An analyst has decided to capitalize the operating leases of Company A. Using in
ID: 2390948 • Letter: A
Question
An analyst has decided to capitalize the operating leases of Company A. Using information in the notes to the company’s 2015 financial statements, she has determined that the present value of future minimum lease payments, at a discount rate of 10 percent, on December 31, 2015 equals €500 million. All lease contracts last another 5 years on December 31, 2015. As expected at the beginning of the year, the company reports an operating lease expense in its income statement for 2016 of €80 million. The company’s tax rate equals 30 percent. The company does not engage in any new operating leases in 2016. The following information is also available from Company A’s financial statements (all ratios use beginning-of-the-year balance sheet values)
Debt to capital (at beginning of 2016) = 0.55
Return on beginning equity in 2016 = 0.10
Assets / Capital (at beginning of 2016) = €3,400 million
The effect of capitalizing Company A’s operating leases on its return on beginning equity equals
A. An increase from 0.10 to 0.15 (rounded).
B. An increase from 0.10 to 0.13 (rounded).
C. A decrease from 0.10 to 0.07 (rounded).
D. A decrease from 0.10 to 0.05 (rounded).
Explanation / Answer
accounting topic of leases is a popular Paper F7 exam area that could feature to varying degrees in Questions 2, 3, 4 or 5 of the exam. This topic area is currently covered by IAS 17, Leases. IAS 17, Leases takes the concept of substance over form and applies it to the specific accounting area of leases.
When applying this concept, it is often deemed necessary to account for the substance of a transaction – ie its commercial reality, rather than its strict legal form. In other words, the legal basis of a transaction can be used to hide the true nature of a transaction. It is argued that by applying substance, the financial statements become more reliable and ensure that the lease is faithfully represented.
WHY DO WE NEED TO APPLY SUBSTANCE TO A LEASE?
A lease agreement is a contract between two parties, the lessor and the lessee. The lessor is the legal owner of the asset, the lessee obtains the right to use the asset in return for rental payments.
Historically, assets that were used but not owned were not shown on the statement of financial position and therefore any associated liability was also left out of the statement – this was known as ‘off balance sheet’ finance and was a way that companies were able to keep their liabilities low, thus distorting gearing and other key financial ratios. This form of accounting did not faithfully represent the transaction. In reality a company often effectively ‘owned’ these assets and ‘owed a liability’.
Under modern day accounting the IASB framework states that an asset is ‘a resource controlled by an entity as a result of past events and from which future economic benefits are expected to flow to the entity’ and a liability is ‘a present obligation of the entity arising from past events, the settlement of which is expected to result in an outflow from the entity of resources embodying economic benefits’. These substance-based definitions form the platform for IAS 17, Leases.
SO HOW DOES IAS 17 WORK?
IAS 17 states that there are two types of lease, a finance lease and an operating lease. The definitions of these leases are vital and could be required when preparing an answer in the exam.
Finance lease
A finance lease is a lease that transfers substantially all the risks and rewards incidental to ownership of an asset to the lessee.
Operating lease
An operating lease is defined as being any lease other than a finance lease.
Classification of a lease
In order to gain classification of the type of lease you are dealing with, you must first look at the information provided within the scenario and determine if the risks and rewards associated with owning the asset are with the lessee or the lessor. If the risks and rewards lie with the lessee then it is said to be a finance lease, if the lessee does not take on the risks and rewards, then the lease is said to be an operating lease.
Finance lease indicators
There are many risks and rewards outlined within the standard, but for the purpose of the Paper F7 exam there are several important areas. The main reward is where the lessee has the right to use the asset for most of, or all of, its useful economic life. The primary risks are where the lessee pays to insure, maintain and repair the asset.
When the risks and rewards remain with the lessee, the substance is such that even though the lessee is not the legal owner of the asset, the commercial reality is that they have acquired an asset with finance from the leasing company and, therefore, an asset and liability should be recognised.
Other indicators that a lease is a finance lease include:
At the inception of the lease the present value of the minimum lease payments* amounts to substantially all of the fair value of the asset
The lease agreement transfers ownership of the asset to the lessee by the end of the lease
The leased asset is of a specialised nature
The lessee has the option to purchase the asset at a price expected to be substantially lower than the fair value at the date
accounting topic of leases is a popular Paper F7 exam area that could feature to varying degrees in Questions 2, 3, 4 or 5 of the exam. This topic area is currently covered by IAS 17, Leases. IAS 17, Leases takes the concept of substance over form and applies it to the specific accounting area of leases.
When applying this concept, it is often deemed necessary to account for the substance of a transaction – ie its commercial reality, rather than its strict legal form. In other words, the legal basis of a transaction can be used to hide the true nature of a transaction. It is argued that by applying substance, the financial statements become more reliable and ensure that the lease is faithfully represented.
WHY DO WE NEED TO APPLY SUBSTANCE TO A LEASE?
A lease agreement is a contract between two parties, the lessor and the lessee. The lessor is the legal owner of the asset, the lessee obtains the right to use the asset in return for rental payments.
Historically, assets that were used but not owned were not shown on the statement of financial position and therefore any associated liability was also left out of the statement – this was known as ‘off balance sheet’ finance and was a way that companies were able to keep their liabilities low, thus distorting gearing and other key financial ratios. This form of accounting did not faithfully represent the transaction. In reality a company often effectively ‘owned’ these assets and ‘owed a liability’.
Under modern day accounting the IASB framework states that an asset is ‘a resource controlled by an entity as a result of past events and from which future economic benefits are expected to flow to the entity’ and a liability is ‘a present obligation of the entity arising from past events, the settlement of which is expected to result in an outflow from the entity of resources embodying economic benefits’. These substance-based definitions form the platform for IAS 17, Leases.
SO HOW DOES IAS 17 WORK?
IAS 17 states that there are two types of lease, a finance lease and an operating lease. The definitions of these leases are vital and could be required when preparing an answer in the exam.
Finance lease
A finance lease is a lease that transfers substantially all the risks and rewards incidental to ownership of an asset to the lessee.
Operating lease
An operating lease is defined as being any lease other than a finance lease.
Classification of a lease
In order to gain classification of the type of lease you are dealing with, you must first look at the information provided within the scenario and determine if the risks and rewards associated with owning the asset are with the lessee or the lessor. If the risks and rewards lie with the lessee then it is said to be a finance lease, if the lessee does not take on the risks and rewards, then the lease is said to be an operating lease.
Finance lease indicators
There are many risks and rewards outlined within the standard, but for the purpose of the Paper F7 exam there are several important areas. The main reward is where the lessee has the right to use the asset for most of, or all of, its useful economic life. The primary risks are where the lessee pays to insure, maintain and repair the asset.
When the risks and rewards remain with the lessee, the substance is such that even though the lessee is not the legal owner of the asset, the commercial reality is that they have acquired an asset with finance from the leasing company and, therefore, an asset and liability should be recognised.
Other indicators that a lease is a finance lease include:
At the inception of the lease the present value of the minimum lease payments* amounts to substantially all of the fair value of the asset
The lease agreement transfers ownership of the asset to the lessee by the end of the lease
The leased asset is of a specialised nature
The lessee has the option to purchase the asset at a price expected to be substantially lower than the fair value at the date