Question

Suppose you did a pro-forma conversion of a company’s operating leases into finance leases. Describe how your pro-forma adjustments would affect the following variables. You should explain the adjustment, if any, that you would make. Then you should describe the effect of the adjustment on the variable – i.e., would it cause the variable to increase, decrease, stay the same or does the sign of the effect depend on the circumstances (i.e., it is indeterminant).

a. Operating assets.

b. Operating liabilities.

c. Net operating assets.

d. Net financial obligations.

e. Common equity.

f. Net operating profit after tax.

G.Net financial expense.

h. Net income.

Answer 1

Answer :-

Capital Lease or Financial Lease is treated on the balance sheet, but while the operating lease is treated as an Expense in Income statement, The value of Lease and the obligation amount to the lesser doesn,t show on the balance sheet, So it is an off-balance sheet item, Under the Finance Leas, it is like owning the asset and it will be depreciated over the lease life and the remaining obligation amount shown on the liability side of the balance sheet, but Under the Operating Lease, it is like renting the property and the expense amount recorded on the Income statement, Not on the balance sheet

.

Affect on conversion of a company’s operating leases into finance leases

a) Operating Asset Increases, When the Lease convert from operating to Financing, then the value of Underlying asset of Lease would be record as Operating asset on the balance sheet

b) Operating Liability  Increases, When the Lease convert from operating to Financing, then the Obligation of the Lessee to the Lessor on the Underlying asset would be record as Operating Operating Liability on the balance sheet

c) Net Operating Asset Increases, when the operating asset increases, The Net Operating asset also Increases

d) Net financial obligations Increases, Obligation of the Lessee means the liability, when the Operating liability increases, the Net fincing Obligations also Increases,

e) Common equity remains the same, Common Equity of company doesn't change even if it is operating or financing Lease, Only the assets and liabilities are change when converting the Operating Lease to Financial Lease

f)  Net operating profit after tax Increases, When the Lease Convert to Finance lease, The huge amount Payed by the lessee to Lesser for the use of leased property can be avoided,it means the amount record as Expense would be decrease when Lease Convert to Financing Lease, When the expenses Decrease then the Net operating profit after tax Increases.

g) Net financial expense Decreases, Like we said earlier, the Company can avoid to record the expense amount paid for the use leased property,and when convert to financing lease then  the whole amount of asset less depreciation record on the balance sheet, therefor the Financing Expenses are reduced.

h) Net income Increases, when Net operating profit after tax Increases, then the Net Income also Increase, because we can reduce the operating Expense amount when using the finance lease and it will leads to incrase the net profit