Need a reply to discussion

I need a reply to the following discussion posts. Needs to have an in-text citation and should be approximately 2-3 paragraphs for each one with an open-ended question to my fellow students. This does not need a title page, and one reference is sufficient. Please make sure there is an open-ended question at the end. (Article attached) Question: To prepare for this discussion, please go the case that you read for this week, “Leasing Decision at Magnet Beauty Products, Inc.,” and calculate the impact of the two lease options on Magnetâ??s income statement, balance sheet, and cash flow. Which lease option should Janette Clark choose? Why? Do you agree with the proposed new lease accounting rules? Why/why not? I need a reply to this post: Reply to Karen! The lease option that I think Janette Clark should choose is the 3 plus 2-year lease for the following reasons: 1. It will decrease her total operating expense; however, it will increase her EBITDA (the difference is going to have to show up somewhere) 2. It will increase her net income before taxes and 3. It will increase her net income, 4. She will have the security of not having to move any of the stores, which is important for her because she has built up a base of clients and will want to remain in a stable location, 5. She will have the security of not having increased rent what will happen with her 1-year leases, the 3 plus 2-year lease will remain at a constant level. I do agree with the proposed new lease accounting rules. This money is still going to have to be paid out with the change in laws, no matter if it is for rent or a lease. Now it is just a matter of accounting for that expense. The income statements may show more expense in the first couple of years but it levels off in the last couple of years. The only way to get around spending money on rent or a lease is to purchase the property, then she would be able to add that as an asset/investment. This might not be the wisest choice if she is thinking of selling her business towards the end of her lease option because then she would have a building that she would no longer have a use for, unless she opened another business or rented out the building to another company. I am still a little confused on how to record operating expense vs. capital investment when it comes to leases, so I look forward to learning from my classmates!
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For the exclusive use of L. FIZZELL, 2018.
9-111-039
REV: SEPTEMBER 14, 2011
KRISHNA PALEPU
GEORGE SERAFEIM
Lea
asing Decision
D
n at Ma
agnet B
Beauty Produccts, Inc.
Intro
oduction
In late August 2010,
2
Janette Clark, the ow
wner of Magn
net Beauty Pro
oducts, Inc., w
was evaluatin
ng the
different leasing op
ptions she ha
ad for her storres. Two weeeks earlier, sh
he had asked David Cameron, a
newly
y recruited acccountant, to analyze
a
the im
mpact that th
he new accoun
nting standarrd for leases w
would
have on her busin
ness. Clark ask
ked Cameron
n to analyze h
how the diffeerent leasing proposals sh
he had
receiv
ved from her landlord wo
ould affect Ma
agnetâ??s financcial statemen
nts. Cameronâ??â??s analysis sh
howed
that, as
a a result of the forthcom
ming accountin
ng changes th
he different leeasing option
ns would havee very
different impact on the compan
nyâ??s financiall statements for years to ccome. She w
wondered how
w she
should take these differences
d
in
nto account in
n making her ffinal leasing d
decision.
Mag
gnet Beautty Productts Inc.
Ma
agnet Beauty Products Incc. was a fast growing
g
start–up selling prremium hair, body and facce care
produ
uct. The comp
pany was set up in 2005 with
w the aim tto utilize its eextensive scien
ntific resourcces for
the crreation of beeneficial and safe productts. Although Magnet starrted with a llimited numb
ber of
produ
ucts being offfered, it grew
w to offer a co
omplete skin and hair caree range, makee-up, and sun
n care
produ
ucts, and herrbal supplem
ments. As of 2010, Magn
net offered cclose to 100 innovative h
herbal
produ
ucts, employin
ng 300 peoplee and maintaiining producttion facilities of 140 thousaands square ffeet.
Th
he firm differrentiated itsellf from the competition
c
b
by selling on
nly products m
made from h
highly
conceentrated naturral ingredientts (Exhibit 1)). Demand w
was particularlly strong for products thaat had
high concentration
n of exotic in
ngredients such as wild ro
ose oil, a natu
ural source o
of vitamin C,, with
signifficant repairin
ng activity forr fine lines an
nd skin colorr disorders, an
nd aloe, rich in vitamin E, Zinc
and antioxidant
a
en
nzymes, whicch enhance th
he immune sy
ystem of the skin. Face prroducts comp
prised
45% of total saless. Hair and body produ
ucts equaled 21% and 199% of total sales respecttively.
Pharm
maceutical an
nd other produ
ucts represen
nted the rest 155% of the salees.
Ma
agnet started
d its operation
ns with one retail store in downtown B
Boston, and eexpanded to tthirtytwo stores
s
throug
ghout Massa
achusetts by mid 2010. All stores w
were occupiied under leeasing
arrang
gements. Thee company had
h
leased all
a its stores from the saame lessor, a large real estate
company operatin
ng in Massacchusetts. Thiss gave Magn
net the advaantage to neg
gotiate the leeasing
arrang
gements collectively for all
a propertiess under one contract. Ap
part from thee thirty-two sstores,
_______
_______________
_______________
________________
___________________________________________________________________
Professo
ors Krishna Palepu
u and George Seraffeim prepared thiss case. The compan
ny mentioned in th
he case is fictional.. HBS cases are deeveloped
solely ass the basis for classs discussion. Casess are not intended to serve as endorssements, sources off primary data, or illustrations of effeective or
ineffectiive management.
Copyrig
ght © 2010, 2011 President and Fellow
ws of Harvard Colleege. To order copiies or request perm
mission to reproducce materials, call 1–800-5457685, write Harvard Busin
ness School Publish
hing, Boston, MA 02163, or go to ww
ww.hbsp.harvard.eedu/educators. Th
his publication may
y not be
digitized
d, photocopied, or otherwise reprodu
uced, posted, or tran
nsmitted, without tthe permission of H
Harvard Business S
School.
This document is authorized for use only by LISA FIZZELL in MBE 503 Accounting & Ethics – Introductory Coursepack-1 taught by DANIELLE FOLEY, New England College of Business from
Feb 2018 to Aug 2018.
For the exclusive use of L. FIZZELL, 2018.
111-039
Leasing Decision at Magnet Beauty Products, Inc.
Magnet was distributing its products through alliances with high-end hotels located in Boston, New
York and Miami, and airlines that used Magnet products for passengers that travelled first class.
For the 2009 fiscal year Magnet reported sales of $52.4 million experiencing a 12% increase from
the previous year. Net income after taxes was $1.4 million, 10% higher than the previous year.
Accounts receivable reached $30 million mainly because of the increasing importance of business
coming from deals with luxury hotels and airlines. However, the company was considerably
leveraged. Accounts payable and outstanding debt had reached $20 and $52 million respectively. The
loans carried a 7% interest rate. Total net cash flow for 2009 was negative $1 million, and negative $2
million before financing cash flows.
Clark was happy with the way her business was progressing. Assuming that things continued to
go well, she was hoping to nurture her start up for the next few years, and then sell the business to
one of the large specialty retailers in her space. To achieve this objective Clark considered it
important to maintain customer loyalty, focus on cost efficiencies, and as a result improve the
profitability and the cash flow position of Magnet.
Accounting for leases
Existing U.S. lease accounting standards, under Financial Accounting Standard No. 13 (FAS 13),
required lessees to classify their lease contracts as either capital or operating leases. Capital leases
were leases that transferred to the lessee substantially all the risks and rewards incidental to
ownership of the leased asset. All other leases were operating leases.1 FAS 13 provided four criteria to
test whether a lease contract met the test of â??substantial transfer of risks and rewardsâ?:
1.
The lease transfers ownership of the property to the lessee by the end of the lease term.
2.
The lease contains a bargain lease option.
3.
The lease term is equal to 75 percent or more of the estimated economic life of the leased
property.
4.
The present value of the minimum lease payments equals or exceeds 90 percent of the fair
market value of the property.
Leases classified as capital leases were treated as similar to a purchase of the underlying asset
with a loan. Consequently, the lessee recognized in its balance sheet the leased item as an asset and
an obligation to pay rentals as a liability. Over the term of the lease, the lessee depreciated the leased
item and apportioned lease payments between a finance charge and a reduction of the outstanding
liability. The lessee recognized no similar assets or liabilities when the lease was classified as an
operating lease. Instead, the lessee recognized the annual lease payments under an operating lease as
rental expense.
Recently, the Financial Accounting Standards Board (FASB) and the International Accounting
Standards Board (IASB) decided to jointly revise their standards on lease accounting after
considerable criticism that the existing accounting model for leases failed to provide useful
information to users of financial statements. Critics noted that operating leases give rise to assets and
liabilities that users of financial statements would like to see on the balance sheet, so they can have a
more complete picture of the financial position of a firm. They also argued that the existence of
different accounting models for substantially similar leases impairs comparability across companies.
2
This document is authorized for use only by LISA FIZZELL in MBE 503 Accounting & Ethics – Introductory Coursepack-1 taught by DANIELLE FOLEY, New England College of Business from
Feb 2018 to Aug 2018.
For the exclusive use of L. FIZZELL, 2018.
Leasing Decision at Magnet Beauty Products, Inc.
111-039
Finally, there was wide-spread concern that FAS 13 provided opportunities to engage in â??accounting
arbitrage� by structuring transactions to achieve a specific lease classification.
In mid March of 2009 FASB and IASB published a discussion paper with the preliminary views of
the board members on how the accounting model for leases would change.2 The boards appeared
determined to eliminate operating leases and treat all leases as capital leases regardless of the
particular lease terms. As a result, a lessee would recognize an asset representing its right to use the
leased item for the lease term (â??right-of-use assetâ?), and a liability for its obligation to pay rentals for
the lease term. Moreover, the board members seemed to favor an approach that would require the
capitalization of leases under renewal options,a contingent rental arrangements,b and residual value
guarantees.c
The discussion paper specified that the right-of-use asset should be initially measured as the
present value of the lease payments discounted using the lesseeâ??s incremental borrowing rate. The
proposal suggested that the asset should be amortized over the shorter of the lease term and the
economic life of the leased item. The liability to pay rentals would initially be measured as the
present value of the lease payments discounted using the lesseeâ??s incremental borrowing rate. The
income statement recognition of expenses associated with leases would also be affected under the
proposed accounting rules. Under the current accounting model, payments for operating leases were
classified as operating expenses on a straight-line basis. Under the proposed accounting model,
interest expense associated with the lease payment liability, and depreciation and amortization
expense associated with the leased asset would be recorded as expenses. As the liability on the
balance sheet declined over the lease term, so would the interest expense. As a result, since rentals
under the operating expenses generally remained the same over the life of a lease, expenses recorded
under the proposed rules would be usually higher than the currently recorded rental expenses in the
initial periods of a lease. The pattern would change the other way during the later part of the lease
period. In late August of 2010 FASB and IASB issued an exposure draft supporting the proposals in
the discussion paper.3 The exposure draft included an exception for lease contracts of 12 or fewer
months. These contracts could continue be recognized as operating leases.
Choosing the new lease contract
Clark was initially considering renewing the lease contract for her stores for five years as a threeyear lease with a renewal option for two more years. Such a long-term lease would ensure that
Magnet would be able to lock in its current store locations for the foreseeable future. The company
a In the boardsâ?? view, the lease term should reflect the entityâ??s reasonable expectation of what the term will be.
The discussion paper proposed that an entity should account for options to extend or terminate a lease by
assuming the longest possible lease term that is more likely than not to occur.
b In some leases, the amount of each lease payment is variable rather than fixed. This variability can arise
because of features, such as contingent rentals, based on price changes, the lesseeâ??s performance derived from
the underlying asset, or the usage of the underlying asset. In the boardsâ?? view, the measurement of the right-ofuse asset and right to receive lease payments should reflect all rights received, even if the payment or receipt of
those rights is contingent.
c The discussion paper proposed that entities should account for residual value guarantees, in which a lessee
compensates a lessor if the value of the underlying asset at the end of a lease is less than a specified amount, in
the same way as it accounts for contingent rentals. In the boardsâ?? view, a residual value guarantee is equivalent
to a contingent payment at the end of the lease term.
3
This document is authorized for use only by LISA FIZZELL in MBE 503 Accounting & Ethics – Introductory Coursepack-1 taught by DANIELLE FOLEY, New England College of Business from
Feb 2018 to Aug 2018.
For the exclusive use of L. FIZZELL, 2018.
111-039
Leasing Decision at Magnet Beauty Products, Inc.
was beginning to establish a loyal customer base, and store location was an important aspect of
cementing this advantage for years to come. The contract had specified that the renewal option
would be automatically exercised subject to sales targets for the next three years for $60 million per
year on average. Clark was confident that these sales targets would be achieved and therefore the
effective term of the lease was most probably five years. The mall developer was offering Clark an
attractive lease contract for the â??three plus two yearsâ? lease. Under the proposed terms, the annual
rental payment would be fixed at $10 million for the whole five-year period. Lessors were willing to
offer better terms for long-term leases because long-term contracts reduced the risk of owing an
unoccupied facility by the lessors. Moreover, under the proposed accounting standard, the three plus
two lease would allow the developer to recognize as revenue the entire present value of the five year
lease payments when the lease was signed.
To analyze the alternatives to the proposed â??three plus two yearsâ? lease, Cameron had collected a
market analysis of the commercial real estate market. Cameron also evaluated the option of one-year
leases that could be potentially rolled over at the end of every year. Under this arrangement, Magnet
would make no legal commitment to renew the lease beyond the first year. Of course, this meant that
Magnet may have to move its stores some time during the next five years, should the current landlord choose not to offer the space on a one-year basis. Further, if Magnet rented retail space year by
year, Cameronâ??s market analysis showed that the forecasted rent would increase 5% every year for
the next five years starting from $10 million in year 1 and reaching $12.2 million in year 5.
Based on the borrowing rate on the outstanding debt of Magnet, Cameron determined that the
incremental borrowing rate of Magnet was 7%. He forecasted sales to increase by 12% every year for
the five-year period, a growth rate that was moderately higher than the expected industry growth.
Cost of goods sold and research and development expenses were expected to grow at 12% each year.
Administrative and distribution expenses were expected to increase by 9% every year, a slower
growth rate that reflected the forecasted cost efficiencies.
Clark received the analysis that Cameron had performed, showing how the proposed accounting
rules would impact the income statement, the balance sheet, and the cash flow statement under the
â??three plus two yearsâ? lease (Exhibits 2 to 4) and the â??five one yearâ? leases (Exhibits 5 to 7). Under
the five year lease, net income was expected to decrease from $1.5 million to $0.8 million for year 1 as
a result of the accounting change. Moreover, leverage was expected to increase from 4.6 to 6.8. A
shorter lease affected the income statement and the balance sheet less dramatically. Under a one-year
lease, net income for year 1 would remain $1.5 million and leverage would equal 4.6. However, the
lease payments would be higher in the future, reducing net cash flow before debt issues.
Cameron also informed Clark that the new leasing accounting model was expected to have a
widespread impact on many companies.4 Exhibits 8 and 9 show the estimated potential effects of the
proposed accounting rules on reported leverage and Earnings before Interest, Taxes, Depreciation,
and Amortization (EBITDA) across various industries and countries.5 The highest increase in
leverage and EBITDA was expected for companies in the retail and transportation industries, and in
Netherlands, United Kingdom, Italy and France. Exhibit 10 shows the effect of capitalizing existing
operating lease obligations reported in the footnotes of 20 of the largest U.S. retail companies,
transportation companies, banks and utilities on the income statement. For most companies higher
expenses would be recognized up to the 7th year of the lease and the cumulative increase in lease cost
in excess of straight line rent expense varied between $98 million and $2.66 billion. As a result of the
accounting change, public companies were expected to record about $1.3 trillion in leases on their
balance sheets, according to estimates by the Securities and Exchange Commission. Because many
4
This document is authorized for use only by LISA FIZZELL in MBE 503 Accounting & Ethics – Introductory Coursepack-1 taught by DANIELLE FOLEY, New England College of Business from
Feb 2018 to Aug 2018.
For the exclusive use of L. FIZZELL, 2018.
Leasing Decision at Magnet Beauty Products, Inc.
111-039
private companies also follow GAAP accounting, the number could be closer to $2 trillion, according
to experts.6
As a small business owner, Clark was very concerned about managing her cash flows, to
minimize the need for external financing. However, she also felt that Magnetâ??s reported profits could
be important in determining the companyâ??s value when she was ready to sell her business. Also, till
she decided to sell the company, she wanted to make sure that she could present attractive financial
statements to the banks if she needed a loan to finance Magnetâ??s growth.
As Clark pondered over the two leasing options for her store, she wondered how she should
balance the various considerations in making her decision.
5
This document is authorized for use only by LISA FIZZELL in MBE 503 Accounting & Ethics – Introductory Coursepack-1 taught by DANIELLE FOLEY, New England College of Business from
Feb 2018 to Aug 2018.
For the exclusive use of L. FIZZELL, 2018.
111-039
Exhibit 1
Leasing Decision at Magnet Beauty Products, Inc.
Ingredients that are used and not used in Magnetâ??s products
Ingredients not used
Disadvantages of
Ingredients not used
Ingredients used
Silicones
Synthetic,non bio-degraded,
which clog the pores, burden
hair
Combination of dry
vegetable oils
Parabens
Conservatives to which a large
percentage of the population is
overexposed to
Organic acids,
food conservatives
Natural, mild, safe
Oil products
(mineral oil)
Synthetics, clog skin pores
Excellent quality
natural oils
Exceptional compatibility,
does not clog pores,
moisturizing properties
Propylene-glycol
Ethanolamines
Synthetic vitamin E
(D- and L-tocopherol)
Dissolution responsible for
allergies
Controllers of pH responsible
for allergies, rashes
Only D-tocopherol has proven
anti-oxidant action
Butylene glycol
Amino acid L-arginin
Natural vitamin Î?
(D-tocopherol)
Advantages of
Ingredients used
Exceptional compatibility,
does not clog pores, does not
burden hair moisturizing
properties
High compatibility, friendly
to the skin
High compatibility,
moisturizing properties
Has a double anti-oxidant
action
Source: Casewriters.
6
This document is authorized for use only by LISA FIZZELL in MBE 503 Accounting & Ethics – Introductory Coursepack-1 taught by DANIELLE FOLEY, New England College of Business from
Feb 2018 to Aug 2018.
Source: Casewriters.
Net income
Taxes
Net Income before taxes
Depreciation
Interest on Debt
Interest on Lease
Amortization
EBITDA
Total operating expenses
R&D Expenses
Distribution Expenses
Administrative Expenses
Rent
Gross Profit
$1,413,755
728,298
2,142,052
1,000,000
3,646,977

6,789,029
25,449,374
794,566
12,087,965
4,566,843
8,000,000
32,238,403
$52,365,734
20,127,331
Year 0
$809,059
416,788
1,225,847
1,120,000
3,646,977
2,870,138
8,200,395
17,063,357
19,043,655
889,914
13,175,882
4,977,859

36,107,011
$58,649,622
22,542,611
Year 1
$2,446,554
1,260,346
3,706,901
1,360,400
4,016,828
2,371,048
8,200,395
19,655,572
20,784,281
996,704
14,361,711
5,425,8 …
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