Page 111 - FINAL CFA II SLIDES JUNE 2019 DAY 5.2

LOS 19.c: Evaluate the quality of a company’s financial
data, and recommend appropriate adjustments to READING 19: INTEGRATION OF FINANCIAL STATEMENT ANALYSIS TECHNIQUES
improve quality and comparability with similar
companies, including adjustments for differences in
accounting standards, methods, and assumptions MODULE 19.7: OFF-BALANCE-SHEET FINANCING AND CHANGING ACCOUNTING STANDARDS

Off-Balance-Sheet Financing –operating leases?
For analytical purposes, an operating lease should be treated as a finance lease, increasing assets and liabilities by the present value of the remaining
lease payments. Since assets and liabilities are initially increased by the same amount, stockholders’ equity is not affected by this adjustment.
Capitalizing an operating lease will increase financial leverage because of the increase in liabilities.

On the income statement, it is necessary to replace the rental expense (payment) for the operating lease with depreciation expense (on the lease
asset) and interest expense (on the lease liability).

Recall that in the early years of a finance lease, depreciation expense and interest expense will exceed the lease payment. As a result, net income will
be lower in the early years for a finance lease compared to an operating lease. In addition, by recognizing interest expense in the lessee’s income
statement, the interest coverage ratio will likely decline (higher denominator).

Consider an example. Roadrunner, Inc., the lessee, reports an agreement to finance manufacturing equipment as an operating lease. The discounted
present value of the lease payments is $9.1 million at an interest rate of 10%. The lease term is five years and the annual payment is $2.4 million.
Figure 19.19 illustrates the effect of analyst adjustments on selected leverage and interest coverage ratios.

LOS 19.d: Evaluate how a given change in accounting standards, methods, or
assumptions affects financial statements and ratios.
As a result of
capitalizing the
operating Anticipating Changing Accounting Standards
lease, financial Users must be aware of proposed changes in accounting
leverage is standards because of the financial statement effects and the
increased and potential impact on a firm’s valuation. In most cases, firms are now
interest required to capitalize leases. This may significantly increase
coverage is reported leverage. Lease capitalization will also affect the firm’s
decreased. compliance with its bond covenants based on financial leverage
calculated in accordance with U.S. GAAP. To avoid the increase
Could also in leverage from capitalizing a lease, the firm could raise additional
split lease equity, which would dilute existing investors’ ownership interests.
liability into
current and
non current
portion!