Assume U.S. GAAP. At the beginning of the year, a lessee company enters into a new lease agreement that is correctly classified as a finance lease, with the following terms:

Annual lease payments due at the end of the year: $100,000
Lease term: 5 years
Appropriate discount rate: 12%
Depreciation method: straight-line basis
Estimated salvage value: $0

With respect to the effect of the lease on the company's financial statements in the first year of the lease, which of the following is most accurate? The reduction in the company's ______

Explanation: The present value of the lease is $360,477.62. (n = 5, I = 12%, PMT = $100,000) 12% of the original PV is $43,257.31, which represents the interest component of the payment in the first year. The difference between the annual payment and the interest is the amortization of the lease obligation included in cash flow from financing. $100,000 - 43,257.31 = $56,742.69

Depreciation is $360,477.62 / 5 or $72,095.52, so the total reduction in pretax income would be interest plus depreciation, or $115,352.83. Cash flow from operations would be reduced by the amount of the interest only because the depreciation would be added back to determine cash flow from operations.