Question

You have just restated a set of financial statements to reflect capitalizing operating leases for the past 5 years. Now you are going to perform the financial analysis. Which of the following statements is absolutely correct when comparing the as-stated and re-stated financials?

a. The debt service margin will be higher on the second year of the restated ratios than as stated.

b. The current ratio will decrease in the first year of the restatements as compared to as-stated.

c. Operating profit margin must always be smaller for the restated ratios.

d. Times interest earned will be smaller on a restated basis

e. Altman’s Z-score will increase on a restated basis.

Answer 1

The correct answer is Option D : Times interest earned will be smaller on a restated basis.

When a company capitalizes an operating lease, it treats its lease as debt. The company acquires both lease and the asset and shows it in Balance Sheet. The company also adjusts depreciation on this asset and interest expense for the lease acquired. While capitalizing lease, the ownership of the asset is transferred to lessee at the end of the term. Operating lease is treated off balance sheet.

As the company treats lease as debt and shows interest as expense, this expense is shown in Financial statements. Times interest earned is a ratio that shows company's ability to meet its debt obligation in the form of interest from its current year income. It is a ratio of EBIT (Earning before interest and tax) to interest expense. When operating lease is capitalized, the interest expense goes up as the lease is shown as debt in Balance sheet. Due to this higher interest expense in Times interest earned ratio, the ratio goes lower. The reason is that if in a ratio, the denominator goes higher without hike in numerator, then the ratio turns smaller. Similar is the case here, as interest expense in times interest earned ratio goes higher, the ratio turns lower. So, times interest earned will always be lower when operating lease is capitali