4) You are the auditor of Big Company. After completing your audit with the exce

Question

4) You are the auditor of Big Company. After completing your audit with the exception of leases, you (and management) have determined that Big has Assets of $6,000,000 Liabilities of $2,500,000 and therefore equity of $3,500,000. Big has leased the following four pieces of land Big has a debt agreement requiring a debt/equity ratio of 1.0 or less. Land A FMV $1,000,000 PV of lease payments $900,000 Land B FMV $1,000,000 PV of lease payments $850,000 Land C FMV $1,000,000 PV of lease payments $800,000 Land D FMV $1,000,000 PV of lease payments $750,000 Under GAAP how do you classify each of these leases? Now what is the debt/equity ratio of Big? Are they violating their debt agreement? Explain

Explanation / Answer

Companies can account for lease agreements as either operating expenses or capital investments. The decision impacts the company's financial statements and can be manipulated to present an inaccurate picture of its financial condition. In the US, Generally Accepted Accounting Principles (GAAP) that govern financial reporting for corporations set standards to control financial statement manipulation through lease agreement classification. GAAP lease accounting requires accountants to apply a four-prong test to a lease to determine whether it should be classified as an operating or capital obligation. There are two types of business leases in general, which include operating leases and capital leases. A lease agreement allows a company to rent equipment for a monthly payment without purchasing the equipment outright. If the lease agreement gives the company the right to use the equipment for a specific length of time with no right to ownership, the monthly payment is considered an operating expense. The expense is written off as an ordinary annual business expense and is reflected on the company's income statement....................................................If the lease agreement ends with the company owning the equipment or allows the company to buy the equipment at a reduced price at the conclusion of the lease term, the lease is considered a capital obligation. In this scenario, the lease has more in common with a long-term financing arrangement than it does with a true rental arrangement. A capital lease creates an asset and a liability on the corporation's balance sheet. The company must depreciate the asset each year and can only deduct the interest paid on the lease. Corporations tend to prefer to classify leases as operating expenses to keep them off of the balance sheet. A rental payment on an income statement looks like a short-term expense that can be jettisoned at any time if the business needs to reduce expenses to preserve profitability. Conversely, a liability on the balance sheet affects the financial standing of the company, because it is an obligation with a multi-year impact that often cannot be canceled without significant cost. GAAP lease accounting was modified to prevent balance sheet manipulation through lease misclassification. Financial standards in the US now require accountants to apply a four-prong test to lease agreements before classifying them as operating or capital. If a lease agreement contains any of the four test criteria, it should be properly classified as a capital obligation under GAAP lease accounting standards. Two of the GAAP lease accounting criteria for capital leases concern the disposition of the equipment at the end of the contract. If the company owns the equipment or has an option to purchase the equipment at a bargain price at the end, the lease is considered capital. Also, if the present value of the lease payments is more than 90 percent of the fair market value of the equipment or if the term of the lease is more than 75 percent of the life of the asset, the agreement is considered a capital obligation....................................................................................................................................................Definition of 'Debt/Equity Ratio' A measure of a company's financial leverage calculated by dividing its total liabilities by stockholders' equity. It indicates what proportion of equity and debt the company is using to finance its assets. total liablities/shareholders equity Note: Sometimes only interest-bearing, long-term debt is used instead of total liabilities in the calculation. Also known as the Personal Debt/Equity Ratio, this ratio can be applied to personal financial statements as well as corporate ones. A high debt/equity ratio generally means that a company has been aggressive in financing its growth with debt. This can result in volatile earnings as a result of the additional interest expense. If a lot of debt is used to finance increased operations (high debt to equity), the company could potentially generate more earnings than it would have without this outside financing. If this were to increase earnings by a greater amount than the debt cost (interest), then the shareholders benefit as more earnings are being spread among the same amount of shareholders. However, the cost of this debt financing may outweigh the return that the company generates on the debt through investment and business activities and become too much for the company to handle. This can lead to bankruptcy, which would leave shareholders with nothing. The debt/equity ratio also depends on the industry in which the company operates. For example, capital-intensive industries such as auto manufacturing tend to have a debt/equity ratio above 2, while personal computer companies have a debt/equity of under 0.5.

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