The Impact of the Capitalisation of Operating Lease Rentals on the Key Accounting Ratios - Essay Example

CAPITALISATION OF OPERATING LEASE RENTALS Introduction In many companies, valuation models often begin with post-tax operating income being used in the process of determining their operating income on the business. In this case, they often reduce it by use of investments rate to reach their free flow cash. In this regard, an assumption is taken that the business’ operating expenses do not comprise of any forms of operating expenses like the interest expense on debt. It is important to note in most cases, this assumption holds some sense and levels of truth. For this reason, a certain level of exception often exists. When firms happen to lease some of its assets in the hope of raising income, the manner in which the lease is treated depends on the kind of lease itself; that is, whether it is capital or operating lease. If the company engages in an operating lease, then the lease agreement will be treated just as an operating expense. An argument can be raised that they represent any other forms of financing expenses. Consequently, capital, operating income, measures of cash flow as well as profitability for businesses that have operating leases need to be effectively adjusted when operating the lease expenses. In this process, they ought to be effectively placed in the category of financing expenses. Companies are expected to ensure that they make proper accounting of all their sources of income in the most effective way so that they can use the resulting income statements for their own purposes. This process can hold certain effects, not only on the valuation of model inputs but also on various multiples like EBITDA/value ratios, which can are normally used in the valuation process. This paper examines the impact and influences of capitalization of operating lease rental on some of the major accounting rations using the ILW methodology. Table of Contents Topic pg. No. Introduction 2 Analysis of a business’ operating income 4 The approach to treating Leases in businesses 4 Treatment of Operating and Financial leases in business organisations 5 Approaches for Accounting of business leases 6 Effects of Leases on the balance sheet 7 The effects of Leases on other financial ratios 8 Conclusion 9 Bibliography 10 Appendix table 1: Consolidated income statement for the year ended 31 December 2007 11 Appendix table 2: Consolidated balance sheet at 31 December 2007 12 Appendix table 3: Consolidated cash flow statement for the year ended 31 December 2007 13 Analysis of a business’ operating income Every firm strives at being successful through creation of various competitive advantages and market position (Rana, 2010, 45). For all businesses, operating income is one of the chief inputs into their valuation models, in this case, an assumption is made that operating expenses have to include the expenses that are designed in the process of creating revenue in the contemporary period. In this case, they do not often any kinds of operating expenses in the firm. In many instances, financial statements often make a clear separation of financial expenses like interest expenses and illustrate them effectively after the operating income. However, a significant exception exists in this rule; it is brought by the treatment of lease expenses in the accounting process, especially those that are grouped as operating expenses in the process of arriving at the operating income. A good example of this analysis can be made in the appendix tables from the financial disclosures from Cadbury Schweppes (Cadbury 2010, 94), a UK based company that manufactures and sells confectionaries in some countries across the world. In this paper, an argument has been raised that the particular expenses are classified as financing expenses. In this process, a business that becomes ignorant to this misclassification can end up creating various significant problems in comparing and measuring their profitability. The approach to treating Leases in businesses Businesses have a duty to achieve their set goals and objectives and fulfill their objectives (Imhoff, Lipe & Wright 1997, 26). In this case, firms often strive at increasing their financial base so that they can compete effectively in the competitive market and establish their market position. Besides profits received from the production and sale of, businesses have two important options they can either lease their assets or buy more. When the businesses make a decision go the leasing option, the manner in which the lease expenses are to be treated largely depends on the way in which the lease has been categorized. This process is very significant since it has an effect on the way operating income is measured as well as the book value for the particular capital. Treatment of Operating and Financial leases in business organisations A service or operating lease is often signed for just a period, which is sometimes short compared to the actual life of the business’ assets. In the life of a business (Imhoff, Lipe & Wright 1997, 29), the current value of lease payments is sometimes lower in comparison to the actual prices and value of assets. By the time the leases reach their maturity, the equipment often reverts, going back to the lessor. In this regard, it become the duty and responsibility of the lessor return the equipment to the lessee or make an arrangement of leasing the equipment to another person. The lessee often has a duty to cancel that particular lease and take back the equipment to the lessor (London Economics 2000, 16). The ownership of those assets as far as the operating lease is concerned is bestowed to the lessor. In this case, ownership of assets as far as the operating lease is concerned remains in the hands of the lessor. The lessee often bears little risks or none at all if the assets become obsolete. A financial lease, also referred to as capital lease is meant to last in the course of the life of the assets an organisation has. It is important to understand that in general, financial leases are not entitled to any form of cancellation; instead, the lease is usually renewed when its life comes to an end, this often takes place are reduced prices that are sometimes favorable. In various instances, the lessor is not always obligated to payment of insurance as well as taxes on assets. In this regard, obligations are left in the hands of the lessee, who consequently decides to make a reduction on the kinds of lease payments, something that leads to what is referred to as net leases. Overall, financial leases often impose substantial risks on shoulders of the lessee, who makes a decision on how to handle the resulting situation. While it may be evident that differences emerging from financial and operating leases are almost obvious. It is impossible for some kinds of leases to fit perfectly on one extreme or more; instead, they allocate some of the features for both leases, which are referred to as combination leases. Approaches for Accounting of business leases Leasing is one of the easiest ways by which businesses use in the process of rising incomes to enhance the success of their businesses and develop products aimed at enabling them develop competitive advantages. For the sake of accountability, it is always important that the lease agreements that businesses engage in be effectively accounted for in the process of enhancing accountability systems in the business. As noted from the foregone discussion, the effect that leasing has on assets depends on the way in which the particular leases are categorized by the business’ internal revenue service (for the sake of taxes), as well as by the GAAPS (Generally Acceptable Accounting Principles) for the purpose of making measurements. It is important to realize that since leasing of assets in a business compared to purchasing new ones serve the purpose of substitution lease payments like a form of tax deduction for payments that would be maintained as by the businesses in the event that they would have owned the particular assets. If the lease payments in the business happen to have a short lifespan in comparison to the life of the particular assets then the lessee has an option of carrying with the leasing process at special nominal amounts or purchases the assets at a price below that offered at the market. According to the ILW methodology, the lease agreement can be viewed as a special kind of loan and forbid the lessee to make a deduction of the particular lease payments according to the year the lease agreement were made. Lease arrangements are important because they often allow firms to remove some assets from their balance sheets, thus reducing their advantages. In other words, it is important to note that leases make it easy for firms to obtain sources of financing outside their balance sheets, thus enabling them to meet their current liabilities and increasing their competitiveness in the market. Effects of Leases on the balance sheet A balance sheet is an important document that illustrates the financial position of the position at a certain period. This is the reason why it is often referred to as a point statement. All transactions that happen on the assets for the business are supposed to reflect on the balance at any point in the course of the life of the business (Day & Kidd 2000, 62). For leases, their effect on the business’ balance sheet depends on the way in which it is categorized as either a capital or an operating lease. In case the lease is categorized as an operating lease, the assets leased are clearly shown on the business’s balance sheet. In such a case, these leases are described as important off-balance sheet sources of financing. If the case is that of a capital lease, the asset that is leased has to be clearly shown on the balance sheet (Beattie, Edwards & Goodacre 1998, 241). Given the discretion involved, many businesses have been showing preferences for the first option, this is because, it often does not show the actual potential liability for the business; in this understanding, it makes an understatement of the particular financial advantages. The question that runs in the minds of many financial analysts is the exact reason that prevents firms and other businesses from developing lease agreements in the process of evading all these requirements (ASB 2001, 25). The lessee and the lessor often have various incentives; this is because, the arrangements that would be needed in making favorable operating leases are those by which the lessor cannot claim depreciations, interests, as well as various kinds of tax benefits resulting from the lease arrangement. Besides the emerging conflicts of interest, the line separating capital leases and operating leases continues to remain thin and firms have a duty to identify ways of crossing this particular line on a continuous basis. The effects of Leases on other financial ratios Just like the balance sheet, the effect that leases have on financial rations in the business is determined by whether it is a capital or operating lease. The table below makes summary of the effects that leases have on the financial ratios in the business. It provides a summary on the solvency, profitability and the leverage ratios as well as effects on the capital and operating leases on each of them. Fig 1. Effects of Operating and Capitalized Leases on financial rations (Yan 2002) Since levels of financial rations, as well as their subsequent predictions can often vary in accordance to the manner in which the leases are treated, it is prudent to say that changing operating leases to capital leases in the process of making comparisons to the ratios is a better approach (Beattie, Goodacre & Thomson 2000, 431). Therefore, businesses have a responsibility to ensure that they effectively make a proper accounting of their lease agreements; this makes it possible for them to calculate their financial rations and arrive at better positions to determine their growth and competitiveness. From the above table, it can be concluded that when a business’ lease arrangement qualifies to become an operating lease, various profound consequences on the earnings reported book value for capital and debt as well as the return of financial ratios to that firm. Overall, both net and operating income of the business can be brought down. In this case, the debt and capital for the business can happen to be understated (Aho 2005, 52). The returns on the equity and capital can be quite higher in case the lease agreement is categorized and treated like an operating lease, as opposed to the capital base. Conclusion From the foregone discussion, it is evident that lease agreements can be essential off-balance sheet sources of capital for the business (Day & Kidd 2000, 67). In most cases, business prefer this approach because they can effectively reduce on the costs that they would have incurred in the process of buying new assets in the process of carrying on with the businesses. It is important that businesses understand ways of accounting for all the lease agreements that are entered created by the businesses. This is an important aspect in the process of creating competitive advantages and accountability in the business’ financial department and general the entire management process Bibliography Aho, J. 2005. Confession and bookkeeping the religious, moral, and rhetorical roots of modern accounting. State University of New York Press, Albany. ASB 2001. 2000 Annual review of the Financial Reporting Council. Accounting Standards Board, London. Beattie, V., Edwards, K. & Goodacre, A. 1998. The impact of constructive operating lease capitalization on key accounting ratios. Accounting and Business Research, Vol. 28, No. 4, 233-254. Beattie, V.A., Goodacre, A. & Thomson, S. 2000. ‘Operating leases and the assessment of lease-debt substitutability,’ Journal of Banking & Finance, Vol 24. No. 3: 427-70. Cadbury, D. 2010. Chocolate wars: The 150-year rivalry between the worlds greatest chocolate makers. Public Affairs, New York. Day, A., & Kidd, D. 2000. Leasing. Euromoney Institutional Investor, London. Imhoff, E. A., Lipe, R. C. & Wright, D. W. 1997. Operating leases: income effects of constructive capitalization. Accounting Horizons, Vol. 11, No. 2, 12-32. London Economics 2000. Rip-off-Britain: Myths and Realities, A report for the British Retail Consortium, London Economics, London. Rana, G. 2010. Practical cost accounting modern methods and techniques. ABD, Jaipur, India. Yan, A. 2002 ‘Leasing and debt financing: substitutes or complements?’, Working Paper, January, Fordham University, New York. Appendix Table 1. Consolidated income statement for the year ended 31 December 2007 Cadbury Schweppes Effects of the operating lease on the balance sheet Suppose company leasing approaches Cadbury Schweppes in order to lease a certain asset for a period of about five years (A non cancelable lease) that yearly payment would total to around $20,000. The discount rate implied would be about 6%. Cadbury Schweppes, in this case has an increasing borrowing rate of about 7%. At the end of the five year period, the asset shall be taken back to its lessor, who will choose to sell it as a scrap. The following is the company’s balance sheet. Appendix table 2. Consolidated balance sheet at 31 December 2007 Cadbury Schweppes Appendix table 3. Consolidated cash flow statement for the year ended 31 December 2007 Cadbury Schweppes Read More