Question

On January 1, 2012, two companies, Polland Ltd. and Turkey Inc. were incorporated. Each company operates a restaurant and had identical revenues during the year of $3 million but Polland bought its building for $1.7 million and the related land for $800,000. The company estimated that the building would have a useful life of 20 years with no residual value. Polland uses the straight-line method of depreciation. Because of the building purchase, Polland had an outstanding 4% bank loan during the year amounting on average to $2.8 million.

Turkey, however, did not buy a building. Instead, it rented a building under a five-year operating lease starting on January 1, 2012, for $17,000 per month. Because of this, the company had to install leasehold improvements for $100,000, which were completed in the first few days of January. Because Turkey did not have to buy a building, its outstanding 4% bank loan during 2012 averaged only $350,000.

The income tax rate for both companies is 22%. Assume both companies had identical revenues and expenses except for the items noted above.

Instructions

(a) If Polland had a net income of $175,000 for the year ended December 31, 2012, what net income did Turkey have?

(b) If Polland had total assets of $3,025,000 as at December 31, 2012, and the only differences between the assets of Polland and Turkey related to land, buildings, and leasehold improvements, the latter being depreciated over the term of the lease, what are the total assets for Turkey at the end of 2012?

(c) Calculate the asset turnover ratio for both companies for 2012. (Hint: Because this is the first year of operations, you can use the year-end asset balance rather than the average asset balance for the denominator.) Explain why the ratios are different.

(d) Calculate the profit margin ratio for both companies for 2012. Explain why they are different.

(e) Calculate the return on assets ratio for both companies for 2012. (Hint: Because this is the first year of operations, you can use the year-end asset balance rather than the average asset balance for the denominator.) Explain why the ratios are different using your answers in parts (c) and (d) above.

(f) What information relating to Turkey is not reflected in the financial statements that may be relevant to assessing its financial position and profitability?

(g) Would adopting the revaluation method under IFRS change the values of any of the three ratios covered above? Would those ratios improve or not?

(h) If new rules for treating operating leases beyond one year as capital leases are adopted in 2013, what impact will this have on Turkey's asset turnover ratio?

(i) Explain generally how an operating lease affects the financial statements of a company, compared with a finance lease.

(j) Is it unethical to deliberately structure a lease as an operating lease just to keep the debt off the financial statements?

(k) Do you think analysts will be able to distinguish between the financial impacts of purchasing buildings by borrowing from a bank compared with leasing it on an operating lease or a finance lease?

Please write your analysis below.

Answer 1

Refer to the below images for the above asked questions, in a detailed way of solution with explanations.

: Deaprirement @ In order to income before solve one most interest, taxes Work backward and depreciation to calcolate (EBITDA). For poll and Net income Amount & 175000 Income taxes ($175000 1.78x•22) $49359 Income before income taxes ($17.5000 1.78) $224359 Add: Interest expense ($2800000 x 40) 112000 Depreciation expense (1 1700000 = 20) & 85000 Income before interest, tares is depreciation ₃ & 421359 For Turkey : Amount § 421359 Income before interest, taxes & depreciation Less: Interest expense (4350000 8440) $14000 Depreciation expense ($100000 5) $20000 Dent expense ($ 17000 412) $204000 Income before income taxes Less:- Income tax expense ($183359822-10) Net income a $(238000) & 183359 (40339) $ 143020

: Amount Amount particulars Requitement $3025000 $ 800.000 & 1615000 depreciation $(2415000) Total Assets polland Dec 31, 2012 Less: Land Buildings net of accumulated [$ 19 D0000 - 85000] Remaining assets Dec 31, 2012 : § 616ooo $ 61000D $ 20000 Assets for Turkey : Easual to remaining assets of polland Add: Leasehold improvements net of accumulated Deprecation [¢ 100 000 - 20000] Total assets Torley Dec 31, 2012 : - - - $690000 Asset tornover Requirement polland: $3000000 $3025000 = 100 times Torrey : & 403 times $ 3 000 ooo / 3690000 Despite the fact that the assets used by these two businesses are essentially the same, the turnover ratio is dramatically different becaused the land and buildings is owned by solland and leased by Turkey This example demonstrates how financial information may be misinterpreted by financial Statement users. This example also demonstrates the need for change in the accounting Standards, to those proposed for implementation in 2013, for public companies.

& - profit margin Requirement polland: $ 17Jovo 18 3025000 =508 times Turites : $143020 & 690000 - 2007 times point polland manages to out pace Turkey by a full percentage on profit margin because, although it incurred additional interest expense, its depreciation expense was a Toriley's combined contevert & rent expense. @ Requirement treated building position return Because the lease of the premises by Toricey is as an operating lease, large amounts for land and are not included on the statement of trancial as assets. Consequently, Turtley has a moch better on asset ratio than polland. a Requirement . : Because the lease of the premises by Gorkey is treated as an operating lease, large amounts for land and building are not included on the statement of financial position as assets. In addition, although there is a Commitment to pay $ 17000 per month for the next 4 years, no liability appears on the statement of financial position Therefore, it is more difficult to readers of the financial statements to assess Toricey's financial position and profitability.

Reajuirement The revaluation method under IFRS affects the amount reported for property, plant and capoipment on the Statement of financial position Torley has treated the lease as an Operating lease and so the assets are not capitaliged and therefore not available for revaluation & Trokers ratios would not change in the case of polland, the revaluation model could affect the ratios for example, if land revalued at a higher amount, the return on assets and asset turnover rabios would reduce and become worse, but the profit margin would remain unchanged as gains on revalued aseets are recorded in other comprehensive income, not net income. 6 Reajoirement Because the accounting been adopted effective the building on its would increase total Vatio to reduce and recommendations concerning teases have. 2013, Turkey would need to capitaline statement of trancal position. This assets and cause the asset durnover therefore become worse- 6 Reapon fement Currently operating lease payments are treated as yont expense The details of the amount of the future payments under the lease contract are reported in the notes to the financial Statements on the other hand, a finance lease is treated as a means of trancing the acajuisition of the asset and So the asset being leared is added to the assets and the total obligations under the lease appear in the abilities Section of the statement of financial position payments on finance lease obligations are treated as part interest expense and part debt repayment. A finance lease causes increased interest expense and debt on the financial Statements and so the debt to total assets ratios and the times interest parmed rasio are adversely affected-

i). Requirement while management does have a choice of structuring a lease agreement as an Operating cor) Finance Lease, it is Unethical on the part of management to deliberately Structure a transaction for the sole purpose of theeping debt off the financial statements. This behavior could be construed as a type of financial engineering which is designed to deceive others and remove obligations that occor as a result of a transaction Requirement : Analysts are not fooled by financial engineering involving leases. Not with standing the application of the current rules surrounding the capitalization of leases, analysts will make the necessary adjustments to the financial results to interpet the impact of the treatment of operating versus finance leases.