(Accounting for leases, LO 5) In May 2005 Isachsen Inc. (Isachsen) signed a fouryear lease with an office supply company to supply Isachsen with all required office equipment over the lease period. Had Isachsen purchased the office equipment, it would have cost about $500,000. The lease requires Isachsen to make annual lease payments of $150,000 on April 30, the company’s year end. At the end of the lease Isachsen will own the equipment. Isachsen’s management believes that the office equipment will be useful for between six and eight years. The interest rate appropriate for this lease is 12%.

On April 30, 2006 Isachsen had total liabilities (before accounting for the lease obligation) of $2,750,000 and capital stock of $1,500,000. Isachsen’s income before lease related-expenses and taxes for the year ended April 30, 2006 is $550,000.

Isachsen’s tax expense for fiscal 2006 is estimated to be $160,000 and retained earnings on April 30, 2005 was $900,000.

Required:

a. What are some of the reasons that Isachsen might have leased rather than purchased the office equipment?

b. Should the lease be accounted for as a capital lease or an operating lease?
Explain.

c. What journal entry would be required when the lease agreement was signed if the lease were considered a capital lease? What entry would be required if it were classified as an operating lease?

d. Prepare a schedule showing the principal and interest components of each annual payment over the life of the lease, assuming the lease is treated as a capital lease. Prepare the journal entries that Isachsen would make on April 30, 2006 and April 30, 2008 to record the lease payment. What would the entries be if the lease were classified as an operating lease?

e. Compare the effect on the income statement of classifying the lease as a capital lease versus an operating lease. Make the comparison for the years ended April 30, 2006 and 2008.

f. What amount would be reported on Isachsen’s balance sheet for the equipment when the lease was signed in May 2005? What does this amount represent?
g. Over what period of time should the equipment be amortized? Explain.
Prepare the journal entry to record the amortization expense for the year ended April 30, 2006. Assume Isachsen uses straight-line amortization.
h. How would Isachsen’s debt-to-equity ratio be affected by accounting for the lease as a capital lease? Compare the debt-to-equity ratio on April 30, 2006 when the lease is classified as a capital lease versus an operating lease.
i. What steps could Isachsen take to have the lease classified as an operating lease? Why might Isachsen prefer that classification?
j. Suppose you were considering buying all the shares of Isachsen. Which balance sheet and income statement would be more useful to you in assessing the company—statements where the lease was classified as a capital lease or as an operating lease?