Accounting Analysis: Lease Project - Case Study Example

Accounting Analysis: Lease Project By: Name Institution Affiliation Date Submitted: Introduction The off-balance sheet financing is used in order to adhere to the financial covenants. The company also employ off-balance sheet to maintain the capacity to borrow. When an asset is leased under off-balance sheet financing, the asset under the lease is exempted in a company’s financial records. The methods, however, has a negative reputation given that it was famously employed by a previously leading energy corporation, Euron. As such, it becomes hard to recognize off-balance-sheet financial transaction since they remain invisible. As commonly required by GAAP, companies are required to disclose their financial arrangements and other invisible transactions as “notes” in their financial statements. Furthermore, GAAP rules require that mangers adhere to the rules governing off-balance sheet items to avoid severe consequences. Two types of leases exist for a company; operating and capital leases (Beattie, Goodacre & Thomson, 2000). The financial analysis and leverage ratios reported and discussed in this document are developed under the GAAP principles and further converted to IFRS for comparison purposes. Nokia’s financial statements for the year ended December 2014 and the annual financial reports are assessed and discussed in different sections of this document. Essentially, the report seeks to understand different perspectives as expressed by GAAP and IFRS lease standards. Exhaustive ratio vales on IFRS approach are worked out and summarized in a table. More details are discussed in the lower sub-sections of this document. Overview of Nokia Corporation Nokia Corporation is one of the leading entities in the mobile industry. Initially, the company formed varied mergers and business divisions before launching a mobile business. The head quarter is based in Espoo, Finland and employees over 132,000 employees across the world. Nokia holds over 35% of the global market share where it sells the mobile products generating over 42 billion euros annually. The operating profit ranges around 2 billion annually (Nokia, 2014). The steady progress of innovation makes Nokia a world’s leading producer of product and services, including the first portable NMT car telephone, Nokia Tunes, Satellite calls DSM call and mobile internet. Nokia’s popularity grew until 2005 where over 2 billion mobile handsets were sold worldwide. Nokia story of excellence continues with its mission of “connecting people”. However, the current financial statements indicate that the company is facing stiff competition in the telecommunication market as shown by downing sales’ figures (Nokia, 2014). Nokia’s financial reports were analyzed and discussed in this document on the basis of GAAP standards. The financial reports evaluated in this document are for the year ending 31st December 2014. For the purpose of this report, the discrepancies on the effect of the IFRS and GAAD standards are described. The leverage ratios under IFRS standards are compared and discussed. Source of Financial Data The Bloomberg website provided the required publications that make Nokia Corporation an appropriate choice for this report. The financial reports for Nokia were obtained from nokia.com. The annual financial report were obtained for major details while the notes added to specific accounts provided the required details on off-balance sheet entries. In this report, the evidence of finance lease and operation lase present formed the basis of the analysis. The financial analysis provides a basis for establishing relations between different financial statements’ entries. These elements can further be related to other business’ information. The analysis determines the prospects of a business while offering a recommendation for improvement or adjustment. The primary objective is to assess the current financial condition and progress of a company upon which judgment and recommendations for the future course are made. Analysis of a business financial position form an investor’s point of view is largely concerned with a company’s profitability while including all entries from financial records and additional notes. Also of interest are the returns that a company pays to the shareholders as dividends or right share as well as an increase in stock value (Spiceland, Sepe & Nelson, 2011). The analysis needs to take into account the annual accounts and annual growth and trend in terms of profit, revenues and market share. For the purpose of this analysis, consolidated accounts of Nokia (including Balance sheet, Income Statement, and cash flow statement) for the year ended 2014 are taken into account. The figures obtained from the company’s website are used. The research chose Nokia Corporation for the purpose of this paper. From the available financial statements, operating lease is applied in the preparation of Nokia’s financial records. According to Nokia’s annual reports, the lease payment for projects is summarized in the table below: Financial statements Table 1: Journal entry for Nokia Corporation, 2014 Source: nokia.com   Entry Debit Credit Reverse Entry Cash 2249   Operating Lease   2249 1/11/2014 Capital Asset 2248   Long-term Liability   2248 31/12/2014 Interest Expense 384   Interest Payable   384 31/12/2014  Depreciation Expense 135   Accumulated Depreciation   135 Table 2: Balance Sheet of Nokia Corporation (GAAP). (Dollars) Balance sheet for the Year ending 31st December 2014 Assets Current Liabilities Current Assets Cash 20456 Accrued Payables 21175 Marketable securities 18383 Accrued expenses 11414 A/c receivables 10930 Deferred revenue 5953 Inventories 791 Total current liabilities 38542 Deferred tax 2583 Deferred revenue- non 2648 Non trade receivables 7762 other non-current 16664 Others 6458 Total Liabilities 57854 Sub Total 57653 Common stock 16422 Long term marketable sec’s 92122 Retained Earnings 101289 Property, Plant & equip Accumulated income 499 Land & buildings 2439 TOTAL LIABILITIES & EQUITY 176064 Machinery & equipment 15743 Office furniture 241 Lease hold improvements 3464 Gross Prop, Plant & Equip 21887 Depreciation & amortization -6435 Net Property, Plant & Equip 15452 Good will 1135 Acquired intangible 4224 Others 5478 TOTAL ASSETS 176064 Source: nokia.com Operating leases involve the acquisition of company equipment, and thus not included in the current liabilities. As such companies ignore the operating leases in the payment for lease taken. In a telecommunication industry, operating lease relates to the income statement entry item whose value is treated as an expense. Capital Lease alternatively is a balance sheet item whose value is treated against the purchase of property and equipment, including plant and machinery. Under the IFSR standards, Capital lease is regarded as Finance Lease. For a capital lease to qualify under this standard, several tests must be met. The first one is the Economic life test where the least lease term should be 75% of the economic life of an asset. Another option is the Transfer of Ownership which requires that at the end of the lease period, lease ownership should be transferred. The bargain purchase option present an option for a lessee to acquire the lease at a bargaining price. The economy recovery test requires that the present value of a lease payment be 90% of the fair market value. For accounting practices, capital Leases require that assets and liabilities be recorded in an amount equal to the present value of lease payment. That means the value should not exceed the actual value of an asset. The depreciation should be recorded as expenses: if there is bargain purchase or title transfer option, the property’s economic life is applied. Contrary, depreciation is treated over the lease term. Lastly, the lease payment interest expense is recorded as well as the reduction of liability through an operative interest method of amortization. Table 3: Nokia Balance Sheet for the year ended 31st December 2014. Amount (In Million) USD Amount (In Million) USD Increment Before After Sales 65,968 65,968 Operating Expenses 25,129 25,399 270 Operating Income Before Interest & Taxes 40,839 40,569 Interest Expense 758 1,523 765 Income Taxes -6,797 -6,797 Income from Continuing Operation 11,075 11,075 Discontinued Operations 0 0 Net Income 10,876 9,841 1,035 Current Assets 19,786 19,786 Fixed Assets 118,323 122,821 4,498 Total Assets 138,109 142,607 Current Liabilities 20,372 20,372 Long-Term Liabilities 47,073 51,571 4498 Stockholder Equity 70,664 70,664 Total Liabilities & Equity 138,109 142,607 Leverage Ratios The leverage rations involve a comparison of IFRS capital lease method and the GAAP operating lease method. The leverage ratio provides insights on a company’s position regarding the ability to raise external finances to offset liability obligations. The ratios include current ratio, debt ratio, cash ratio, and quick ratio and time interest earned. The annual financial accounts for Nokia shows that Nokia raised a minimal long term liabilities for the year 2014 a thus the debt to capital ratio is 1:1. These relations among other ratios are summarized in the table below, for US GAAP operating lease approach versus IFTS capital lease method (Spiceland, Sepe & Nelson, 2011). LEVERAGE RATIOS US GAAP IFRS Operating Lease Capital Lease Current Ratio (Current Asset / Current Liabilities) 1.6 1.59 Quick Ratio (Operating Expenses / Net Sales) % 1.56 1.55 Cash Ratio (Operating Income Before Interest & Taxes + Depreciation – Taxes) 0.85 0.84 Times Interest Earned (Net Income + Tax + Interest) / Interest Expense) 400.31 99.25 Debt ratio (Total liability/Total Assets 0.5 0.57 Leverage ratios are the common measures of assessing the liquidity of a company as well as understanding the financial method of the same. Lease capitalization present varied effects on leverage ratios and these changes reflect particular aspects of a business. Different studies have found out that lease capitalization often increases thee D: A ratio for different companies. For the purpose of this report reflects the effect of lease capitalization on Nokia Current Ratio The ratio analysis above shows a negligible increase upon the inclusion of operating lease. The table above indicates a 1:1 ratio suggesting that the company maintains an insufficient cash level to resolve temporary cash expenses. These ratios contravene the ideal position where a business should maintain a 2:1 ratio. Debt Ratio The analysis shows an increase in the debt ratio with the additional operating lease. The improvement in balance sheet figures implies a positive effect on Nokia Corporation. However, an increase in debt presents financial pressure to a business and consequentially hinders its ability to determine other sources of funding during the operating lease. Time interest ratio Time interest ratio drops significantly with an addition in an amount of operating lease. For a healthy business, the trend should be vice versa. For Nokia, the reducing ratio indicates unhealthy business. A higher ratio of time interest implies a better position for a business to settle its interest debts and obligations. Operating Ratio The analysis shows a slight increment in the ratio and thus a lower effect of the additional operating lease expense. Recommendations: Operating Lease: GAAP vs. IFRS The purpose of including operating lease in the off-balance sheet entries relates to the need of reducing the expenses (depreciation) that stem from the usage of a leased asset. Given that the depreciation expenses are excluded from a company’s account, adding operating lease as an off-balance sheet entry corrects the company’s profit statement. When the operating lease is included I the balance sheet accounting, the debt liabilities often become overstated for an extended period. Excluding operating lease from the profit statements improves the leverage position of a company and provides greater funding opportunities for business development. According to the evident positive implications, it, therefore, follows that keeping the operating lease under the off-balance sheet entry system is crucial, and thus, recommended Compared to the GAAP, the IFRSS standard captures the financing lease or capital lease and thus increases the liability position of a company by treating the item as an expense or purchase of a fixed asset. As observed from the ratios, the values seem lower on the IFRS method compared to the GAAP side. The differences indicate that IFRS standards are more conventional for creditors, unlike the US GAAP. This analysis concludes, therefore, that IFSR principles offer an excellent assessment method for potential investors or external creditor, about the perpetual state of a business. Conversely, GAA P is a lesser approach given that its standards are essential only from a business perspective. Conclusion According to the analysis above, the operating lease as provided by Nokia’s income statements demonstrates the company’s scope as well as the strategies applied to reduce liabilities. The observations also represent the company’s average position about the actual detail. The IFRS approach includes the operating lease in the off-balance sheet. Given that operating lease is an instance of a company’s liabilities, installments for credit are settled on a regular basis for a given period. Nevertheless, the leased assets are not included in business ownership, and thus, expenses are not recorded on company’s income statements References Agoglia, C., Doupnik, T., & Tsakumis, G. (2011). Principles-Based versus Rules-Based Accounting Standards: The Influence of Standard Precision and Audit Committee Strength on Financial Reporting Decisions. The Accounting Review, 86(3), 747-767. http://dx.doi.org/10.2308/accr.00000045 Beattie, V., Goodacre, A., & Thomson, S. (2000). Operating leases and the assessment of lease–debt substitutability. Journal Of Banking & Finance, 24(3), 427-470. http://dx.doi.org/10.1016/s0378-4266(99)00045-x Harris, P., Stahlin, W., Arnold, L., & Kinkela, K. GAAP vs. IFRS Treatment of Leases and the Impact on Financial Ratios. SSRN Electronic Journal. http://dx.doi.org/10.2139/ssrn.2248140 Nokia,. (2013). Our story. Retrieved 16 January 2016, from http://company.nokia.com/en/about-us/our-company/our-story Spiceland, J., Sepe, J., & Nelson, M. (2011). Intermediate accounting. New York: McGraw-Hill Irwin. Read More