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IAI Actuarial Core Principles · Business Finance · Interpreting company accounting information

Two companies in the same industry report identical profit after tax. Company X has leased most of its plant under arrangements treated as operating items off the balance sheet, while Company Y owns its plant financed by bank loans shown on the balance sheet. Which conclusion about comparing their accounts is most appropriate?

Reported gearing may understate Company X's true financial risk because lease commitments are fixed obligations similar to debt but not shown as borrowings. Analysts should adjust for them before comparing gearing or return on capital employed between the two firms.

  1. ACompany X is necessarily less risky because its reported gearing is lower
  2. BCompany Y is necessarily more profitable because it has more assets
  3. CThe gearing ratios are directly comparable since both use the same profit figure
  4. DComparison of return on capital employed is unaffected by the financing method
  5. Reported gearing may understate Company X's true financial risk, so adjustments for lease commitments are needed before comparingCorrect

Explanation

Off-balance-sheet lease obligations are fixed commitments like debt. Without adjusting, X's gearing looks lower than its real risk, and ROCE also differs because capital employed is measured differently. Identical profit does not imply identical risk or comparability.

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