CASE 131 Capital versus Operating Leases

On January 2, 2017, two identical companies, Daggar Corp. and Bayshore Company, lease similar assets with the following characteristics:

1. The economic life is eight years.
2. The term of the lease is five years.
3. Lease payment of $20,000 per year is due at the beginning of each year beginning January 2, 2017.
4. The fair market value of the leased property is $96,000.
5. Each firm has an incremental borrowing rate of 8 percent and a tax rate of 40 percent.

Neither company has early adopted the new lease standard, and Daggar capitalizes the lease, whereas Bayshore records the lease as an operating lease. Both firms depreciate assets by the straightline method, and both treat the lease as an operating lease for federal income tax purposes.

Required:

1. Determine earnings (i) before interest and taxes and (ii) before taxes for both firms. Identify the source of any differences between the companies.
2. Compute any deferred taxes resulting from the lease for each firm in the first year of the lease.
3. Compute the effect of the lease on the 2017 reported cash from operations for both firms. Explain any differences.
4. Compute the effect of the lease on 2017 reported cash flows from investing activities for both firms. Explain any differences.
5. Compute the effect of the lease on 2017 reported cash flow from financing activities for both firms. Explain any differences.
6. Compute the effect of the lease on total 2017 cash flows for both companies. Explain any differences.
7. Give reasons why Daggar and Bayshore might have wanted to use different methods to report similar transactions.