Relevant Adjustments for Improving Quality and Comparability with Similar Companies

Off-Balance-Sheet Financing

Off-balance-sheet financing is an accounting practice where companies exclude liabilities on their balance sheet and the associated interest expense on the P&L. Operating lease is a typical example of off-balance-sheet financing. It is an expense that is kept off the balance sheet and can be thought of as more like renting a property. Additionally, it does not involve the transfer of ownership. Rental expense, which is equal to the periodic lease payment, is treated as an operating expense on the income statement, and it affects both the net and operating income.

On the other hand, a financial (capital) lease is treated as a purchase of an asset financed with debt. It is used to lease longer-term assets and gives the lessee ownership rights. Thus, the lessee reports an asset and a liability on the balance sheet. Also, the lessee reports depreciation expense and interest expense instead of rental expense on the income statement. With all the other factors that affect the performance of an entity constant, firms that report operating leases record a better performance relative to those reporting capital leases because:

• They report less debt on the balance sheet.
• They report higher profits, which appear to be generated by a relatively smaller investment in assets.

The operating lease should be treated as a capital lease for analytical purposes, increasing balance sheet items by the present value of the remaining lease payments. Shareholders’ equity is unaffected by this adjustment since the same amount is initially used to increase the balance sheet items.

Capitalizing the operating lease by adding it as an asset and a liability on the balance sheet increases the financial leverage. The rental expense for the operating lease is replaced with depreciation expense on the leased asset and interest expense on the lease liability on the income statement. Due to capitalization, the interest coverage ratio declines.

During the early years of a capital lease, depreciation & interest expense exceed the rental expense. Therefore, net income is lower in the early years for a finance lease relative to an operating lease.

We may disaggregate the lease liability into current and long-term liabilities where we increase the current liabilities by the principal amount of the lease payment due within 12 months. We obtain the principal amount by subtracting the interest expense from the total lease payment. On the other hand, long-term liability is the difference between the total lease liability and the current liability. This adjustment results in a decline in the current ratio.

There are other off-balance sheet items, including debt guarantees, sales of receivables with recourse, and take-or-pay agreements. The same approach applies here as with the operating lease adjustment. In other words, the assets and liabilities are increased by the transaction amount that is off-balance sheet.

Example: The Effect of Adjustment on Selected Leverage Ratios and Interest Coverage Ratios

Suppose that Move Inc., a food supply company, reports an agreement to finance a vehicle as an operating lease. The company is required to make level annual payments of $10,000 at an interest rate is 12% p.a. for a lease term of 6 years.

The following figure demonstrates the effect of adjusting the operating lease on selected leverage and interest coverage ratios.

$$\small{\begin{array}{l|r|r|r} \textbf{Amount in US\$} & \textbf{Reported} & \textbf{Adjustment} & \textbf{Pro Forma}\\ \hline\text{Total assets} & 92,083 & 41,114 & 133,197\\ \hline\text{Total equity} & 70,333 & – & 70,333\\ \hline\text{Total debt} & 32,486 & 41,114 & 73,600\\ \hline\text{EBIT} & 6,280 & 3,148 & 9,428\\ \hline\text{Interest expense} & 1,930 & 4,934 & 6,864\\  \end{array}}$$

$$\small{\begin{array}{l|r|r} \textbf{US\$} & \textbf{Reported} & \textbf{Pro Forma}\\ \hline\text{Financial leverage} & 1.31 & 1.89\\ \hline\text{Total debt-to-equity} & 0.46 & 1.05\\ \hline\text{Interest coverage} & 3.25 & 1.37\\  \end{array}}$$

The calculations are as follows:

$$\text{Financial leverage}=\frac{\text{Total assets}}{\text{Total equity}}$$

$$\text{Total-debt-to-equity}=\frac{\text{Total debt}}{\text{Total equity}}$$

$$\text{Interest coverage}=\frac{\text{EBIT}}{\text{Interest expense}}$$

The present value of the lease payments is:

$$10,000\times(\frac{1-(1+0.12)^{(-6)}}{0.12})=\$41,114$$

Therefore, assets and liabilities are increased by $41,114.

$$\text{Depreciation expense}=\frac{\text{41,114}}{\text{6 years}}=\$6,852$$

The EBIT is adjusted by \(\$10,000-\$6,852=3,148\)

Finally, the interest expense is:

$$\$41,114\times0.12=\$4,934$$

Thus, the interest expense will be increased by $4, 934.

In conclusion, we see that capitalizing the operating lease results in increased financial leverage and declined interest coverage.

Question

A financial analyst suspects that the company he has invested in might have hidden financial leverage. He researches the company and finds out that it reports an operating lease of financing machine equipment. The rental expense is 3 million per annum. The present value factor on an 8-year level payment discounted at 10% is 5.33.

What is the most likely effect of capitalizing the operating lease on the company’s leverage?

      A. No change.

      B. Increase.

      C. Decrease.

Solution

The correct answer is B.

Capitalizing the operating lease will result in an increase in liabilities by 16 million (i.e., Rental expense × Present value factor = 3 × 5.33 = 16 million) which ultimately increases financial leverage.

B and C are incorrect. Even without calculations, recall that capitalizing the operating lease by adding it as an asset and a liability on the balance sheet increases the financial leverage.

Reading 16: Integration of Financial Statement Analysis Techniques 

LOS 16 (c) Evaluate the quality of a company’s financial data and recommend appropriate adjustments for improving the quality and comparability with similar companies, including adjustments for the differences in the accounting standards, methods, and assumptions.