Analyzing, Interpreting and Capitalizing Operating Leases

Analyzing, Interpreting and Capitalizing Operating Leases Assume the Abercrombie & Fitch 10-K report contains the following footnote relating

Analyzing, Interpreting and Capitalizing Operating Leases

Assume the Abercrombie & Fitch 10-K report contains the following footnote relating to its leasing activities. This is the only information it discloses relating to its leasing activity.

At January 29, 2011, the Company was committed to non-cancelable leases with remaining terms of one to 17 years. A summary of operating lease commitments under non-cancelable leases follows (thousands):

Due in Fiscal Year Total
Fiscal 2011 $ 254,056
Fiscal 2012 262,679
Fiscal 2013 252,249
Fiscal 2014 235,480
Fiscal 2015 214,714
Thereafter 953,217
Total $2,172,395

(a) What lease assets and lease liabilities does Abercrombie report on its balance sheet? How do we know?

Because no capital leases are included in the Abercrombie & Fitch footnote, we know that it only has operating leases. Because operating leases are not capitalized on the balance sheet, neither lease assets nor lease liabilities appear on the Abercrombie & Fitch balance sheets.

Abercrombie reports that it leases its retail locations. Because the leases represent contractual obligations, they are reported as liabilities on Abercrombie’s balance sheet. Abercrombie also reports assets relating to the real property it leases.

Under GAAP, Abercrombie must recognize the present value of the lease obligations as both an asset and a liability. The asset is subsequently depreciated and the liability is amortized like a mortgage obligation.

Abercrombie reports that it leases its retail locations. Because the leases represent contractual obligations, they are reported as liabilities on Abercrombie’s balance sheet.

(b) What effect does the lease classification have on A&F’s balance sheet? Over the life of the lease, what effect does this classification have on the company’s net income? 

Total assets and total liabilities for Abercrombie are lower than if the operating leases had been capitalized. Total profit is unaffected by this classification.

Total assets and total liabilities for Abercrombie are lower than if the operating leases had been capitalized. Total profit is lower as a result of this classification.

Total assets and total liabilities for Abercrombie are lower than if the operating leases had been capitalized. Total profit is higher as a result of this classification.

Total assets and total liabilities for Abercrombie are higher than if the operating leases had been capitalized. Total profit is higher as a result of this classification.

(c) Using a 10% discount rate and rounding the remaining lease life to the nearest whole year, estimate the assets and liabilities that A&F fails to report as a result of its off-balance-sheet lease financing.

(Use a financial calculator or Excel to compute. Do not round until your final answers. Round each answer to the nearest whole number.)

($ millions) Present Value
Year 1 Answer 230960

 

Year 2 Answer 217090

 

Year 3 Answer 189518

 

Year 4 Answer 160836

 

Year 5 Answer 133321

 

After 5 Answer 538065

 

Total Answer 1469790

 

*Use subsequent rounded answers to compute total.

(d) What adjustments would we consider to A&F’s income statement corresponding to the adjustments we would make to its balance sheet in part c. 

No adjustments to the income statement are required.

We would remove rent expense from the income statement and replace it with depreciation expense relating to the leased assets.

We would remove rent expense from the income statement.

We would make the following adjustments to ANF’s income statement: remove rent expense, add depreciation expense, and add interest expense.

(e) Indicate the direction (increase or decrease) of the effect that capitalizing these leases would have on the following financial items and ratios for A&F:

return on equity (ROE), net operating profit after tax (NOPAT), net operating assets (NOA), net operating profit margin (NOPM), net operating asset turnover (NOAT), and measures of financial leverage.

ROE Answer  decrease

 

NOAT Answer  decrease

 

Financial leverage Answer increase

 

NOPAT Answer increase

 

NOA Answer increase

 

NOPM Answer increase

 

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