Does changing operating leases to finance leases affect the amount of equity? I thought the retained earning would change because finance leases’ expenses are depreciation and interest, which aren’t equal to operating leases’ rental expense, but CFAI says operating leases don’t affect the amount of equity. Why?
Same overall NI under both, just different in how you account for it. Timing of the NI is different. So overall equity will be same.
Same overall NI, yes. But if we consider the early years of the lease, finance leases give less NI because of high interest. In this case the retained earning should be different, right?
^I think that’s correct. This is also why ROA & ROE is higher w/ operating leases in the early years. w/ operating leases in early years: greater NI, lower assets. In future years, finance lease ROA & ROE go up b/c NI goes up b/c lower deprec & interest expense compared to the operating leases’ rental payment
This is another poorly worded question from CFA…but I believe this is the reason: in the Q, they say “Operating leases require adjustments to both the amount of equity and the future earnings of ABC” Now think of that literally. If you were to classify an Operating Lease to a Finance lease today, the only thing you would do is increase both A and L by PV(MLP). Then, at the end of the next reporting period, you will adjust your I/S to include a component for interest exp and a component for depreciation. But, as of today, no interest has accrued, no depreciation has taken place. So Equity will not need to be adjusted; A and L cancel each other out. Further, the question says “and the future earnings of ABC” - this is where our operating vs finance lease logic comes into play! because it is the FUTURE earnings that will be impacted…not today’s earning per se. If I am doing a Residual Income model, I am going to adjust everything as of today. Thus the answer is correct. The only reason I could see it being contradictory is you if you need to retroactively apply the classification which would result in a one-time charge to Equity. But I don’t think that is what it is implying…this is adjusting a B/S for valuation today, not a change in accounting estimates/policy.
You’re probably right, tiredofstudying. These kinds of questions really annoy me, especially when I know the concept inside-out but have to try to figure out what CFAI is asking. I heard the real exam’s wording is no better than that of mocks. We can only pray it doesn’t hit us at our most comfortable topics on the exam day.
I’m trying to learn to be less of a nerd. I know it sounds weird, but so many times I see a question and over analyze it. Then I end up choosing the wrong answer. Happened to me with that equity index contract q in the mock. they gave a 180 day rate for risk free and an annual rate for dividend yield and i assumed the 180 day rate had to be modified but wasnt sure how. so i calculated the answer using the rates as is (assuming this was a ‘common’ mistake by candidates), and figured it had to be wrong and chose the only other logical option. i ended up doing it correctly … haha