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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The Mader Corporation leases an asset for five years with lease payments of $10,000 per year. If Mader classifies the lease as a finance lease, which financial statements are affected at the end of the first year?

A) Statement of cash flows, income statement, and balance sheet.

B) Income statement and balance sheet only.

C) Income statement only.

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The classification of a lease as a finance lease creates an asset, a debt obligation, financing cash flows (amortization of the loan), and operating cash flows (interest expense).

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For a finance lease, the amount recorded initially by the lessee as a liability will:

A) be less than the total of the minimum lease payments.

B) equal the total of the minimum lease payments.

C) equal the present value of the minimum lease payments at the beginning of the lease.

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With a finance lease, both an asset and liability are reported on the lessee's balance sheet, with lease payments divided between interest and principal components. The future payments on principal and interest must be discounted to present value at the beginning of the lease.

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Which of the following statements regarding finance and operating leases is least accurate?

A) During the life of an operating lease, the rent expense equals the lease payment.

B) Asset turnover is higher for the lessee with an operating lease than a finance lease.

C) For financial reporting of finance and operating leases, no entry is required on the lessee's balance sheet at the inception of the lease.

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If the lease is an operating lease there is no entry made on the balance sheet for the lessee. For finance leases, the leased asset and liability are recognized on the balance sheet by the amount equal to the present value of the minimum lease payments using as the discount rate the lower of the lessor's implicit rate or the lessee's incremental borrowing rate.

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Which of the following statements about leases is least accurate?

A) In the first years of a finance lease, the lessee's current ratio is greater than it would have been had the firm used an operating lease.

B) In the first years of a finance lease, the lessee's debt to equity ratio is greater than it would have been if the firm had used an operating lease.

C) All else equal, when a lease is capitalized the lessee's income will rise over the term of the lease.

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From the lessee's perspective, if a lease is considered to be a finance lease instead of an operating lease, then the lessee's current liabilities will be greater until the lease has expired. This will result in a lower current ratio (larger denominator).

In the early years, the capitalized lease expense (interest plus depreciation) is greater than in the later years because interest expense decreases over time. Less expenses = more income.

In the first years of a finance lease the lessee's debt to equity ratio will be greater than if the firm had used an operating lease because in the case of the finance lease, the numerator is comprised of (debt + lease), while the numerator in the case of the operating lease is (debt) only. In addition, the greater capitalized lease expense flows through to decrease shareholder's equity (the denominator).

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Which of the following statements about the impact of leases on the financial statements of the lessee is least accurate?

A) Net income is lower in the early years of a finance lease than an operating lease.

B) Cash flow from investing is higher for a finance lease than an operating lease.

C) A finance lease results in higher liabilities compared to an operating lease.

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Cash flow from investing is not affected by a lease being either a finance or an operating lease. Finance leases reduce cash flow from operations by only the portion of the lease payment attributed to interest expense. Cash flow from financing is reduced by the rest of the finance lease payment which is the principal part of the payment.

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Which of the following statements regarding the effect of a finance lease on the lessee's statement of cash flows is least accurate?

A) The rental expense serves to reduce the cash flow for financing because it is an investment expense.

B) The change in the finance lease liability on the balance sheet is a cash flow from financing.

C) The interest expense portion of the lease payments reduces cash flow from operations.

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In finance leases, there is only interest expense and principal repayment. Rental expense is only charged when the lease is an operating lease.

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Under a finance lease (versus an operating lease) which of the lessee's financial ratios will be higher?

A) Asset turnover.

B) Return on equity.

C) Debt/equity.

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The debt/equity ratio will be higher because the finance lease requires the creation of a long-term liability on the balance sheet.

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Which of the following statements about leasing is least accurate?

A) Firms that capitalize their leases will have lower current ratios and higher debt to equity ratios than firms that structure their leases as operating leases.

B) If the lessor is only financing the purchase of an asset, the lease is considered to be a direct financing lease and gross profits are recognized at the inception of the lease.

C) The interest rate implicit in a lease is the discount rate that the lessor used to determine the lease payments.

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With a direct financing lease, the lessor recognizes profit as interest revenue over the life of the lease. A sales-type lease allows the lessor to recognize profits at the lease inception.

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Which of the following statements regarding a direct financing lease is least accurate?

A) The principal portion of the lease payment is a cash inflow from investing on the lessor's cash flow statement.

B) Interest revenue on the lessor's income statement equals the implicit interest rate times the lease payment.

C) The lessor recognizes no gross profit at the inception of the lease.

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Interest revenues are calculated by multiplying the implicit interest rate by net receivables at the beginning of the period.