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

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.

Shop CFA® Exam Prep

Offered by AnalystPrep

Featured Shop FRM® Exam Prep Learn with Us

    Subscribe to our newsletter and keep up with the latest and greatest tips for success
    Shop Actuarial Exams Prep Shop Graduate Admission Exam Prep


    Daniel Glyn
    Daniel Glyn
    2021-03-24
    I have finished my FRM1 thanks to AnalystPrep. And now using AnalystPrep for my FRM2 preparation. Professor Forjan is brilliant. He gives such good explanations and analogies. And more than anything makes learning fun. A big thank you to Analystprep and Professor Forjan. 5 stars all the way!
    michael walshe
    michael walshe
    2021-03-18
    Professor James' videos are excellent for understanding the underlying theories behind financial engineering / financial analysis. The AnalystPrep videos were better than any of the others that I searched through on YouTube for providing a clear explanation of some concepts, such as Portfolio theory, CAPM, and Arbitrage Pricing theory. Watching these cleared up many of the unclarities I had in my head. Highly recommended.
    Nyka Smith
    Nyka Smith
    2021-02-18
    Every concept is very well explained by Nilay Arun. kudos to you man!
    Badr Moubile
    Badr Moubile
    2021-02-13
    Very helpfull!
    Agustin Olcese
    Agustin Olcese
    2021-01-27
    Excellent explantions, very clear!
    Jaak Jay
    Jaak Jay
    2021-01-14
    Awesome content, kudos to Prof.James Frojan
    sindhushree reddy
    sindhushree reddy
    2021-01-07
    Crisp and short ppt of Frm chapters and great explanation with examples.