Impact of Leases on Financial Statements and Financial Ratios - Essay Example

Leasing Project: Impact of Leases on Financial Statements and Financial Ratios Name: Unit: Course: Professor: Submission Date: Leasing Project: Impact of Leases on Financial Statements and Financial Ratios Introduction Both the GAAP and IFRS categorize lease into two categories. GAAP categorize lease into a capital lease and operating lease. IFRS, on the other hand, categorize lease into the financial lease and operating lease. The two classifications are similar, but the impact on financial statements is different (Harris, Stahlin, Arnold, Kinkela, 2013) A capital/financial lease is recorded on the balance sheet as the purchase of plant, equipment, and property. The operating lease is an off-balance sheet financing technique that is recorded on an income statement as a rent expense. Certain criteria are used to demarcate between capital/financial lease and the operating lease. First, if the economic life of the asset is less than or equal to 75% of the lease term, then it is a capital/financial lease; otherwise, it is an operating lease. Secondly, it is a capital lease if ownership is transferred to the lessee at the end of the lease term; otherwise, it is an operating lease. Thirdly, it is considered a capital/financial lease if, at the end of the lease term, there is a bargain option to purchase the asset; otherwise, it is considered an operating lease. Finally, the minimum lease payment’s present value has to be equal to or greater than the asset fair market value for it to be considered as a capital/financial lease; otherwise, it is an operating lease (Harris, Stahlin, Arnold, Kinkela, 2013) This study focuses on operating lease. It is an off-balance sheet financing technique that involves the recording of the asset leased on the income statement while the lease liability associated with such a transaction is not recorded on the financial statements. The operating lease is used for acquisition or purchase of equipment. Companies prefer this form of financing because it lowers the debt ratio as well as the liabilities. However, on a proper accounting system, the picture depicted is incomplete for business financing information to the investors and shareholders. It is taken as a long-term liability thus not considered in leases’ present payments. The operating lease financing technique is mostly used in the airline industry and mining industry to acquire large machinery, hardware, and equipment that would be rather expensive to buy. Therefore, it lowers the costs of acquiring such items significantly facilitating savings. The operating lease also writes of the risk of obsolescence that the company would incur through owning the equipment (Fridson& Alvarez, 2011). To illustrate the impact of the operating lease on financial statements, this paper undertakes to study the leasing of a plant, machinery, and equipment by the BHP Billiton Company. The company is a mining concern whose leasing for the plant, machinery, and equipment stands at USD 2368 million as per the 2015 financial reporting (BHP Billiton, 2015). The Overview of the BHP Billiton Company The BHP Billiton is an Australian multinational company that deals in minerals, petroleum products, and metals. It’s thus a mining and petroleum company that is headquartered in Australia. The merger of Anglo Dutch Company and an Australian company is a leader globally as Resources Company. The company has a long-term strategy of creating shareholder value facilitated by discovering, acquiring, developing, and marketing of various natural resources. The company is the largest producer of iron ore, copper, metallurgical coal, and uranium in the world. The company also produces oil, gas, and energy coal and has the potential for expansion in the world markets. The company’s corporate strategy is to own and operate assets diversified by geography, commodity, and market. The company employs a diversity of over 49000 employees from different ethnic and cultural backgrounds all over the world. The company’s market capitalization was found to be USD 108 Billion by 30th June 2015 (BHP Billiton, 2015). Data Collection This study uses secondary data from the BHP Billiton website. The 2015 financial report was extracted from the company website for analysis. The footnotes to accounts provided additional information about the key items affecting the off-balance sheet financial reporting. This study extracted and made use of data regarding financial and operating lease depicted under the company commitments. According to the 2015 financial report, the company produced a profit of USD 1.9 Billion for the year ended 30th June 2015. However, profit from operations decreased by 62% from USD 22.6 billion in 2014 to USD 8.7 billion in 2015. This resulted from the rise in the cost of goods sold and a fall in revenue registered during the financial year (BHP Billiton, 2015). The data in the 2015 annual financial report indicated that the company had taken various leases under operating lease for property, plant, and equipment. The company also took finance leases. The 2014 operating lease was USD 3,527 million and decreased to USD 2,368 in 2015. The finance lease also decreased from USD 1,384 million in 2014 to USD 438 in 2015 (BHP Billiton, 2015). This study focuses on the operating lease. Case Study To facilitate a proper understanding of the impact of operating lease on financial statements, this study shall make various assumptions. First we shall assume that the capital lease shall be used for eight years on average. Secondly, the useful life of fixed assets such as property, plant, and equipment is estimated to be approximately 3 to 30 years under the straight-line method of depreciation. (BHP Billiton, 2015). This study assumes the useful life of fixed assets to be 8 years. The depreciation rate under the straight line method of depreciation is taken to be 12.5% for assets with an average life of 8 years. The capitalization rate for the year ended 30th June 2015 was 2% as given in the BHP Billiton Report (BHP Billiton, 2015). BHP Billiton Journal Entry (in USD millions) Title Dr Cr Reverse Entry Cash 2368 Operating Lease 2368 On 30/06/2015 Capital Asset 2368 Long-term Liability 2368 On 30/06/2016 Interest Expense 47 Interest Payable 47 On 30/06/2016 Depreciation Expense 296 Accumulated Depreciation 296 Financial Statement Key Figures and Accounts The journal entry presented above is a reflection of the enactment of operating lease showing interest payable and accumulated depreciation and their presentation within accounting statements. The effect of the operating lease on financial statements is represented in the financial statement summary below. Year ended 30th June 2014 2015 Increase Amount (US $ M) Amount (US $ M) Amount (US $ M) Sales 56,762 44,636 Operating Expenses 36,523 36,819 296 Operating Income Before Interest & Taxes 20,239 7,817 Interest Expense 181 228 47 Income Taxes -207 -275 Income from Continuing Operation 256.5 65.5 Discontinued Operations 13.5 29.6 Net Income 15,224 14,881 343 Current Assets 13,251 8,860 Fixed Assets 36,728 39,065 Total Assets 49,979 47,925 Current Liabilities 2,565 2,046 Long-term Liabilities 115 76 Stockholder Equity 47,299 45,803 Total Liabilities & Equity 47,925 49,979 (Source: BHP Billiton, 2015). Ratio Analysis The ratio analysis represents financial ratios before the enactment of the operating lease and also after the enactment of the operating lease in the financial statements. Financial Ratio Before After Current Ratio (Current Assets/Current Liabilities) 5.166 4.330 Debt Ratio (Total Liabilities/Total Assets) 0.0536 0.0443 Times Interest Earned ((Net Income + Tax + Interest)/Interest Expense) 86.254 67.474 Operating Ratio (Operating Expenses/Net Sales) % 62.344% 82.487% Operating Cash Flow (Operating Income Before Interest & Taxes+Depreciation-Taxes) 20328 7838 (Source: BHP Billiton, 2015). From the above analysis, the current ratio decreases with the enactment of the operating lease. The current ratio corresponds to 1.2:1 scenario indicating that the company has enough financial resources to meet the creditor’s demands. The indication is that the company has the financial strength to meet the short-term liabilities in the current financial year. However, in accounting terms, the best current ratio should be 2:1 for the company to have adequate liquidity to meet its liabilities in the short run. The debt ratio decreases with the addition of the operating lease. In both cases, the debt ratio is below 0.5% indicating that the company assets are least financed through debt capital but mostly financed through equity. The times interest earned (TIE) decreases with the introduction of the operating lease. This indicates that the operating lease increases the company debt obligations. However, the TIE is greater than 2.5 times indicating the company is in a better position to meet its debt obligations. The operating ratio increases with the addition of the operating lease in the financial statements. This is a bad sign as it shows an increase in operating expenses compared to sales. A high operating ratio indicates management inefficiency to cut down operating expenses compared to the net sales. The operating cash flow decreases drastically with the addition of the operating lease. However, in both cases, it is a positive cash flow indicating that the business can generate adequate positive cash flow to finance its operations. The Installment Schedule To analyze the payment of installments to the operating lease, we use the Ordinary Annuity Method and the Annuity Due Method separately. The Annuity Due Method The operating lease principal totals to USD 2368 million. To analyze the lease payment under the Annuity Due Method, we assume the installment amount is USD 296 million spread over eight years. Under the Annuity Due method, the payments are to be made at the beginning of each financial year. We assume the interest rate is fixed at 8% per annum. The calculations are made to the nearest whole number. Date Installments Lease Payment Reduction in Liability Lease Liability 01-07-2015 2368 07/01/2015 296 296 296 2072 07/01/2016 296 274 296 1776 07/01/2017 296 254 296 1480 07/01/2018 296 235 296 1184 07/01/2019 296 216 296 888 07/01/2020 296 201 296 592 07/01/2021 296 187 296 296 07/01/2022 296 173 296 0 2368 1836 2368 10656 The Ordinary Annuity Method Under this method, payments of fixed amounts are made at the end of the financial year at regular intervals of time. To show the payment of operating lease obligation, we take interest rate to be 8% per annum, and fixed payment of USD 296 million spread over eight years. Date Installments Lease Payment Reduction in Liability Lease Liability 30-06-2015 2368 06/30/2015 296 274 296 2072 06/30/2016 296 254 296 1776 06/30/2017 296 235 296 1480 06/30/2018 296 216 296 1184 06/30/2019 296 201 296 888 06/30/2020 296 187 296 592 06/30/2021 296 173 296 296 06/30/2022 296 160 296 0 2368 1700 2368 10656 The operating lease payment via the Ordinary Annuity Method is lower than the payment made using the Annuity Due Method. This is because payments are shifted backward by one period in the Ordinary Annuity Method. Recommendations: US GAAP Lease vs. IFRS Lease The operating lease is appropriate if the estimated life of the leased equipment’s use does not conform to the guidelines of the International Reporting Standards for a capital lease. The operating lease is an off-balance sheet financing technique. The exclusion of the operating lease from the balance sheet items can be justified by the fact that the actualization of the occurrence of the liability and contingent liabilities is not similar to that of other balance sheet items that are actualized on the occurrence of an event. The installments for the debt settlement are paid on regular intervals over specified period throughout the use of the leased equipment. Throughout this period, the leased property belongs to the lessor and the lessee does not own the property after the lease period unlike in a capital lease. Therefore, the depreciation expense is borne by the lessor and should not be charged on the lessee. This lowers the operating expenses. The two methods used for computation of lease payments; the Annuity Due Method, and the Ordinary Annuity Method also possess their advantages. This study recommends the Ordinary Annuity Method for payment of operating lease because it was found that the lease payment under this method is less than that of Annuity Due Method. Hence, the Ordinary Annuity Method has the effect of lowering the amount payable as interest obligations. Hence, the interest expense is low under the Ordinary Annuity Method. This study recommends the use of operating lease to finance company property, plant, and equipment due to its various advantages. For instance, its exclusion from balance sheet items eliminates depreciation expenses from the business accounts. It, therefore, offsets operating expenses. Lowering of operating expenses translates to higher operating profits. Again, the operating lease relieves the lessee from the risk of obsoleteness associated with capital assets. Further, it avoids overstating of debt liabilities, in the long run, being an off-balance sheet item. Therefore, the operating lease expands the company’s operating capital base to undertake more production activities and expand business operations. Based on this analysis, therefore, it is recommended that the operating lease should always be kept as an off-balance sheet item. Conclusion A Lease is classified into a capital lease (GAAP)/ finance lease (IFRS) and the operating lease. The analysis of operating lease in this study has identified that it has various advantages as a capital financing tool. The lease does not only offset the operating expenses but also relieves the lessee from the risk of obsoleteness as the leased property stays under lessor’s ownership over its useful life. However, the leased property is sometimes made according to the lessee specifications, and the lessor may not own it back after the lease period. The study also analyzed the effect of the operating lease on the BHP Billiton financial statements and found out that it increases operating expenses as well as lowering net income. However, the benefits highlighted above surpass the shortcomings. Hence, it is recommended as a good financing tool. Finally, the study found out that the Ordinary Annuity Method of the lease payment is better than the Annuity Due Method. This is because it leads to lower interest obligations than the latter method. References BHP Billiton (2015). About BHP Billiton, http://www.bhpbilliton.com/aboutus/ourcompany, Retrieved 12/22/2015. BHP Billiton (2015). Resourcing Global Growth: Annual Report 2015. Available at: www.bhpbilliton.com/.../bhp/.../annual-reports/2015/bhpb, Retrieved 12/23/2015. Fridson, M. & Alvarez, F. (2011).Financial statement analysis: A practitioner's guide. New Jersey: John Wiley & Sons. Harris, P., Stahlin, W., Arnold, L.W., Kinkela, K. (2013). GAAP Vs. IFRS Treatment of Leases and the Impact on Financial Ratios. Review of Business and Finance Studies, 4(2), 97-106. Read More