Quick question regarding an example in the curriculum of the CFA level 2, reading 17, example 10 about leasing. The exercise is a very example to illustrate impact of operating vs finance lease.
In question 3 they asked to work out the ROA under both types of lease. For the operating lease I don’t understand why they don’t reduce the asset with the amount of cash paid. Asset are $4,500 at the beginning of the year, ok there is not depreciation but there is still a cash payment of $264 which should reduce cash in my asset ? So why the assets at the end of the year are unchanged ? At the end of the year we should have $4500 – $264 (cash payment) = $4236 (if we assume there is no other income/expense)
if the formula for ROA used only none current assets I would understand but it is not the case.
I doubt there is something wrong in the CFA curriculum so I would like to know where I am wrong.
Thank you very much.
I just read it over and totally understand where you are coming from. I will try to explain it from my view, keep in mind I am a level II candidate as well.
Only a finance lease affects levels of Assets and Liabilities on the balance sheet. In a finance lease the cost for the asset are absorbed in two places on the Income Statement via Interest expense and depreciation. Operating lease is a one liner on the IS as rent expense.
The way this question reads it does not really account for the the income statement performance through out the period. As you can see for finance and operating, comparing beg of period assets and end of period assets does not have any inclusion of net incomes effects on the end of period asset levels. Maybe they paid all retained earnings out as dividends? I could argue the same thing about how they treated the finance lease. Beginning assets were 4500 and end of period was 1000-200 (depreciation)=800+4500= 5300. But wait, shouldnt the net income increase assets? Well, no, not if they paid it all out.
In the end, net income is going to be the same whether its a finance or operating lease, although in the beginning years of a finance lease NI will be lower due to higher interest expenses and higher NI in later years. The big picture here is that the finance lease affects the level of assets and liabilities on the B/S. You are doing what i would do, “over thinking it”. ROA will always be lower for a finance lease because assets are always higher.
By reading your question I assume you are talking about Solution 3, Column 2, right? The numbers are the following:
Net income, excluding net asset $800
Subtract additional expenses (solution 2 above) 264
Net income adjusted $536
Total assets, beginning, excluding new asset $4,500
Add additional asset (solution to 1 above) 0 – Okay, we understand that.
Total assets, beginning, adjusted $4,500
Add additional asset 0
Total assets, end, adjusted $4,500 – Why is this not $4,236? right?
Average Total Assets $4,500 – [($4,500+$4,500)/2)]
Return on Average Assets 11.91% – ($536/$4,500)
I honestly wonder why assets didn’t change by the expense amount, but there is a hypothetical scenario in which that is possible:
You incurred the expense, but did not pay it in cash, it is in your accounts payable.
Dr. Operating Expenses $264
Cr. Accounts Payable $264
Then your cash (and total assets) would be intact, and your cash wouldn’t change until after you pay Dr. A/P and Cr. Cash. While the question does not specify whether the expense is paid in cash or through an A/P account, we just have to assume that’s the case for the example to make sense. I know, annoying!
Hope this helps!
P.S. Sorry about the formatting, it looks aligned when I type it, but once submitted looks crooked.
I still think you guys are over thinking this. The assets CFAI is referring to are Fixed long lived Capital assets. With your line of thinking why isn’t it beginning fixed assets + new assets – depreciation – interest = ending assets? The point here is operating lease has no impact on fixed capital long lived assets. The “assets” reduction you are trying to justify come out through reductions in cash or accruals. They are not listing total assets, just fixed ones. Just my 2 cents!
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