Vista Inc. (Vista) is a new manufacturing company that was formed in January 2014, 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 \($1,500,000\). Instead, Vista signed an eight-year lease for the equipment in January 2014 that required it to make annual payments of \($225,000\) 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 market value at the time. However, Vista’s management thinks it’s unlikely it will exercise the option because after eight years the equipment will likely be technologically out of date. The interest rate appropriate for this lease is 10 percent.

On December 31, 2014, Vista had total liabilities (before accounting for the lease obligation) of \($1,200,000\), capital stock of \($750,000\), and income before lease-related expenses and taxes of \($540,000\). Vista’s tax expense for 2014 is estimated to be $60,000

(including the effect of the lease).

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 was considered a capital lease? What entry would be required if it was 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, 2014 and December 31, 2017 to record the lease payment. What would the entries be if the lease were classified as an operating lease?

e. What amount would be reported on Vista’s balance sheet for the machinery when the lease was signed in January 2014? What does this amount represent?

f. Over what period of time should the equipment be depreciated? Explain. Prepare the journal entry to record the depreciation expense for the year ended December 31, 2014. Assume Vista uses straight-line depreciation.
g. 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, 2014, when the lease is classified as a capital lease versus an operating lease.
h. 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, 2014 and 2017, and in total over the term of the 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’s more appropriate to treat the lease as a capital lease or an operating lease? In answering, focus on determining management’s bonus, not how IFRS would require the lease to be classified.