Question 9.19: Financial Statement Impact of a Finance versus an Operating ......

to 1: In Year 1 and Year 2, CAPBS reports higher expenses because the depreciation expense and interest expense of its finance lease exceeds the lease expense of OPIS’s operating lease. Therefore, OPIS reports higher net income in Year 1 and Year 2. The companies’ total expense over the entire four-year period, however, is equal as is the companies’ total net income.

Each year, OPIS reports lease expense of €28,679 associated with its operating lease. For CAPBS, its finance lease is treated as being economically similar to borrowing money and purchasing an asset. So, on its income statement, CAPBS reports depreciation expense on the leased asset acquired and interest expense on the lease liability.

The following table shows by year CAPBS’s depreciation expense and book values on the leased asset.

(Table 1)

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

• Column (b) is depreciation expense of €25,000 per year, calculated using the straight-line convention, as the acquisition costs less salvage value divided by 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 carrying amount at year end of the leased equipment, which is the difference between the acquisition cost and accumulated depreciation.

The following table shows CAPBS’s lease payment, interest expense, and carrying amount for its lease liability by year.^{33}

(Table 2)

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

• Year 1: €100,000

• Years thereafter: lease liability at end of previous year

• Column (b) is the annual lease payment made at the beginning of the year. Part of the lease payment pays any interest accrued in the previous year, and the remainder of the lease payment reduces the lease liability. For example, in Year 2, the €28,679 paid on 1 January reduces the interest payable of €7,132 that accrued in Year 1 (0.10 × 71,321) and then reduces the lease liability by €21,547.

• Column (c) is the interest portion of the 1 January lease payment made on that date. This amount of interest was accrued as interest payable during the prior year and is reported as the interest expense of the prior year.

• Column (d) is the reduction of the lease liability, which is the difference between the annual lease payment and the interest portion.

• Column (e) is the lease liability on 31 December of a given year just before the lease payment is made on the first day of the next year. It is equal to the lease liability on 1 January of the same year (column a) less the reduction of the lease liability (column d).

The following table summarizes and compares the income statement effects of the lease for CAPBS and OPIS. Notice that over the four-year lease, both companies report the same total amount of expense but CAPBS shows higher expenses earlier in the life of the lease.

(Table 3)

The complete income statements for CAPBS and OPIS follow. Notice under the assumption that the same accounting is used for financial and tax purposes, CAPBS’s taxes are lower in Year 1 and Year 2. The lower taxes in the earlier years reflect the higher expenses in those years.

(Table 4)

to 2: On the statement of cash flows, observe that over the four years, both CAPBS and OPIS report the same total change in cash of €59,698. Operating cash flows reported by CAPBS are higher because a portion of the lease payment each year is categorized as a financing cash flow rather than an operating cash flow. In the first two years, CAPBS’s change in cash is higher due to its lower taxes in those years.

(Table 5)

to 3: Based on ROE, CAPBS looks less profitable than OPIS in the earlier years. 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, did not pay dividends, and experienced no capital contributions from shareholders, 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, CAPBS Inc. had Year 1 ROE of 6.1 percent: €12,508/ [(€200,000 + €212,508)/2].

(Table 7)

to 4: Based on the ratio of debt-to-equity, the solvency position of CAPBS appears weaker than that of OPIS.

For the debt-to-equity ratio, take the total shareholders’ equity from Part 3 given earlier. Initially, both companies had reported liabilities of €100,000. For OPIS, the amount of total liabilities remains constant at €100,000. For CAPBS, add the lease liability at the end of the year and the amount of accrued interest payable at the end of each year from Part 1. So at the end of Year 1, CAPBS’s total liabilities are €178,453 (€100,000 + €71,321 lease liability + €7,132 accrued interest payable at the end of the year), and its debt-to-equity ratio is 0.84 (€178,453/€212,508). At the end of Year 2, CAPBS total liabilities equal €154,751 (€100,000 + €49,774 lease liability + €4,977 accrued interest payable at the end of the year). The remaining years are computed in the same manner. The following table presents the ratios for
each year.

(Table 8)

^{33}The computations included throughout the example were made using an Excel worksheet; small discrepancies in the calculations are due to rounding.