EPPA4716 INTEGRATED CASE STUDY

SESSION 2021/2022
SET 3

CASE 4
NUPETCO: A TAIL OF TWO LEASING?

TOPIC
CASE REPORT

LECTURER'S NAME
PROF DATO’ DR NORMAN MOHD SALEH

PREPARED BY
PASTEL GROUP

MEMBERS GROUP MATRIC NUMBER

MALYANAH BINTI SHAHARUDDIN A163936

DEANNA AMIRA BINTI AHMAD HAZMAN A168076

NURUL ASHIKIN BINTI HASSAN A168104

SUVATHI NAGALINGAM A168291

NURUL FARAH ASYIKIN BINTI MOHD FAUZI A169023

SUBMISSION DATE: 8TH JULY 2022

 TABLE OF CONTENTS

1.0 INTRODUCTION 5

2.0 BACKGROUND 5

3.0 ANALYSIS AND DISCUSSION 7

3.1 The Benefit of Leasing and The Changes of MFRS 117 to MFRS 16 7
3.2 Updated Financial Statement using MSRS 16 and The Differences
Between IAS 842 and MFRS 16 11
3.3 The Changes of Standard Will Impact the Company’s KPI 15
3.4 The Changes of Estimated Useful Life of The Equipment 16
3.5 The Impact of The Change in Accounting for Leases 18
3.6 Action Plan 20
3.7 Performance Based-Compensation 23

4.0 CONCLUSION 25
1.0 INTRODUCTION

A lease is a legal agreement that requires the user to pay the owner in exchange for using a
certain item. The agreement promises the lessee use of the property for an agreed length of time
while the owner is assured consistent payment over the agreed period. Both parties are bound by
the terms of the contract, and there is a consequence if either fails to meet the contractual
obligations. Common assets that are leased include real estate, construction projects, and cars.
Equipment for businesses or industries is also rented. A lease agreement is, in general, a contract
between the lessor and the lessee.

The lease agreement guarantees the rights and obligations as between the lessor and
lessee. Either party to the agreement can sue each other for non-performance of any terms and
conditions of the agreement. The agreement also specifies the notice period for vacating the
leased property. One lease agreement may be different from the other. However, certain terms
and conditions are the same, such as the clause on the amount of rent, names and address of the
lessor and lessee, due dates, and notice period. The lessor and lessee both sign the lease
agreement and date the same.

The original copy of the lease agreement should be kept by both the lessor and the lessee
for their records and for future reference. The contract serves as a legal framework for resolving
any disagreements that may arise between the lessor and the lessee. Generally speaking, the lease
calls for the lessee to cover the utility costs. While some leases have set periods, others could
permit early lease termination.

2.0 BACKGROUND

NuPetCo was founded by its current chief executive officer (CEO), Brian Carol, along with his
wife, the current chief operating officer (COO), Amy Carol. The headquarters of the privately
held business are in Portland, Ore. After losing Chase, their beloved terrier to heart disease at the
age of six, the Carols started the business some years later. To create a plant-based,
meat-alternative diet that is high in protein, whole grains, vitamins, and minerals and low in salt,
cholesterol, and saturated fat, Brian and Amy worked closely with Chase's veterinarian, Dr. Sue
Caveli. When Carols first mentioned the idea of a meat-alternative pet food to Caveli in 2014,
she was intrigued.

Midway through 2015, the Carols began offering samples of their brand-new product,
Beyond Mutt, to their pals at the neighbourhood dog park. As word of the vegan dog food spread
among pet owners in the Portland area, Brian and Amy started working on vegan cat food as
well. The fact that feline customers were significantly pickier about tastes and textures than
canine consumers did not surprise them. But after much perseverance and with the blessing of
their two own cats, Minnie and Tigger, the Carols created Impawsible Kibble, a vegetarian cat
food.

Early in 2017, the Carols formally launched NuPetCo and chose to manage the Beyond
Mutt dog food brand and Impawsible Kibble cat food line as two different company divisions.
Even while Brian and Amy still own all of the company's ownership, it is extensively financed
by debt, notably through a $20 million, 20-year loan from First National Bank of Portland with a
set interest rate. Based on financial statements prepared in accordance with U.S. Generally
Accepted Accounting Principles, the loan covenant states that NuPetCo cannot exceed a
liabilities-to-assets ratio of 0.75 and must maintain a current ratio above 1.30.

The pair decided to lease their manufacturing and packaging equipment, and they
coordinated the leasing arrangements with Seattle-based Standard Leasing Services Company
(SLS). NuPetCo signed two separate leases because the two kinds of pet food it manufactures
call for various components and procedures. NuPetCo committed to a two-year initial lease term
with an optional two-year extension on each lease when the initial leases were signed in January
2017. Both leases came to an end at the end of 2020, and fresh lease contracts for new equipment
with five-year lease durations were negotiated with SLS on January 1, 2021.

The issue of this case starts when Jack, the new Chief Finance Officer (CFO) realised that
the two leases that were signed in January 1, 2021 were both recorded as operating leases under
the previous Financial Accounting Standards Board (FASB) accounting standard, Accounting
Standard Codification® (ASC) Topic 840, not the new standard which is ASC Topic 842. Under
the new standard, most leases with terms greater than 12 months must be reported as assets and
liabilities on the balance sheet. The standard became effective for public companies in 2019 and
for nonpublic companies in 2021. His concern is that changing the two leases accounting
treatment would significantly affect the ROA, current ratio, the ratio of liabilities to assets, and
perhaps net income as well.

Jack is in a dilemma in this situation moreover after he talks with Craig Belgan, the
senior vice president of operations. Craig asks Jack to reestimate the life of Kibble’s equipment
to eight years so the lease will remain as operating lease as before. Because the change of
accounting in lease could affect the ROA and net income and it will lead to no bonus for that
year. Jack also realised that the bank loan had conditions that might be violated in accordance
with the new lease accounting guidelines. The advantages of leasing, the distinction between the
previous and current accounting standards, and financial analysis will all be covered in this
report.

3.0 ANALYSIS AND DISCUSSION

3.1 The benefits of NuPetCo leasing its manufacturing equipment instead of purchasing

a) Obsolescence can be avoided by industrial equipment leasing. Leasing allows businesses

to address the problem of obsolescence. A lease shifts the risk of obsolescence to the
lessor if you use it to buy products like high-tech equipment that might become obsolete
quickly. After lease expires, lessees are free to lease brand-new, higher-end equipment. It
might help NuPetCo to have more up-to-date and cutting-edge technology to help them
create novel cat and dog food recipes.

b) Less initial expense. The primary advantage of leasing business equipment is that it
allows you to acquire assets with minimal initial expenditures. Because equipment leases
rarely require a down payment, you can obtain the goods you need without significantly
affecting your cash flow.
 c) NuPetCo could save some money. Instead of financing with a large down payment,
leasing requires a minimal deposit and low monthly payment designed around your needs
and budget. Plus, it is more manageable on your budget than an equipment purchase. This
would be advantageous for NuPetCo to help the business to maintain a strong cash flow
profile and payments for the use of assets are accurate when the assets generate cash flow
which makes them easier to manage.

d) Leasing usually has flexible conditions. When purchasing equipment, leases are typically
more flexible and easier to get than loans. If you have weak credit or need to negotiate a
lengthier payment plan to reduce the costs, this can be a considerable advantage.

3.1.1 The major change to lease accounting in the past few years, in Malaysia

Starting on 1 January 2019, the The Malaysian Accounting Standards Board (Board) has issued
MFRS 16 Leases to replace the existing Standard on Leases, MFRS 117. With the introduction
of MFRS 16 Leases, there was a paradigm shift in how lease-related rights and duties were
handled and ultimately recognised. Finance and operating lease contracts had separate
accounting treatments under the prior standard, MFRS 117. This is addressed by MFRS 16,
which eliminates the distinction between financing and operating leases. The MFRS 16
conceptual framework acknowledges the "right-of-use" approach and offers a single model for
lessees.

MFRS 117 MFRS 16

Operating leases off balance sheet All leases that are more than 12
- If the lease was classified as months will be recorded on the
operating, then the lessees did not balance sheet (either operating or
show either asset or liability in finance lease).
their balance sheets – just the lease
payments as an expense in profit
or loss.
Lease payments under an There won't be a distinction
operating lease shall be recognised between financing leases and
as an expense on a straight-line operating leases any longer. The
basis over the lease term unless revised Standard would result in
another systematic basis is more the recognition of lease assets and
representative of the time OPERATING lease liability for existing
pattern of the user’s benefit. operating leases.
Under MFRS 117, a lease Under MFRS 16, a lessee
typically recognized under rental typically recognises depreciation
expenses under operating lease in of the ROU asset and interest
income statement expense on the lease liability
(included within finance cost) in
profit or loss
Under MFRS 117, operating lease Under MFRS 16, all leases uses
uses Straight-line lease depreciation/ amortisation in its
rental in its operating costs operating costs
Finance leases on the balance All leases that more than 12
sheet will be recorded under asset months will be recorded on
and liability at amounts equal to balance sheet (either operating or
the fair value of the leased finance lease)
property or, if lower, the present
value of the minimum lease
payments, each determined at the
inception of the lease.
A lease is classified as a finance FINANCE Whether a lease is a finance lease
lease if it transfers substantially all or an operating lease depends on
the risks and rewards incidental to the substance of the transaction
ownership of an underlying asset. rather than the form of the
A lease is classified as an contract. MFRS 16 carries
operating lease if it does not forward from MFRS 117 the
transfer substantially all the risks examples of situations that
and rewards incidental
ownership of an underlying asset
Under MFRS 117, finance lease
uses depreciation in its operating
costs
Under MFRS 117, for finance
lease, interest will be place in its
finance cost
to individually or in combination
would normally lead to a lease
being classified as a finance lease.
Under MFRS 16, all leases uses
depreciation/ amortisation in its
operating costs
Under MFRS 16 interest will be
place in its finance cost for all
leases

3.1.2 Possible Reasons Regarding Operating/Finance Leasing Of The Major Changes

1. Due to various pertinent factors, MFRS 16, the new lease standard, has been introduced.
Eliminating off-balance sheet financing is the main reason for the upgraded standard.
Lessees were required to categorise a lease under MFRS 117 as either a finance or an
operating lease. If the lease was categorised as operating, the lessees would only have the
lease payments to report as an expense in their profit or loss statements rather than any
assets or liabilities. Whether a lease is a finance lease or an operating lease depends on
the substance of the transaction rather than the form of the contract. MFRS 16 carries
forward from MFRS 117 the examples of situations that individually or in combination
would normally lead to a lease being classified as a finance lease.
2. MFRS 16 provides detailed guidance to determine whether a contract is a lease contract
or a service contract. A service contract will be recorded off balance sheet in this new
standard. A customer needs to obtain substantially all of the benefits from the use of an
asset (‘benefits’ element) and have the ability (right) to direct the use of the asset
(‘power’ element) or a contract to contain a lease. In contrast, in a service contract, the
supplier retains control of the use of any resources needed to deliver the service.
Consequently, the definition of a lease focuses on whether a customer controls the use of
an asset. An entity shall consider all relevant facts and circumstances in assessing
whether a contract is, or contains, a lease.
 3. The MASB noted that investors and other users of financial statements have to estimate
the effect of operating leases on financial leverage and earnings, as there are deficiencies
in the quality of information on lease accounting under the current MFRS 117. The
current lease accounting does not provide a complete picture of an entity’s leasing
activities. Many investors believe that operating leases give rise to assets and liabilities,
and hence, should be reflected in the statement of financial position. If similar lease
transactions are accounted differently, it would be hard for users to compare different
entities and the implications of different leases. It could also lead to structuring
opportunities whereby lease contracts could be structured in a particular way that they
lead to a particular outcome.
4. MFRS 16 also disclosure requirements is for lessees and lessors to disclose information
in the notes that, together with the information provided in the statement of financial
position, statement of profit or loss and statement of cash flows, gives a basis for users of
financial statements to assess the effect that leases have on the financial position,
financial performance and cash flows of the lessees and the lessors.

3.2 Update the balance sheet and income statement for each division so that they include
the financial statement impacts of the lease as shown in Tables 3 and 4. Although the case is in
the US, assume you are using MFRS. Explain the differences between the requirements in the
US and Malaysia? Explain the major impacts of recording the leases on the financial
statements.

Table 2. Preliminary Divisional Income Statements (According to MFRS 16)

For the Year-Ended December 31, 2021 (in thousands of dollars)

Factor Beyond Mutt Impawsible Kibble Total

Sales 15,690 47,980 63,670
Cost of goods sold 12,310 39,617 51,927
Gross profit 3,380 8,363 11,743
Lease expense 0 0 0
Other operating expenses 1,100 1,800 2,900
Depreciation expense 682 2,283 2,965
Total operating expenses 1,782 4,083 5,865
Operating income 1,598 4,280 5,878
Interest expense, net 418 1,024 1,442
Income before income taxes 1,180 3,256 4,436
Provision for income taxes 179 782 961
Net Income 1,001 2,474 3,475

Table 3. Preliminary Divisional Balance Sheets (According to MFRS 16)

For the Year-Ended December 31, 2021 (in thousands of dollars)

Factor Beyond Mutt Impawsible Kibble Total

Assets:
Cash and cash equivalents 2,800 1,180 3,980
Receivables, net 2,300 1,290 3,590
Merchandise inventories 1,310 9,300 10,610
Other current assets 350 590 940
Total current assets 6,760 12,360 19,120

Property and equipment, at cost 4,300 11,100 15,400

Less: Accumulated
Depreciation -1,700 -3,800 -5,500
Leased Equipment ROU 3,731 11,414 15,145
Less: Accumulated -2,965
Depreciation ROU -682 -2,282
Net property and equipment 5,649 16,431 22,080
Other long-term assets 1,254 2,070 3,324
Total assets 13,663 30,860 44,524

Liabilities:
Short-term debt 878 1,400 2,278
Accounts payable 1,670 3,150 4,820
Accrued expenses 1,134 1,440 2,574
Lease Liability 712 2,180 2,892
Other current liabilities 383 1,030 1,413
Total current liabilities 4,777 9,200 13,977

Long-term debt 1,560 8,500 10,060

Lease liability 2,337 7,147 9,484
Other long-term liabilities 389 570 959
Total liabilities 4,286 16,217 20,503

Stockholders’ Equity:
Common stock 100 60 160
Paid-in capital 1,200 2,300 3,500
Retained earnings 3,300 3,083 6,383
Total stockholders’ equity 4,600 5,443 10,043
Total liabilities &
stockholders’ equity 13,663 30,860 44,523

ASC 842 (USA) DIFFERENCES MFRS 16 (MALAYSIA)

Public Business:15 December 2018 The new MFRS 16 will replace

the old MFRS 117 and its related
Other Entities:15 December 2019 interpretations for annual periods
Effective Date commencing on or after January 1,
2019. Early adoption is authorised
if the new revenue standard MFRS
15 is also implemented.

A lessee must classify a lease as MFRS 16 establishes an unified

either a finance or an operating lessee accounting model, requiring
lease under ASC 842. For financing lessees to recognise assets and
leases, interest and amortisation Lease liabilities for all leases lasting
expenditures are recognised, Classification
 whereas for operating leases, only a more than 12 months, unless the
single lease expense is recognised, underlying asset is of low value.
usually on a straight-line basis.

Lease payments are classified as According to MFRS 16, a

operational expenses under an
operating lease, just like they are in
a rental. Leased assets are not
recognised on the balance sheet of
the company; instead, they are
expensed on the income statement.
customer has the right to direct the
use of an identified asset if either:
the customer has the right to direct
Lease Recognized how and for what purpose the
asset is used throughout its period
of use; or the customer has the
right to direct how and for what
purpose the asset is used during its
period of use.

IFRS 16 requires most leases including those for property, equipment and vehicles to be
‘capitalised’ by recognizing both right-of-use assets and lease liabilities on the balance sheet.
The change affects lease accounting for all companies that report under International Financial
Reporting Standards (IFRS), and the only exemptions are for leases with terms of less than 12
months without purchase options or where the underlying asset is of low value. IFRS 16 results
in an increase in assets, liabilities and net debt where leases are brought on to the balance sheet,
and can also affect key accounting and financial ratios impacting a company’s attractiveness to
investors and its ability to raise finance..

In the balance sheet, a lessee will recognise a right-of-use asset and a lease liability.
Generally, a lessee measures right-of-use assets at cost less accumulated depreciation. On the
other hand, a lessee initially measures the lease liability at the present value of the future lease
payments. The lease liability has to distinguish between current liability and non-current
liability.
 In the income statement, a lessee depreciates right-of-use assets in accordance with the
requirements of IAS 16 Property, Plant and Equipment – i.e. the depreciation method reflects the
pattern in which the future economic benefits of the right-of-use asset are consumed. This will
usually result in a straight-line depreciation charge. Depreciation starts at the commencement
date of the lease. In addition, interest expense of a lease is also required to record. The interest
on the lease liability in each period during the lease term is the amount that produces a constant
periodic rate of interest on the remaining balance of the lease liability. The ‘periodic rate of
interest’ is the discount rate used in the initial measurement of the lease liability

3.3 Calculate the following KPIs that are expected to be discussed at the board meeting, both
before and after the leases are correctly accounted for; operating margin, net sales margin,
asset turnover, and return on assets (ROA). Show how ROA can be broken down
(decomposed) into its two components—sales margin and asset turnover.

Beyond Mutt Impawsible Kibble

Analysis
Before After Before After
1 Operating Margin 0.0911 0.1018 0.0826 0.0892
Operating Profit 1,430 1,598 3,963 4,280
Net Sales 15,690 15,690 47,980 47,980
2 Profit Margin 0.0638 0.0638 0.0547 0.0516
Net Income 1,001 1,001 2,624 2,474
Net Sales 15,690 15,690 47,980 47,980
3 Asset Turnover 1.4782 1.1484 2.2080 1.5547
Net Sales 15,690 15,690 47,980 47,980
Total Assets 10,614 13,663 21,730 30,861
4 Return on Assets (ROA) 0.0943 0.0733 0.1208 0.0802
Net Income 1,001 1,001 2,624 2,474
Total Assets 10,614 13,663 21,730 30,861

The decomposition of ROA differs a lot for both divisions after the adjustments because of the
increment in total assets and not because of the profit margin. Therefore, the decomposition of
ROA is related to the company’s strategy. NuPetCo as a pet store that sells cats and dogs’ foods,
they may pursue on increasing their asset turnover by focusing on becoming a low-margin with
high-volume producer instead of profit margin with high-margin and low-volume competitors.

3.4 Should Jack change the estimated useful life of the equipment used by Impawsible
Kibble as Craig suggested? Explain why or why not. Explain the ethical considerations.

Yes, Jack should change the estimated useful life of equipment used by Impawsible Kibble as
suggested by Craig, as changes in the estimated useful life could result in a large increase in net
income. Changes in estimated useful life do not represent accounting errors. Budget changes are
an important and ongoing part of the budgeting process. In this case, to make changes in the
useful life of the equipment, Jack should make a proper evaluation process to the limit of border
without violating any requirement cause there is some situation where the company can lengthen
the useful life of assets by upgrading it. Therefore, by complying with the standard, Jack’s ethical
consideration of integrity and his credibility will not be affected.

According to the IAS 8 – The effect of a change in accounting estimates means that the
change is applied to transactions, events and other conditions from the date of the change.
Changes in accounting estimates can only affect current and future period gains or losses. So, the
changes in the estimated useful lives, or expected patterns of use of future economic benefits
contained in, depreciable assets affect the depreciation expense for the current period and for
each future period during the remaining useful lives of the assets. The effect of changes related to
the current period is recognized as income or expense in the current period. The effect, if any, on
a future period is recognized as income or expense in that future period

To the extent that a change in accounting estimates gives rise to a change in assets and
liabilities, or relates to an item of equity, it shall be recognized by adjusting the carrying amount
of the asset, liability or related equity item in the period of the change. This means that an entity
must disclose the nature and amount of changes in accounting estimates that have an effect in the
current period or are expected to have an effect in a future period, except for disclosure of effects
over future periods when it is impractical to estimate that effect. If the amount of the effect in a
future period is not disclosed because the estimate is unworkable, the entity shall disclose that
fact.
NupetCo has depreciated the equipment over its useful life of 6 years. The cost of the
equipment is $ 2,600,000 and the annual depreciation charge is $ 433,333. No residual value is
expected at the end of the useful life of the equipment. Assuming one year later, the remaining
useful life of the equipment is estimated at 8 years. Assume that during Year 2 - after 1 (1) year
of use and depreciation of the equipment, the company changes its estimated useful life: it
assumes that the equipment can be used for 6 more years from the date of change or 8 years from
the date of purchase. Therefore, the depreciation expense for the machine is as follows:

Depreciation Accumulated
Year Value Calculation
Expenses Depreciation

0 2,600,000 Cost of the equipment

1 433,333 433,333 2,166,667 (2,600,00 / 6)

2 309,524 742,857 1,857,143 (2,166,667 /7)

3 309,524 1,052,381 1,547,619 (1,857,143 / 6)

4 309,524 1,361,905 1,238,095 (1,547,619 / 5)

5 309,524 1,671,429 928,571 (1,238,095 / 4)

6 309,524 1,980,952 619,048 (928,571 / 3)

7 309,524 2,290,476 309,524 (619,048 / 2)

8 309,524 2,600,000 0 (309,524 / 1)

Although the estimated useful life of the machine has increased at the end of the second year, the
depreciation expense recorded in previous years has not been affected. On the other hand,
depreciation expense is reduced accordingly in years 2 to 8. An increase in the estimated useful
life reduces the depreciation rate and increases net income. When a useful life review
significantly increases reported net income (i.e., from what is reported without a review),
companies are required to explain the review in footnotes to their financial statements.
3.5 Assume the role of Jack during the presentation to the board meeting. Explain the impact
of the change in accounting for leases on each division’s balance sheet, income statement, and
KPIs. What could be the possible incentives behind the choice between operating and finance
lease, if companies were given the choice?

3.5.1 The impact of the change in accounting for leases on each division’s.
Role of Jack during the presentation to the board meeting is as a manager of accounting
for NuPetCo. The impact of the change of accounting standard for Beyond Mutt to the income
statements will still remain as before while for Impawsible Kibble the net income will decrease
and will affect the retained earnings of the company. This is because the lease expense is
replaced by depreciation expense and interest expense. For the balance sheet, the change will
happen to both of the products which is the total assets and total liabilities will increase. This is
because of the new standard order to recognize Right-of-use in asset and lease liabilities which is
separated into short term lease liability and long term lease liability. Changes of the balance sheet
and income statement may not indicate any problems to the company. But these changes will
affect the company’s KPIs.

Next, the KPIs of the company also change because of changes in income statement and
balance sheet. For operating margin, the percentage of Beyond Mutt and Impawsible Kibble are
increased due to increasing operating profits. While for profit margin, Beyond Mutt has no
change in margin because net income also does not change from before. But for Impawsible
Kibble, the profit margin is decreasing due to decreasing net income. Beside that, asset turnover
and return-of-asset for both products are decreasing. This is because the assets for both products
have increased after the change of accounting standard. The decrease of asset turnover shows
that the company generates less revenue, while ROA decrease shows that the company is
inefficient in using assets to generate profits.

Although the change on balance sheet, income statement and KPIs for Beyond Mutt and
Impawsible Kibble showed a negative impact, the decline in KPIs actually does not adversely
affect the company in the future. So, Jack as management accountant should testify to the board
that the change of accounting standard will not affect the reputation of the company.
3.5.2 The possible incentives behind the choice between operating and finance lease.

There are three incentives behind the choice between operating and finance lease. First is
about Bonus Hypothesis. Bonus hypothesis is an accounting incentive where the employee or
accountant is tied to the company’s accounting performance and tends to manipulate accounting
methods to show better in accounting performance during the year. So, this hypothesis will make
the manager accountant more prefer to choose the operating leases method to record the leases.
This is because operating leases give more profit and benefits to the company.

Second is Debt Covenant Hypothesis states that managers will tend to show better profits
with the intention of having a better performance and liquidity position to pay the interest and
principal of the debt they have accumulated in the business. This hypothesis also prefers the
operating leases method because the method can give more net income to the company compared
to finance leases.

Lastly, is Political Cost Hypothesis where the firms tend to show their profits lower by
using different accounting methods and procedures so that the firm does not attract the attention
of politicians, who will have an eye on high profit industries to put higher regulation on high
earning firms. This hypothesis will make manager accounting to choose finance lease. This is
because using a finance lease will reduce the net income of the company which is indeed an
incentive for managers and accountants to reduce revenue to avoid being subject to higher
regulations.

So, we assume the hypothesis shows the actions of accountants to manipulate accounting
methods is because of having a self-interest motive, with the primary goal of maximising their
own wealth without considering any adverse effects.
3.6 Assume that the debt covenants indicate that the company’s current ratio may not
fall below 1.30 and that the liabilities-to-assets ratio may not exceed 0.75. Calculate each of
these measures for the company after the leases have been properly recorded. Does the
company violate either of these covenants once the leases are appropriately accounted for? What
consequences may result from violating a debt covenant? What actions should NuPetCo plan
for?

The current ratio is a liquidity ratio that measures a company’s ability to pay short-term
obligations or those due within one year. It tells investors and analysts how a company can
maximise the current assets on its balance sheet to satisfy its current debt and other payables. To
calculate the current ratio, we compare a company’s current assets to its current liabilities. So,
based on the calculation above, the current ratio is 1.37 which is its show for every $1 of current
debt, NutPetCo had $1.37 available to pay for debt.The liabilities to assets ratio is also known as
the debt to asset ratio and this ratio shows the percentage of assets that are being funded by debt
which means the higher the ratio is, the more financial risk there is in the company. To calculate
the liability to asset ratio is by dividing total liabilities by total assets. So, based on the
calculation above, the liability to asset is 0.46 or 46% which shows that 46% of NutPetCo assets
are being funded by debt.
 Debt covenants are clauses in the loan agreement with which the borrower guarantees to
comply. In this case, debt covenants are agreements between First National Bank of Portland and
NuPetCo in which the loan covenant stipulates that NuPetCo current ratio may not fall below
1.30 and the liabilities-to-assets ratio may not exceed 0.75. Based on the calculation above, for
the current ratio it has not been violated because it fulfils the debt covenant which is now 1.37,
not below 1.30 and for Liabilities to assets also has not violated because it fulfils the debt
covenant which is now 0.46, not exceeding 0.75.

Debt covenants are designed to act as an ‘early warning system’ for a creditor. A breach
of a debt covenant alerts the creditors to financial underperformance that the borrower may be
experiencing before a payment default occurs even though debt covenants are an ‘early warning
system’, the effect on a borrower of breaching them can be significant. Besides, A covenant
breach, no matter the severity, is a technical violation of the loan agreement and allows the
financial institution to take any action legally available. There are some consequences that may
result from violating a debt covenant which depending on the severity, the creditors can do
several things.

First consequences may result from violating a debt covenant by penalty or fee charges
by the creditors because once there is a breach of a debt covenant, usually the creditors will send
out a letter acknowledging the breach and advising that they reserve their right to take action.
The creditors can enforce a penalty payment or increase the interest rate. Therefore, entering into
a debt agreement is a serious step and there are consequences that may impact the company if the
breach of contract happens so the company needs to comply with the obligations of the
agreement or penalties may apply if the company doesn't.

Second consequences may result from violating a debt covenant is the chance for the
termination of a relationship with creditors.Debt covenants are contractual restrictions on firms’
policies. Once borrowers fail to comply with debt covenants specified in loan contracts lenders
have contractual rights to terminate the loan contracts. The effect of this matter can harm
company credit scores thereby making it harder for the company to borrow money in the future.
This also can affect a company 's ability to obtain future credit because the company history
about termination of loan might appear on a credit reporting agency whereas the records might
be up to 5 years, or longer in some cases. So, it will be difficult to secure a loan in future.

Third consequences may result from violating a debt covenant is the influence on the
liquidity of a debtor. Loan agreements often include debt covenants that, if breached by the
borrower, give permission to the lender to demand repayment before the loan’s normal maturity
date. However, if the company breaches a debt covenant on or before the reporting date, the
respective liability will normally become repayable on demand. If this is the case, the liability
will need to be presented as current on the balance sheet even if it is a long-term liability. The
breach of a loan covenant may indicate the existence of wider problems with a borrower’s
overall financial health since they are presented as current liabilities. Covenant breaches need to
be considered as part of management’s assessment of the going concern assumption as they may
have a severe impact on liquidity if breach the contract.

Next, we go to what actions should NuPetCo plan to tackle the impact of consequences.
First plan is, negotiate with the bank about the real situation when projections indicate that a debt
covenant breach is possible. It is best to discuss the situation with the banker. Bankers hate
surprises. Tell the banker that the early projections indicate a potential covenant problem, and we
want to discuss the possible effects. Although this discussion is not hypothetical, it is based on
projections but this way, the banker is forewarned that a breach could occur, but he or she is not
necessarily alarmed. So, The bank will monitor covenant progress more closely, and hopefully
that company can prevent the breach from occurring. If a breach does not occur, the banker will
have gained greater insight into the business since he or she is already prepared for the
possibility. If a breach does occur, the bank will have had ample time to react appropriately.

Second plan is, monitor debt covenants closely throughout the year, which is if a breach
has occurred or is likely to occur, think about obtaining a waiver from the lender that provides a
grace period of at least twelve months from the reporting date. To do that, companies need to
implement the concept of ‘Timing is everything’ which means companies need to monitor
covenants closely throughout the year. If early December arrives and think there is a possibility
that covenants may be breached at year-end, start speaking with bankers immediately to
maximise the chances of obtaining a waiver pre-year end if necessary. A covenant waiver is
when a lender temporarily forgives a borrower's breach of a loan covenant. Lenders can specify
different courses of action in covenant waivers, including unconditional forgiveness of a
repayment obligation, a one-time waiver of a compliance obligation, or a new set of tests or
conditions for a borrower to comply with.

3.7 Assume that over the past five years, each division’s ROA had been steadily increasing.
Explain to the board how performance-based compensation may be affected by the change in
accounting for leases during this period.

An ROA that rises over time indicates the company is doing a good job of increasing its
profits with each investment dollar it spends. It also can be interpreted as either net income is
increasing or the average total assets are decreasing. However, due to the change in lease
accounting, the increase in ROA may not be necessary due to the increase in net income and
company performance. It may be because of the change in the way of presentation and disclosure
of items in financial statements.

● According to the lease table for Beyond Mutt,

ROA ↑ = Net Income / Total Asset ↑

For net income, the decrease in interest expense is the same as the increase in depreciation
expense. Hence, there is no change in net income. While lease assets decrease from years to
years, hence this might result in decrease in total assets over the past five years. Overall, the
ROA of Beyond Mutt will continue to increase during the upcoming years.

● Impawsible Kibble

ROA ↑ = Net Income ↑ / Total Asset ↓

The decrease in interest expenses might cause the net income to increase over the past 5 years.
The total asset will decrease due to decreasing lease assets. Overall, the ROA of Impawsible
Kibble will continue to increase during the upcoming years.
This clearly shows that the increase in ROA in each division is merely due to the change in lease
accounting. The Board of Directors should not use ROA to distribute bonuses to shareholders.
The board should compare item-by-item in ROA such as the net income, net sales and other
indicators instead of just looking at the final ROA.

Regarding the changing in accounting standard for leasing both equipment leases need to
be recorded on the balance sheet. This is going to affect ROA. When considering financial ratios,
it’s expected that return on assets (ROA) will decrease due to the increase in total assets driven
by the additional operating lease right-of-use assets in noncurrent assets. Since Carols decided
that performance-based compensation would be determined on a division basis and measured
based on managers’ divisional return on assets which bonus will give to segments that achieve an
increase in ROA. Performance-based compensation (PBC) is a system for rewarding employees
financially, outside of their regular salaries. The financial compensation is based on how
individual employees, departments, the company, or the company’s stock price performs during a
specific time frame and in accordance with predetermined goals set by the organisation. These
programs may also be called Pay-For-Performance systems. Companies who utilise these
systems must be prepared to define and track performance, as well as provide compensation,
such as bonuses, when objectives are met according to benchmarks. So, performance-based
compensation may be affected which is no bonus since the ROA decreases. However, economic
performance is improving. It’s only the accounting that’s changed. So, the suggestion is to
reassess performance-based compensation metric which cannot use ROA as the metric because
the new leasing rules will have a material impact on ratios such as ROA.
4.0 CONCLUSION

Changing in accounting standards is to provide greater clarity regarding a unit's lease

obligations and its financial terms. Companies must report all rentals of 12 months or more in
their balance sheets. The biggest change from ASC 840 to ASC 842 is the recognition of the
balance sheet which will impact the KPIs of the company. In this case, even though the use of
finance lease will reduce the company’s KPIs, the company has another advantage which is
NupetCo can deduct taxes due to depreciation and interest are in their nature non-taxable and
therefore allowable as deductions. We know that using an operating lease can make it easier for
the management to record that transaction which means the company will recognize the lease as
rental expenses.
So, this case has taught that an ethical accountant is very important in preparing a
company’s financial statements. This is because it can help the company record transactions and
prepare financial statements properly, supervise or manage subordinate staff and do the work as
an internal auditor. So, the company needs to decide whether the company wants to use assets,
but doesn't want to recognize under accounting record, operating lease is the best option for the
company. But, if the company wants to use the asset in the long term but doesn't want to own the
asset, the company should use the finance lease method to be recognized in the income statement
and balance sheet.
In conclusion, if NupetCo wants to maintain the operating leases method to maintain the
company’s net income, NupetCo needs to lease the assets for only 12 months i.e. NupetCo
should act like they are using an operating lease. But if the lease is more than 12 months,
NupetCo has to accept the fact that actually the company uses the finance leases method.