Question 9.21: Financial Statement Impact of a Direct Financing Lease versu......

to 1: LOPER reports higher expenses in Year 1 because, under an operating lease, the lessor retains ownership of the asset and continues to report associated depreciation expense. DIRFIN, treating the lease as a finance lease, does not reflect ownership of the asset or the associated depreciation expense. DIRFIN has higher net income in Year 1 because the interest revenue component of the lease payment in that year exceeds the lease revenue net of depreciation reported by LOPER.

exceeds the lease revenue net of depreciation reported by LOPER. On its income statement, LOPER reports depreciation expense for the asset it has leased and lease revenue based on the lease payment received. The following table shows LOPER’s depreciation and book values on leased equipment by year.^{35}

(Table 1)

• Column (a) is the cost of €100,000 of the leased equipment.

• Column (b) is depreciation expense of €25,000 per year, calculated using the straight-line method as the cost less the salvage value divided by the useful life [(€100,000 – €0)/4 years].

• Column (c) is the accumulated depreciation on the leased asset calculated as the prior year’s accumulated depreciation plus the current year’s depreciation expense.

• Column (d) is the ending book value of the leased equipment, which is the difference between the cost and accumulated depreciation.

DIRFIN, however, records the lease as a direct financing lease. It removes the leased asset from its assets and records a lease receivable. On its income statement, DIRFIN reports interest revenues earned from financing the lease. The table following shows DIRFIN’s interest revenues and carrying amounts on the lease receivable.

(Table 2)

• Column (a) is the lease receivable at the beginning of the year.

• Column (b) is annual lease payment received at the beginning of the year, which is allocated to interest and reduction of the lease receivable.

• Column (c) is interest accrued in the previous year calculated as the lease receivable outstanding for the year times the interest rate.

• Column (d) is the reduction of the lease receivable which is the difference between the annual lease payments received and interest. Because the lease payment is due on 1 January, this amount of interest is a receivable at the end of the prior year and is reported as interest revenue in the prior year.

• Column (e) is the lease receivable after the lease payment is received and at the end of the year. It is the lease receivable at 1 January (Column a) less the reduction of the lease receivable (Column d).

The table following summarizes and compares the income statement effects of the lease for DIRFIN and LOPER. Notice that over the four-year lease, both companies report the same total amount of revenue, but DIRFIN’s revenues in the earlier years of the lease are higher than the net of lease revenues less depreciation reported by LOPER in those years.

(Table 3)

The complete income statements for DIRFIN and LOPER follow. Notice that, under the assumption that the same accounting is used for financial and tax purposes, DIRFIN’s taxes are higher than those of LOPER in Years 1 and 2.

(Table 4)

to 2: Looking at the statement of cash flows, observe that operating cash flows reported by DIRFIN are lower, but investing cash flows are higher than LOPER. Over the four years, both DIRFIN and LOPER report the same total change in cash.

(Table 5)

to 3: Based on ROE, DIRFIN appears more profitable than LOPER in the early years of the lease.

Computing ROE requires forecasting shareholders’ equity. In general, Ending shareholders’ equity = Beginning shareholders’ equity + Net income + Other comprehensive income – Dividends + Net capital contributions by shareholders. Because the companies in this example do not have other comprehensive income, do not pay dividends, and have no capital contributions, Ending shareholders’ equity = Beginning shareholders’ equity + Net income. The forecasts are presented here.

(Table 6)

ROE is calculated as net income divided by average shareholders’ equity. For example, DIRFIN Inc. had Year 1 ROE of 18.2 percent: €39,992/[(€200,000 + €239,992)/2].

(Table 7)

From the comparisons given earlier, DIRFIN looks more profitable in the early years of the lease, but less profitable in the later years.

^{35}The computations included throughout the example were made using an Excel worksheet; small apparent discrepancies in the calculations are due to the rounding.