### CFA Practice Question

An analysis of operating leases by a firm indicates that they should be accounted for as capital leases. Which of the following impact of the adjustment (changing operating to capital) is likely correct?
A. Asset Turnover will be higher.
B. Total Assets will be lower.
C. ROE will be lower in the early years.
Explanation: As Total Assets will increase both Asset Turnover and ROA will fall. NI will fall. This becomes clearer if you consider this example.

A firm has a lease for \$55K for 5 years with a lease rate of 6%.
Operating Lease: All the \$55K is like rent, comes out of CFO.
Capital Lease: PV of lease payments = \$230K is added on as debt on RHS of B/S
First year, out of the lease payment of \$55K, we have \$230K * 0.0625 = \$14.38K
The remaining part of the payment of \$55K is equal to \$55K - \$14.38K = \$40.62K = amortization of the lease.
So till now, compared to the \$55K reducing in NI with OL, we have only \$14.38K reduction in NI with CL (as amortization is not an expense).
There is however one more item to consider, that is depreciation. The asset of \$230K depreciates down to a value of zero over the five years. So each year there is a depreciation expense of \$230K/5 = \$46K to consider. This makes the first years total expenses equal \$46K + \$14.38K = \$60.38K, which is greater than what we had with OL. So the adjustment to CL reduces income in the early years.
Over all the 5 years, the total expenses from both OL and CL will add up to \$275K (that is \$55K * 5). This follows from the nature of discounting.
So whereas adjusting to CL from OL in the early years will reduce NI, in the later years it will actually increase NI.