884 SECTION 3 Financial Instruments and Liabilities Decision Makers’ Perspective—Financial Statement Impact As indicated in the Decision Makers’ Perspective at the beginning of the chapter, leasing can allow a firm to conserve assets, to avoid some risks of owning assets, and to obtain favorable tax benefits. These advantages are desirable. It also was pointed out earlier that some firms try to obscure the realities of their financial position through off-balance-sheet financing or by avoiding violating terms of contracts that limit the amount of debt a company can have. Accounting guidelines are designed to limit the ability of firms to hide financial realities. Nevertheless, investors and creditors should be alert to the impact leases can Leasing sometimes is have on a company’s financial position and on its risk. ● used as a means of offbalance Balance Sheet and Income Statement Capital lease transactions impact several of a firm’s financial ratios. Because we record liabilities for capital leases, the debt-equity ratio (liabilities divided by shareholders’ equity) is immediately impacted. Because we also record leased assets, the immediate impact on the rate of return on assets (net income divided by assets) is negative, but the lasting effect depends on how leased assets are utilized to enhance future net income. As illustrated in this chapter, the financial statement impact of a capital lease is no different from that of an installment purchase. Even operating leases, though, can significantly affect risk. Operating leases represent long-term commitments that can become a problem if business declines and cash inflows drop off. For example, in 2009 the economic crisis caught many companies with a deadly combination of declining cash inflows and cash outflow commitments for lease agreements. Nearly four billion dollars in off-balance sheet obligations related to operating lease commitments was a major contributor to Circuit City ’s demise after a 60-year history as a leader in the electronics industry. Whether leases are capitalized or treated as operating leases affects the income statement as well as the balance sheet. However, the impact on the income statement generally is not significant. Over the life of a lease, total expenses are equal regardless of the accounting treatment of a lease. If the lease is capitalized, total expenses comprise interest and depreciation. The total of these equals the total amount of rental payments, which would constitute rent expense if not capitalized. There is, however, a timing difference between lease capitalization and operating lease treatment, but the timing difference usually isn’t great. The more significant difference between capital leases and operating leases is the impact on the balance sheet. As mentioned above, a capital lease adds to both the asset and liability side of the balance sheet; operating leases do not affect the balance sheet at all. How can external financial statement users adjust their analysis to incorporate the balance sheet differences between capital and operating leases? A frequently offered suggestion is to capitalize all noncancelable lease commitments, including those related to operating leases. Some financial analysts, in fact, do this on their own to get a better feel for a company’s actual debt position. To illustrate, refer to Illustration 15–18 on the previous page, which reveals the operating lease commitments disclosed by Walmart. If these arrangements were considered capital leases, these payments would be capitalized (reported at the present value of all future payments). By making some reasonable assumptions, we can estimate the present value of all future payments to be made on existing operating leases. For example, the interest rates used by Walmart to discount rental payments on capital leases range from 3.0% to 13.6%. If we use the approximate average rate of 10%, and make certain other assumptions, we can determine the debt equivalent of the operating lease commitments as shown in Illustration 15–19 . If capitalized, these operating lease commitments would add $9,456 million to Walmart’s liabilities and approximately $9,456 million to the company’s assets. 29 Let’s look at the Lease liabilities affect the debt to equity ratio and the rate of return on assets. Do operating leases create long-term commitments equivalent to liabilities? Operating lease commitments create problems during an economic downturn. The net income difference between treating a lease as a capital lease versus an operating lease generally is not significant. The difference in impact on the balance sheet between capital leases and operating leases is significant. 29 If these operating leases were capitalized, both assets and liabilities would increase by the same amount at inception of the lease. However, in later years, the leased asset account balance and the lease liability account will, generally, not be equal. The leased asset account is reduced by depreciation and the lease liability account is reduced (amortized) to zero using the effective interest method. sheet financing.
Spiceland_Inter_Accounting8e_Ch15
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