“Leasing Decision at Magnet Beauty Products, Inc.”
New vs. Old
Under the old method the leases were treated as operating leases on the books. This resulted in what can be called “off-balance sheet” financing, because the leases were not required to be carried as assets on the balance sheet. Instead, leases showed up only through rent expense on the income statement. On the contrary, under the new method of accounting for leases, all leases are required to be carried as capital leases. This affects both the balance sheet and the income statement together. On the balance sheet, the leases are carried as an asset (Right-to-Use) and a liability (Lease Obligation). Both of these are decreased through amortization expenses that hit the income statement. In addition to the amortization expense recognized in the income statement, we also see interest expense due to the amortization process of the Lease Obligation. Financial Statement Analysis
First off, when we look at the old method, the rent expense hits the income statement above the line and affects EBITDA (Operating Income). Whereas, in the new method we see the expenses as Depreciation/Amortization and Interest Expense, which occur below EBITDA to arrive at Net Income. On the Cash Flow Statement, the operating lease affects Cash Flow from Operating Activities, while the capital lease affects the Cash Flow from Financing Activities. Ultimately, these differences do not affect the cash flow in aggregate. However, they do change the make-up of the Cash Flow Statement due to different uses in various activities. Ratios
Return on Assets (Net Income/Avg. Total Assets)
In the “3 plus 2 year lease” the new method causes the Return on Assets ratio to decrease by multiple percentage points. This is due to the fact that the leases are now a capitalized asset, increasing our Total Assets as a whole. In the “five 1-year leases” both methods create the same ratio percentage. This is due to the leases being...
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