Accounting Analysis for Leasing Project - Essay Example

Leasing project ACCOUNTING ANALYSIS Operating lease (Off-Balance Sheet Financing) Off-balance sheet financing is a situation in which a company does not include liability on its balance sheet. There are two common types of off-balance financing; operating lease and partnership. Operating lease allows a company to rent or lease equipment and then acquire the equipment at the end of the lease through buying with a minimal amount of money or by buying its outright. In the operating lease, the company only records the expenses of the equipment instead of recording the full cost of buying its outright. This system is preferred by many companies because it reduces liabilities and debt ratios (Altamuro, J., Johnston, R., Pandit, S. S., & Zhang, H. H. (2014)). In this paper, the research is based on ACE Corporation, an electrical automobiles company to give a clear distinction in accounting which records leases in their financial statements and those which do not. According to research conducted by Peter Harris et al. (2011), the company is leasing an asset for $26, ACE Corp. overview ACE Corp is a manufacturer of an electronic automobile that is based in Detroit, Michigan. It is a worldwide company that sells its products to large companies such as Ford, Toyota, and General Motors. The company sells its automobiles to a retail market and in total, and it has captured 10% of the world market. According to US Stock and Exchange Commission, ACE Corporation’s share cost $ 25 per share, and it has a 52- week price that ranges from $19.85 and $27.15. The market capital of the company stands at 10.6 billion dollars. Data collection The research uses data of the company as provided by Peter Harris et.al (2011) article. The data was extracted from the company’s website, and it includes the financial statement that is important for analysis reasons. The financial statement is prepared using US GAAP, but the company intends to use an off-balance sheet in future. Each account has some supporting notes that are meant to provide useful information on the data regarding off-balance sheet. The data used in this paper is based on the commitment data extracted from the off-balance sheet accounts. Case study In this study, the capital lease is estimated to take a minimum of 3 years. Using the straight method, the average useful life of the fixed assets is assumed to be 49 months. Therefore, in this study, 49 months shall be used as the useful time. The interest rate for the use of leased manufacturing equipment is fixed at 6 % (Peter Harris et. al 2014). ACE Corp Journal Entry The depreciation rate for the assets is estimated to be 6% for the average useful life of the assets which is 49 months.   Title Dr. Cr. Reverse Entry Cash 33000   Operating Lease   33000 On 1/1/2011 Capital Asset 33000   Long-term Liability   33000  On 31/12/2011 Interest Expense 4000   Interest Payable   4000 On 31/12/2011  Depreciation Expense 10,000   Accumulated Depreciation   10,000 Financial statement key figure and Accounts The journal entry above shows the beginning of operation lease within the accounting statement. The effect on the financial statements shall be represented as follows: During 2011 After 2011 Increase Amount (In Million) USD Amount (In Million) USD Sales 250,000 270,000 Operating Expenses 13000 19000 6000 Operating Income Before Interest & Taxes 219000 251,000 Interest Expense 4000 4000 0 Income Taxes 30000 50000 Income from Continuing Operation 21000 35000 14000 Discontinued Operations 0 0 Net Income 10500 21000 10500 Current Assets 118000 57000 Fixed Assets 82000 122000 40000 Total Assets 200000 179000 Current Liabilities 40,000 44,000 Long-Term Liabilities 50,000 49,000 1000 Stockholder Equity 110,000 86000 Total Liabilities & Equity 200,000 179,000 Ratio Analysis The ratio analysis below shall represent the difference in various ratios in the present context and when the operating leases are enacted in the Balance Sheet. Current Ratio (Current Asset / Current Liabilities) 2.95 1.295454 Debt Ratio (Total Liabilities / Total Assets) 0.45 0.519553 Times Interest Earned (Net Income + Tax + Interest) / Interest Expense) 8.5 8.83 Operating Ratio (Operating Expenses / Net Sales) % 5.2% 7.04% Operating Cash Flow 220,000 246,000 (Operating Income Before Interest & Taxes + Depreciation – Taxes) (Source: Buchman, T. A., & Harris, P. (2014, May) The above analysis suggests that there is a slight change in the current ratio with the addition of operating lease into the balance sheet items. The current ratio is stable at approximately 2:1 and this shows that the business has sufficient cash to meet short-term cash needs. According to Buchman, T. A., & Harris, P, (2013), current ratio should be 2:1 and the corporation are almost achieving this requirement. The Debt ratio improves with the addition of operating lease within the balance sheet. This is a positive implication for the ratio analysis in ACE Corp. The rise in a debt shall only put pressure on the financing of the company and restricts its liability to source further funds when in the operating lease. The times interest ratio increases by a significant amount when operating lease is added to the balance sheet. This is a good sign for the business because the higher the ration of times interest earned higher gets the ability of the business to repay its interest obligations and debts. Operating Ratio grows slightly showing the lower impact of including operating lease expense. Installment Schedule The installments have been prepared based on Annuity Due method. The table below shows the payment of lease obligations over a period of 49 months using the Ordinary Annuity method. Here, the payments are made at the end of each year, where the interest rate is taken to be 6%; the installment value is at USD 10,000 million while the PV factor is taken to be 5.00. Date Lease Payment Interest Expense Present Value Interest Expense Reduction in Liability Lease Liability 01-01-2012           33,000 01-01-2012 10,000       10,000 23,000 12/31/12 10000 1.0 9985.714 7499.9 10,000 13000 12/31/13 10000 0.91 9100.109 7484.9 10000 3000 12/31/14 10000 0.86 8600.151 7469.9 10000 0 Total 40,000 22454.7 40,000 39,000 Annuity Due The table below is a representation of the lease payment for a lease amount of USD 33000 with an installment amount of USD 10,000 for 49 months based on the Annuity Due method, where the payments are to be made at the beginning of each period. The interest rate is considered to be fixed at 6% while the PV factor is 6.00. Date Lease Payment Interest Expense Present Value Interest Expense Reduction in Liability Lease Liability 01-01-2013           33,000 01-01-2013 10,000       10,000 23,000 12/31/13 10,000 0.94 9400.019 8996.88 10,000 13,000 12/31/14 10,000 0.89 8899.999 8978.88 10,000 3,000 12/31/15 10,000 0.84 8399.886 8960.88 10,000 0 Total 40,000 26900.64 40,000 39,000 Recommendations Preparation of a balance sheet in the US is either based on US GAAP or IFRS, which most companies are considering nowadays. Under IFRS, operating lease is treated as an off-balance sheet while US GAAP includes the liability in its financial statement. Operating lease is a kind of a liability which requires the debtor to pay the debts on installment on a regular basis for a specified period. Here, the company that leased the equipment is not liable for the depreciation of the equipment because the lease does not grant him ownership of the property. Therefore, depreciation is not charged to the company. Since the company is under the off-balance sheet operating lease, the results from the financial statement give an accurate profit of the company. This is because depreciation is discarded from the list. The off-balance sheet also prolongs the period of paying the debts and therefore and the company can generate more funds for its business growth. A company should also use ordinary annuity method over the due annuity method because ordinary method has a lesser amount of interest. In general, it is advisable that companies should include operating lease as off-balance sheet liability because of the benefits associated with it. References Altamuro, J., Johnston, R., Pandit, S. S., & Zhang, H. H. (2014). Operating leases and credit assessments. Contemporary Accounting Research, 31(2), 551-580. Buchman, T. A., & Harris, P. (2014, May). GAAP VS. IFRS TREATMENT OF LEASES AND THE IMPACT ON FINANCIAL RATIOS. In Global Conference on Business & Finance Proceedings (Vol. 9, No. 2, p. 219). Institute for Business & Finance Research. Samvelovna, P. T. (2015). Off-Balance Sheet Lease. Economics, (3), 64-66. Read More