Evaluating the Effects of Change in Accounting Standards, Methods or Assumptions on the Financial Statements and Ratios

Users of financial statements must be cognizant of proposed changes in accounting standards because of the impact they have on financial statements and a firm’s valuation. We anticipate significant changes in the accounting standards over the next few years as the US GAAP and IFRS converge. One striking difference between the two accounting standards is that US GAAP is rules-based, while IFRS is principles-based. Converging the two may pose significant challenges in consolidation, the income statement, inventory, the earnings-per-share (EPS) calculation, and development costs.

The Financial Accounting Standards Board (FASB) has obliterated the treatment of the operating lease in financial statements in the United States. Firms are typically required to capitalize leases. The implication is that the lessee must recognize both depreciation expense and interest expense on the lease. In other words, the lessee must post the lease obligation as an asset on the balance sheet. Recall from the previous section that capitalizing leases significantly increase the reported leverage.

Furthermore, capitalization of the lease impacts the firm’s compliance with its bond covenants based on financial leverage computed in line with the US GAAP. To avoid the increase in leverage from lease capitalization, the firm may raise additional equity, which would dilute existing shareholder’s ownership interests.

Question

New accounting rules that require all leases to be capitalized on a company’s balance sheet are anticipated over the next few years. An analyst believes that ABC Ltd. will be among the entities most affected by the change. He gathers financial information from the company’s most recent annual financial statements, as shown in the following exhibit.

$$ \textbf{Selected Financial Data for ABC Ltd. (US\$ Millions)} $$

$$\small{\begin{array}{l|r} \text{Revenue} & 7,945\\ \hline\text{EBIT} & 518\\ \hline\text{Interest expense} & 41\\ \hline\text{Income tax} & 163\\ \hline\text{Net income} & 262\\ \hline\text{Average total assets} & 3,151\\  \end{array}}$$

After examining the company’s lease disclosures, he estimates that its average lease term is 10 years with a reasonably consistent lease obligation of $2,000 over that term. He believes that leases should be capitalized at a rate of 6% per annum, which is the rate at which the company recently issued bonds.

If the accounting rules were to change, ABC Ltd.’s asset would most likely increase by:

    A. $7,360.

    B. $14,720.

    C. $18,613.

Solution

The correct answer is B.

The capitalized value of ABC Ltd.’s leases, the amount by which assets would increase, is estimated as the discounted present value of the operating lease obligations (expenses). The present value of 10 payments of $2,000 at 6% is $14,720, calculated as:

$$ $2,000\times\frac{1-(1.06^{-10})}{0.06}=$14,720$$

Reading 16: Integration of Financial Statement Analysis Techniques 

LOS 16 (d) Evaluate how a given change in accounting standards, methods, or assumptions affects financial statements and ratios.