The Balance Sheet of Leighton Ltd and Clough Ltd - Research Proposal Example

Executive Summary: This research proposal is a study into the lease arrangements carried out by companies. It evaluates the operating and finance lease vis-à-vis each other in the contemporary business world where the obsolete operating lease is being used by companies for getting tax deductions and increasing the profits simultaneously. The G4+1 (US, Australia, New Zealand, and UK) have called for amendment of rules for effecting in these countries. We will study the balance sheet of two companies Leighton Ltd and Clough Ltd in the light of this paper. Introduction: Leasing is an important concept in asset management and trade. A lessor can lease out an equipment, building, machinery, vehicle, etc, and enjoy the benefits of getting capital of their value in circulation. Many companies find certain asset of no significant use in their business. The lease out such assets and as the lease amount gets transferred to the lessee, the lessor can again lessee the lessor, the risks and benefits of ownership get transferred to the lessee. Lease specifies the contingent liabilities returns, fixing responsibility for maintenance of assets and availing of depreciation. Diversity in accounting practices and a system of rapid and 100 percent finance for fixed interest rates makes leasing a subject matter of enquiry. Definition and Difference between Operating and Finance Lease The ABSB defines lease as an agreement whereby the lessor conveys to the lessee in return for a payment or series of payments the right to use an asset for an agreed period of time (AASB 117 para 4). As the lease period increases from short term to long term the risks and rewards associated with ownership shifts from the lessor to the lessee. There are two types of leases—1. Operating Lease. 2. The Finance Lease. The Operating Lease: In this kind of lease, the risk and rewards of the asset remain with the lessor. Simply it is also defined as a lease that is not Finance Lease. Finance Lease: In the Finance Lease, the fair value of the asset is taken into account. Fair value is the actual cost of the asset assessed at the time when the lease agreement is signed. The lessee then pays the amount of interest on the lease amount which is called the finance charges. The Finance Lease last for most of the life of an asset that it can be put to good use. The ‘time of good use’ is agreed upon by the lessee and lessors with the help of analysts before the signing of lease agreement. In other words, the company can avail the depreciation benefits only for such a time as the asset can put to good use. It is recognised in the finance lease that at the end of the lease period the ownership gets transferred to lessee. The Present Value of the Lease is arrived at calculating the interest over the years, the lease is valid. The interest component is added to the current value of the asset and the Present Value of the Lease is included in the assets of the lessee. The Present Value (PV) keeps on decreasing every year and its value becomes null as the lease expires. Through finance lease a company or an individual is able to acquire or lease an asset and pay or get a fixed amount for the lease that is called the Finance Charges. The Finance Charges are reflected in the balance sheet of the company. Finance charges, would typically mean that the lessee has acquired some property through and it is paying the charges of interest for the value of the asset The Difference between Operating and Finance Lease The situation on the other hand is ambiguous for Operating Lease in this context when the companies enter into off-balance sheet agreements. The lessor thus enjoys dual benefit of getting capital in circulation and avail the annual depreciation it its value. The concept of leasing is about two decades old. The current business scenario has thrown up interesting situations where leasing methods are being questioned. In nutshell the furore in the finance world is to change or operating lease to finance lease. The studies into the balance sheets of Leighton Holdings and Clough Limited for 2006 show this interesting scenario in practice. Leases of property, plant and equipment where the Group has substantially all the risks and rewards of ownership are classified as finance leases (note 17). Discussion Leasing gives the company a benefit of 100 percent finance at fixed rates for an asset. Leasing as a form of asset financing has been growing worldwide during the past twenty years (Beattie et. al). The lease that transfers the risk and rewards to the lessee is the finance lease. The lessee pays an interest on the amount he has been financed for. The operating lease on the other hands makes the lessor carry the risks and rewards that are incidental with ownership of a property and equipment. A Finance lease is also called in-substance lease in the common man’s parlance. Lately, the financial experts have found difficulty and tracking the effects of leasing and that is why the suggestions of G4 gain relevance. Study by Ravilic (2003) shows that a company can use an operating lease as tool to strike its assets from the balance sheet. This was done in the Dow Jones case when it leased its two commercial buildings to Deutsche Bank. As per the lease agreement these assets got reflected in the balance sheet of the company and the amount that it accrued as lease income were reflected in the balance sheet as the revenue. However, to bye pass this increase in income from getting in reflected in the balance sheet and avail the benefits of an operating lease, the company again sub-leased these building from DRIT. This led to Dow Jones, the retailers, paying rent for the same buildings to the lessee and the company could use the leased property as a liability and avail the accruing tax benefits. Members of the IASB are going to consider scrapping the current leasing approach by forcing companies to book both the right to use property and a corresponding liability on the face of balance sheet (Ravilic, 2003). As early as 1984 analysts defined it as the ‘leasing puzzle.’ Finance theory generally predicts that leasing and debt are substitutes, to a greater or lesser extent. Yet Ang and Peterson (1984), in their seminal empirical study using financial statement data, failed to confirm this prediction, instead finding a complementary relationship. They referred to this result as the ‘leasing puzzle’. (Beattie, Goodacre, et.al.). Ravilic quoting Gallery of New South Wales University says that most balance sheets gain weight once their off-balance sheet arrangements materialise in numerical form in accounts. In both the cases of Clough Limited and Leighton Holding the companies have constructively capitalised on the lease amounts. This has an effect on various ratios. Beattie, et al point out that Capitalization has a significant impact (at the 1% level) on six of the nine selected ratios (profit margin, return on assets, asset turnover, and three measures of gearing). We can effectively study how Finance and Operating Leases allow a lessor to avail the benefits of owning an asset and show its depreciation in accounts to avail tax saving tool. It has been noted that it is particularly so in the times of recession when companies can show inflated picture of their profits by juggling with numbers. An analysis of the impact of capitalization over the five-year period from 1990 to 1994 showed that capitalization had the greatest impact during the trough of the recession. Results were shown to be robust with respect to key assumptions of the capitalization method (Beattie et.al.) Clough and Leighton In the case of Clough Limited and Leighton Holding the basic difference of Operating Lease and Finance Lease is cited. Whereas Leighton Holding a construction company that has a operating lease. Leighton Limited signed has signed a 570$ million Operating Lease with Commonwealth Bank of Australia. The facility includes the sale and lease back of some $360 million worth of mining equipment with the balance available to support the continued expansion of the Group’s mining fleet. As a result, we have increased our flexibility to expand or contract the size of the fleet – in line with market conditions– while reducing our risk profile, and freed up an otherwise committed portion of the balance sheet for other operational and investment activities (Clough, 2006). Capitalization of Leighton Holding The Operating Lease has been ostensibly signed to give the company a narrowed approach in the balance sheet. The depreciation of Land and Building shown in the Operating Lease is $820000 and Leasehold improvements expenditure is $1984000. In the same vein Operating Lease Payments show an amount of $157003000 in the expenses (Leighton,2006). Leighton Holding shouldn’t be having the cake and eating it too. This is a typical scenario where the companies makes use of the lacunae in the Operating Lease laws and avail dual benefit. The Finance or the Capital Lease transfers the ‘risk and reward’ of the asset to the lessor from the lessee. The protection against obsolescence or availing the benefits of depreciation for such at time that lease is in existence is right of the lessor. Thus lessee balance sheets are expected to reflect additional lease liabilities if this new approach is adopted ( Lipe, 2001). The median total of lease liabilities could be as large as 30-40 percent of the total liabilities (Lipe, 2001). This shows that the liability component linked to operating lease could be very high thus making a big difference in the net profit reflected on the balance sheet. The balance sheet of the company thus is reflects availing of depreciation charges on its assets as well as lease payment charges. Imhoff et.al. quoted by Lipe (2001) find that share holder risk is better explained by debt-to-asset ratio after being adjusted for off-balance sheet leases. Ratio Analysis: Ratio Analysis is the analysis of figures in the balance sheet to observe how they influence its results. Ratio Analysis is making definite conclusion about a factor vis-à-vis others. Also known as quantitative analysis, this involves looking at revenue, expenses, assets, liabilities and all the other financial aspects of a company. Fundamental analysts look at this information to gain insight on a companys future performance (Janssen). Ratio analysis helps to find the true value of company, its actual profits and losses and brings forth those hidden facts that have been deliberately concealed in the balance sheet. Hence ratio analysis helps us reveal the real scene in quantitative form of the financial health of the company from the books. Ratio analysis can help us to ascertain whether the company is actually making profits or is it practicing deception in the game of numbers. It determines whether a company is paying its taxes by good means or using some numerical methods to usurp them. It is also used to ascertain the performance of the company over the previous years. Normally, ratios required for analysing the problem of operating lease are 1. Profit/Turnover ratio, 2. Return Ratio, 3.Current/ Fixed Asset Ratio (Liquidity) ratio are of interest to us in the Leighton Holding case will be Profit/ Turnover Ratio, Current/ Fixes Asset Ratio, and Return Ratio. Ratio Analysis of Leighton 1. Profit/ Turnover Ratio Analysis: In the case of Leighton Limited, the balance sheet reflects the Depreciation Amount on Assets that has been availed by the company as deduction from its gross revenue. Since the company has made an Operating Lease, the ‘risks and rewards’ of the ownership. Since the lease benefits to the company are listed in the availed depreciation in the assets of the company, they significantly increasing the profit of the company. Any decrease in the value depreciation benefits on the other hand affects the ratio adversely. The Formula for calculating the ratio is P/TO x 100. Here P stands for Profit, TO for Turnover/ 2. Return Ratio: Return Ratio can be defined as the ratio of the annual profit to the assets of the company. The formula for deducting the Return Ratio is Profit of the Year/ Assetsx100. Calculation of return ratios throws up some interesting insights in the Leighton case. The company is availing depreciation in the value of the assets. This decreases the value of the assets. On the other hand, Leighton is also showing the Lease payments it makes annually. The Lease Payments deducted from the Gross profits is one of the variables that adversely affect the profits of the company. The Return Ratio decreases in the case of Leighton Ltd by using both the asset depreciation and showing the lease payments in the liabilities of the company. 3. Current/ Fixed Asset Ratio: This kind of ratio is also called the Liquidity Ratio. Since the lease agreement doesn’t add to the current assets of the company, there is only an increase in the Fixed Asset Ratio, the Operating Lease as in the case Leighton Limited only decreases the ratio. Only a finance lease adds to the Current Assets of a company. Lease Capitalisation of Clough Limited The availing of depreciation in the asset liability and operating lease payments in the Clough Limited is a lessee that pays lease charges. It holds equipment and machinery under both Finance Leases and Operating Leases. The fixed interest expense on debt or fixed rental payment on the lease reduces the level of net income without changing its variability (Lipe, 2001). Clough Limited is using both Operating Lease and Finance Lease at the same time. Finance charges only get reflected in the finance lease. The finance obligation of the lease is capitalized at the fair value of the leased object at the beginning of the lease term. The Finance Lease payments reflect that the company is a lessee that has executed a lease agreement for some equipment or building. Leases of property, plant, and equipment where the Group has substantially all the risks and rewards of ownership are classified as finance leases (Clough, 2006). Lease of property, plant and equipment where the Group has substantially all the risks and rewards of ownership are classified as finance leases (Clough, 2006). Capitalization: Annual lease commitment of Clough Ltd by the way of operating leases is $ 23563000. For a five year period, the projected figures of debt accruals for meeting operating lease commitments are pegged at $ 71,947000. To offset this amount and strike off the liabilities from the balance sheet, the Board has already recommended making sub-lease arrangement. On the other hand the company has also entered into a Finance lease for which its annual commitments are $ 6, 676000 which go by the way of interest charges to its lessee. Minimum lease payments in five years will be $21,293000. The interest component in this arrangement is $1716000 and the commitment towards the lease only component is $21293 000. The non current component, the amount to be paid for the duration of lease is $16 333 000. By paying this amount Clough Limited will add to its assets an object of the same value on which it can then attain standard depreciation. Ratio Analysis: Since Clough Limited has a Finance Lease as well as Operating Lease the Ratio Analysis for the company has to be conducted for both kinds of leases. Since the Operating Lease Payments are decreased from the Gross Revenue, they affect the figure of the net profit. Lease payment is part of the expenses of the company. Ratio analysis can be conducted by the same formula as used above in the Leighton example. Any increase in the Operating Lease expenses will adversely affect the profit margin. The Return Ratio also decreases with the hike in operating lease similar to how it is effective in the Leighton example. The significant effect of the Finance Lease is on the Liquidity Ratio. The Liquidity Ratio is deducted by dividing current stocks by current liabilities. In Finance lease expenditure of Clough Limited, the lease component is gets added to the current stocks of the company. As the company makes on making lease payments the assets equal to that of the lease component is added to the fixed assets of the company. Thus Finance Lease helps in projecting the actual value of the profits by including the asset worth to the company. This is the primary difference between Operating and Finance Lease in terms of Accounting. Conclusion: In order that companies avoid entering into sub lease type of arrangements for wiping off less useful assets from their balance sheet by entering into operating lease and the sub-lease, the Finance or Capital Lease should be preferred. The Finance Lease transfers the risks, obligations and rewards of a leased asset to the lessee thus giving the lesser the advantage of getting the liquidity transferred to its name. The Operating Lease is employed by companies to offsetting the profits with liabilities, which leads to the development of the ‘lease puzzle’ References 1. Lipe, Robert C., Lease accounting research and the G4+1 proposal (2001), American Accounting Association. 2. Ravlic, Tom, DJ’s I billion leasing blowout, CFO : the Magazine for Chief Financial Officers 3. Leighton Concise Annual Report 2006, Leighton Financial Report 2006 4. Clough Limited, Annual Financial Report 5. Financial Ratio Analysis, Biz/ed.co.uk http://www.bized.co.uk/compfact/ratios/index.htm accessed on 19-09-2007. 6. Janssen, Cory, Fundamental analysis, what is it?Investopedia a forbes media company,http://www.investopedia.com/university/fundamentalanalysis/fundanalysis1.asp accessed on 19-09-07 7. Leasingideas.com, accessed on 19-09-07 8. Beattie, Vivinen, Edward Keith, Goodacre, Alace, The impact of constructive operating lease capitalization on key accounting ratio (1998), http://eprints.gla.ac.uk/785/01/beattieaccbusres1998.pdf accesses on 19.09.07 Appendices: CLOUGH LIMITED                 2006   2005         $ 000   $ 000                   1 Current Ratio 1.22   1.23                   2 Return On Propriety Fund (0.08)   (0.33)                   3 Lease Exp on total Revenue 0.03   0.01                   4 Debts to Tortal Assets Ratio 0.11   0.11                   5 Interest Coverage Ratio (0.67)   (7.93)                   6 Fixed Assets to Capital Employed 0.79   0.76                   7 Debt/Eqity Ratio 0.33   0.26                     (All figures in 000)                         After analysis of Co. balance- Sheet it is found that Co. Current Ratio is going to decrease as 123 to 1.22 & in future the same trend will happen The reason of the same is Co. cash & cash equivalent are on decrease trend. It is 53636 $ compare to last year 64908. In future co. have to pay 71797 $ towards operating lease payment. The huge amount of operating lease amount will impact on Company profitability & the profit will decrease due to lease payment, interest & depreciation. Also In fixed Assets amount leased amount property is increasing .Company is not earning (Losses) from its operating activities & receiving major funds from its financing activity. In last two years he has taken major loans. Its Debt equity ratio is increase trend In nutshell: 1- Company will take more loan in future to pay his operating lease. 2- losses will increase to operating & finance lease 3- Current ratio will decrease due to interest bearing liability 4- Due to above reason company E.P.S will decrease. Appendices: LEIGHT ON                   2006   2005           $ 000   $ 000                       1 Current Ratio 0.94   0.83                       2 Return On Propriety Fund 0.25   0.24                       3 Lease Exp on total Revenue 0.02   0.01                       4 Debts to Total Assets Ratio 0.01   0.02                       5 Interest Coverage Ratio 0.07   0.12                       6 Fixed Assets to Capital Employed 0.82   0.96                       7 Debt/Eqity Ratio 0.04   0.06                                                                                         (All figures in 000)             As per profit & loss account co. profit is increased but it is only a year changer. Company operating liability is increasing & within a year it will impact 128761 $ on profit. Company have to pay 1142176 $ which is committed liability . Company has issued share & received fund and also taken borrowing. Company interest coverage ratio is decreasing & lease expenses in increasing. It will pay a major role in future to calculate profitability. Company paying operating lease 156973 $ compare to last year 69337 & in next one year it his to pay $ 243559 towards the same. In nutshell: 1- Company will take more loans in future to pay his operating lease. 2- losses will increase to operating Lease 3- Company E.P.S will decrease. Read More