Case Study: Leasing Decision At Magnet Beauty Products
Instead, we calculated the change in Net Income between the two methods to see the affect it would have on at least one of the variables.
In the “3 plus 2 year lease” the old method essentially overstates Net Income compared to the new method by 271% in the first year, down to 10% in the fifth year. This is because the only expense incurred in the operating leases deal with rent. In the “five 1-year leases” both methods display the same Net Income. This is because the 1-year lease acts in the same manner as rent expense.
We recommend that Ms. Janette Clark, of Magnet Beauty Products Inc., take on the five 1-year leases. Although this will ultimately increase the lease payments, it will also overstate the Net Income of her business. This will help her attain higher quality loans from banks and be more attractive to the investment community.
Although footnotes will be disclosed allowing analysts to recompute her financial statements as though the leases had been classified as a long-term capital lease, the average user would not go through the