the present value of the four remaining debt/lease payments of $264 discounted at 10 percent (and rounded).