Question

Innovation Delivery Express Ltd (IDEL) leases trucks which it uses to deliver goods throughout Australia. IDEL has not yet adopted AASB 16 Leases. It classifies its leases as operating leases under AASB 117, which means it does not recognise lease assets and associated liabilities. The draft financial statements for the year ended 31 December apply AASB 117 and contain the following items:

All items are in $M
Truck Rent expense                       300
Profit before interest and tax           300
Interest expense                             100
Profit before tax                              200             

Total liabilities                                600
Total assets                                 1200

The accountant for IDEL is considering adopting AASB 16 Leases in the 2019 financial statements. She has estimated that the Truck rental expense would be replaced by depreciation expense of $160M and interest expense would increase by $170M. Also, IDEL would recognise a right of use asset of $800M and lease liability of $800M in its financial statements at the end of 2019.

The management of IDEL receive a bonus equal to 1% of before tax profit, provided a performance hurdle of 15% before tax return on investment is achieved.

The liabilities reported by IDEL include debentures payable with a debt covenant that restricts leverage to a maximum of 60% of total assets.

Required

Please label your responses.

a) Using information presented in the draft financial statements, calculate the following items BEFORE the application of AASB 16:

i) the interest coverage (EBIT/Interest expense)

ii) the before tax return on investment (profit before tax/total assets at the end of the year)

iii) the leverage ratio (total liabilities/total assets)

b) The amount of profit before tax and interest for 2019 of IDEL adopts AASB 16. (1 mark)

c) Calculate the following items if IDEL adopts AASB 16 in its 2019 financial statements:

i) the interest coverage (EBIT/Interest expense)

ii) the before tax return on investment (profit before tax/total assets at the end of the year)

iii) the leverage ratio (total liabilities/total assets)

d) According to agency theory, would the management of IDEL prefer to adopt AASB 16 Leases in its 2019 financial statements. Give reasons for your answer, drawing on the facts of the case and your analyses in parts a), b) and c) to support your answer. (8 marks

Answer 1

(a)

(1) Calculation of interest coverage ratio:

EBIT/Interest. =. 300/100 = 3

(2)The before tax return on investment:

Profit before tax / assets at the end of the year

• 200/1200. = 16%

(3) Calculation of levarage ratio:

• total liabilities/total assets

• 600/1200 = 0.5

(b) calculation of profit before tax and interest:

Total profit. 600

(_) depreciation. 160

Profit. 440

(C)

(1) calculation of interest coverage ratio:

EBIT/INTEREST

440/170. = 2.59

(2) RETURN ON INVESTMENT:

270/1840 = 14.67%

NOTE : Assume given assest before depreciation so depreciation reduced from the assest

I.e., 1200+800-160=1840

(3) leverage ratio:

1104/1840= 0.6

Note: By information given in sum it says that leverage ratio restricts to 60% of total assets

So total assests after depreciation is 1840 and 60% of assets is 1104.

(D) By the above calculations it is suggested not to adopt AASB16 because return on investment is less on adoption of AASB 16