You are the chief financial officer at SD International (SDI). SDI is a small but growing computer hardware retailer. The company plans to purchase new buildings this year. However, SDI has an existing commercial loan with National Commercial Bank (NCB). One of the conditions of the existing loan was for SDI to maintain interest coverage ratio (operating income/interest expense) of two or higher.
Below is the projected data for next year.
Interest expense on existing loan
New buildings cost
If SDI borrows the $25 million needed to finance the new buildings, the increased interest expense will cause SDI to be in violation of the interest coverage constraint.
The controller suggested an accounting solution to this dilemma: lease the new buildings, carefully constructing the lease agreements so that the leases will be accounted for as operating leases. The leasing arrangements will be economically similar to purchase of the buildings with borrowed money, but the annual payments will be reported as rent expense instead of interest expense. Accordingly, the interest coverage loan covenant will not be violated. You were involved in the negotiation of NCBs loan. Therefore, you know that the intent of the loan covenant was to prevent SDI from incurring large fixed obligations that might endanger the repayment of the NCB loan. Operating lease payments are fixed obligations, just like interest payments, and you are uneasy about using this accounting trick to get around the loan covenant. However, there does not seem to be any other solution. Write about what you would do.
1.Explain the theoretical basis for requiring lessees to capitalize certain long-term leases.
2.Explain how SDI should account for the lease.
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