Question

Identify three possible adverse effects on an entity’s financial statements arising from recognition of a lease arrangement on the statement of financial position.

Answer 1

The recognition of Lease arrangement on the statement of Financial position will have some adverse impacts like :

1. The Right to Use asset will be recognized as asset and Lease liability will be recognized as Liability. As a result the net debt will increase. The invested capital will increase and ROIC (return on invested capital) will decrease.

2. The increase in asset values will lower the Return on Assets .

3. The higher net debt will result in higher Debt/Equity ratio or gearing of the firm, thereby increasing the risk premium on cost of equity capital.

4. The rental expense of Operating lease will get replaced by depreciation on asset and interest on the Lease liability. In the initial years the interest cost will be higher , thereby reducing the net income in the initail years and the net income will go up in later years. This causes fluctuations in net income.