Sporon Corp. is a fast-growing Canadian private company in the manufacturing, distribution, and retail of specially designed yoga and leisure wear. Sporon has recently signed 10 new leases for new retail locations and is looking to sign about 30 more over the next year as the company grows and expands its retail outlets. All of these leases are for five years with a renewal option for five more years. All of the leases also have a contingent rent that is based on a percentage of the excess of annual sales in each location over a certain amount. The threshold and the percentage vary between locations. The contingent rent is payable annually on the anniversary date of the lease. The company has currently assessed these to be operating, as they have no conditions that meet the capitalization criteria under accounting standards for private enterprises. All of these payments on these leases are expensed as incurred.
The company has also moved into a new state-of-the-art manufacturing and office facility designed specifically for its needs, and signed a 20-year lease with PPS Pension Inc., the owner. As this building lease also does not meet any of the criteria for a capital lease under accounting standards for private enterprises, Sporon accounts for this lease as an operating lease. As a result, it expenses both the monthly rental and the annual payment that it agreed on with PPS to cover property tax increases above the 2010 base property tax cost. The tax increase amount is determined by PPS and is payable by September 30 each year.
The small group of individuals who own the company are very interested in the company’s annual financial statements as they expect, if all goes well, to take the company public by 2012. For this and other reasons, Sporon’s chief financial officer, Louise Bren, has been debating whether or not to adopt IFRS or ASPE for the 2011 year end. Louise has also been following the new changes that are being proposed by the IASB to adopt the contract-based approach.
(a) Explain to Louise Bren to what extent, if any, adjustments will be needed to Sporon’s financial statements for the leases described above, based on existing private enterprise accounting standards and international accounting standards.
(b) Assume that the joint IASB-FASB study group supports the contract-based approach for leases. Prepare a short report for the CFO that explains the conceptual basis for this approach and that identifies how Sporon Corp.’s statement of financial position, statement of comprehensive income, and cash flow statement will likely differ under revised leasing standards based on this approach.
(c) Prepare a short, but informative, appendix to your report in (b) that addresses how applying such a revised standard might affect a financial analyst’s basic ratio analysis of Sporon Corp.’s profitability (profit margin, return on assets, return on equity); risk (debt-to-equity, times interest earned); and solvency (operating cash flows to total debt).