Tradeall, Inc., leases automobiles for its sales force. On January 1, 2011, the company leased 100 automobiles and agreed to make lease payments of $10,000 per automobile each year. The lease agreement expires on December 31, 2015, at which time the automobiles can be purchased by Tradeall for a nominal price. Assume an effective rate of 10 percent.
a. Compute the annual rental expense if the lease is treated as an operating lease.
b. Prepare the journal entry on January 1, 2011, if the lease is treated as a capital lease. What dollar amount represents an approximation of the fair market value of the automobiles?
c. Assume that the automobiles are depreciated over a five-year life, using the straight-line method with no salvage value. Compute the total rental expense (interest and depreciation) associated with the lease during the first year if the lease is treated as a capital lease.
d. Which of the two methods of treatment (operating or capital) would give rise to a higher net income in the first year? Which method would give rise to a lower debt/equity ratio?
e. Define off-balance-sheet financing, and explain how leases can be arranged to practice it.