“Previously, a manufacturer of high-quality industrial electrical generators” [question removed by moderator] Correct answer : C, I chose A. Why A is wrong ?
Net income will be lower with an operating lease because there is a lease payment that comes out of NI where as if it’s a financing lease there isn’t.
A is wrong because your net income is the same regardless of lease type. The lease type just changes your balance sheet reporting.
For a finance lease, the asset is removed from the balance sheet and replaced with a “lease receivable”, which is somewhat less liquid than the underlying asset.
This is from the CFAI mock right? – Not sure what happened wither answer B… maybe they forgot to finish typing it.
Ultimately, net income is the same uncer the two methods.
Initially, net income will be less under an operating _ capital _ lease because the sum of the interest expense and depreciation will exceed the lease payment.
Net Income will be higher in the initial years under the operating lease (but will be the same eventually), because:
-
Total expense under operating lease consists only of the lease payment
-
Total expense under finance lease consists of:
a) operating expense (depreciation of the asset)
b) non-operating expense (interest)
In the initial years, the sum of 2a) and b) tends to be higehr than the lease payments, thus Net Income is higher in the initial years for the operating lease.
You can find a nice side by side comparison here:
http://www.investopedia.com/exam-guide/cfa-level-1/liabilities/lease-asset-value-determination.asp
C) is correct because this affects the liquidity measure. Liquidity is commonly measured with the current ratio:
Current Ratio=Current Assets/Current Liabilities
Current liabilities contains:
- Current portion of capital-lease obligation - This is the portion of a long-term capital lease that is due within the next year.
Current Assets on the other hand do not contain the item that you lease (it goes in fixed assets instead).
Since only the denominator increases, the current ratio decreases, thus liquidity decreases as measures by the current ratio.
A short video that explains the liquidity ratio:
http://study.com/academy/lesson/liquidity-ratio-definition-calculation-analysis.html
You can also measure liquidity with the acid ratio and you will get to the same conclusion.
I presume B) is NOT saying that total cash flows are the same, but rather larger or smaller under either method, so that it can be wrong and only C) remains correct.
Good catch.
I was thinking capital lease and typed _ operating _ lease.
I corrected my original post.
Yeah, I had to re-read my own sentence a couple of times to make sure I write it down correctly.