(Accounting for leases, LO 5) Vista Inc. (Vista) is a new manufacturing company that was formed in January 2007 to supply certain specialized machine parts to a large public company. Vista’s managers decided to arrange long-term leases for the company’s equipment, rather than to arrange financing and buy the equipment. Had Vista purchased the equipment, it would have cost about $1,000,000. Instead, Vista signed a 10-year lease for the equipment in January 2007 that required it to make annual payments of $150,000 on December 31, the company’s year end. At the end of the lease Vista has the option to purchase the equipment at its fair mar- ket value at the time. However, Vista’s management thinks that it is unlikely that it will exercise the option, since after 10 years the equipment is likely to be techno- logically out of date. The interest rate appropriate for this lease is 10%.

On December 31, 2007 Vista had total liabilities (before accounting for the lease obligation) of $800,000, capital stock of $500,000, and income before lease-related expenses and taxes of $350,000. Vista’s tax expense for 2007 is estimated to be

$40,000.

Required:

a. What are some of the reasons that Vista might have leased rather than purchased the 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 Vista would make on December 31, 2007 and December 31, 2010 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 December 31, 2007 and 2010.

f. What amount would be reported on Vista’s balance sheet for the machinery when the lease was signed in January 2007? 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 December 31, 2007. Assume Vista uses straight-line amortization.

h. How would Vista’s debt-to-equity ratio be affected by accounting for the lease as a capital lease? Compare the debt-to-equity ratio on December 31, 2007 when the lease is classified as a capital lease versus an operating lease.

i. What steps could Vista take to have the lease classified as an operating lease?

Why might Vista prefer that classification?

j. For purposes of determining a bonus for Vista’s managers, do you think it is more appropriate to treat the lease as a capital lease or an operating lease? In answering, focus on determining management’s bonus, not how GAAP would require the lease to be classified.