Reading 22: Long-lived Assets: Implications for Financial Sta leases, center, finance, statements, 2011

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Session 5: Financial Reporting and Analysis: Inventories and Long-lived Assets
Reading 22: Long-lived Assets: Implications for Financial Statements and Ratios

LOS f: Discuss the implications for financial statements and ratios of finance leases and operating leases from the perspective of both the lessor and the lessee.

 

 

Which of the following statements that classify a lease as a finance lease under U.S. GAAP is least accurate?

A) Title is transferred at the end of the lease period.

B) The present value of the lease payments is at least 80% of the fair market value of the asset.

C) A bargain purchase option exists.

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For a lease to be classified as a finance (capital) lease the present value of the lease payments must be at least 90% of the fair market value of the asset.

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An analyst compares two companies that are identical except that Company X uses finance leases and Company Y uses operating leases. The analyst would expect Company X’s debt-to-equity ratio, relative to Company Y’s, to be:

A) lower.

B) higher.

C) the same.

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Lease capitalization adds both current and noncurrent liabilities to debt, resulting in a corresponding increase in the debt-to-equity and other leverage ratios. Thus, Company X’s (Debt + Lease)/Equity is greater than Company Y’s Debt/Equity.

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In a sales-type lease, a lessor recognizes a gross profit at the inception of the lease equaling the:

A) sale price of the leased asset plus the present value of the minimum lease payments.

B) present value of the minimum lease payments less the cost of the leased asset.

C) sale price of the leased asset less the present value of the minimum lease payments.

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In a sales-type lease, the implicit interest rate is such that the present value of MLP is the selling price of the asset. At the time of the lease inception, the lessor will recognize a gain equaling the present value of the MLPs, less the cost of the leased asset.

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In a direct-financing lease, the implicit rate is such that the present value of the minimum lease payments:

A) equals the sale price of the leased asset.

B) is lower than the cost of the leased asset.

C) equals the cost of the leased asset.

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In a direct-financing lease, the implicit rate is such that the present value of the MLPs equals the cost of the leased asset. Thus, at lease inception the total assets do not change and no gain is recognized.

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Under an operating lease (versus a finance lease) which of the following is higher for the lessee?

A) Cash flow from financing.

B) Cash flow from operations.

C) Assets.

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The lessee's cash flows from financing will be higher for an operating lease because the payments made for an operating lease are operating cash outflows, not financing cash outflows. The payments made under a finance lease are split between interest paid and principal. The latter is charged to cash flow from financing.

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Compared to an operating lease, a lessee using a finance lease is least likely to have:

A) a lower current ratio.

B) higher cash flow from financing during the lease period.

C) lower net income in the earlier years of the lease.

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Since a portion of the lease payment is treated as repayment of principal under a finance lease, cash flow from financing will be lower.

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Classifying a lease as an operating lease for a lessee, as opposed to a finance lease, will result in:

Current Ratio

Debt/Equity Ratio

Asset Turnover Ratio

A) Higher Lower Lower

B) Lower Lower Higher

C) Higher Lower Higher

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For a lessee using operating leases, the current ratio will be higher, the debt/equity ratio will be lower, and the asset turnover will be higher than they would be with finance leases. With operating leases, assets and liabilities are lower.

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If a lessee enters into a finance lease rather than an operating lease, it can expect to have a:

A) higher return on assets.

B) higher debt-to-equity ratio.

C) lower debt-to-equity ratio.

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Leasing the asset with an operating lease avoids recognition of the debt on the lessee’s balance sheet. Having fewer assets and liabilities on the balance sheet than would exist if the assets were purchased increases profitability ratios (e.g., return on assets) and decreases leverage ratios (e.g., debt-to-equity ratio). In the case of a finance lease, the assets are reported on the balance sheet and are depreciated.

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For a given lease payment and term, which of the following is least accurate regarding the effects of the classification of the lease as a finance lease as compared to an operating lease?

A) The lessee's asset turnover will be lower for a finance lease.

B) The lessee's current ratio will be higher for a finance lease.

C) The lessee's debt-to-equity ratio will be higher for a finance lease.

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The lessee's current ratio will be lower because the current portion of the finance lease increases current liabilities, hence reducing the current ratio.

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If a lease is treated as a finance lease, as compared to being treated as an operating lease, the effect on the lessee's current ratio and the debt/equity ratio will be an:

Current Ratio

Debt/Equity Ratio

A) Increase Increase

B) Decrease Increase

C) Increase Decrease

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With finance leases the lessee's assets, current liabilities, and long-term liabilities will be greater than if the lease was an operating lease. With the debt to equity ratio, the liability is in the numerator, which results in an increase in the ratio. With the current ratio, current liabilities are increased and are in the denominator which results in a decrease in the ratio.