Magnet Beauty Case Study
Magnet Beauty is a fast-growing retailer is facing two different leasing options for its stores. In choosing between the two options, management is considering the potential impact of the two options on the company's financial statements, considering the proposed new accounting standard for leases.
Leasing obligation was treated as operating leases on under the old method in the financial book. Also, they were not considered as an asset that results in a term called off-balance sheet financing. Therefore, the leases show as rent expense on the income statement. Under the new method of accounting for leases, they considered as capital leases; this has an impact on the balance sheet and income statement as well. Leases are recorded …show more content…
In the analysis of the income statement with one-year rent option, the rent is recorded as an operating expense. Also, with the 1-year lease option, the rental payment will rise by 5% over time, which causes the earnings before interest, tax, depreciation, and amortization to decrease. There is no interest on lease and depreciation since the rent is acknowledged as the cost. Despite, the tax is higher in the first year compared to the three plus-2-year lease, however by the time the income tax increase in progressive rate compares. Whereas under the five-year option, no rent expense records on the books. Moreover, in 3 plus 2-year lease rental option the payment would be set for the whole five years’ period at $10 million. Also, this amount is not realized as rent expense in the income statement. As a result, this method causes earnings before interest, tax, depreciation, and amortization to increase. At the beginning of the lease, the interest is high; and tax is lesser. However, the income tax increases significantly, while the interest on the lease reduces. If you compare the net income of the five years and one-year lease option, the total net income in five years, it higher by …show more content…
But by year three and four years four and five, net income have grown higher again in the three plus two-year lease, resulting in a total net income that is 3.7 million higher in the new lease agreement. In the five 1-year lease agreement records amortization, there is no amortization expense since the property is not recognized as an asset. The three plus two-year lease records amortizations beginning in the year 1 for the same amount in each subsequent year.
Principal payments under lease obligations- The five 1-year lease SCF does not record any principal payment under lease obligation because this was already recorded as a rental expense on the income statement and is factored into the net income on SCF. The three plus two-year lease shows a principal payment under lease obligation for each of the five years that reflects the 10 million in rent, less the yearly interest expense.
Net Debt Issues- The five 1-year lease records higher net debt issues each year than does the three plus two-year lease. This is because the five one year lease entails higher expenses per year that the company must borrow more money to cover as compared with the existing debt issues in the other