Exhibit 3.8 shows the restated balance sheet and income statement for Best Buy before and after operating lease reclassification using the results in Exhibit 3.7. The operating lease reclassification has a limited effect on Best Buy’s 2004 income statement. Using the calculations for 2005 depreciation and interest expense from Exhibit 3.7 Best Buy’s 2004 income statement can be recast as follows:'
Operating expenses decrease by $177 million (elimination of $454 million rent expense reported in 2004 and addition of $277 million of depreciation expense)4 Interest expense increases by $193 million (to $201 million) Net income decreases by $10 million [$16 million pretax (1 0.35), the assumed marginal corporate tax rate] in 2004.
Operating expenses decrease by $177 million (elimination of $454 million rent expense reported in 2004 and addition of $277 million of depreciation expense)4 Interest expense increases by $193 million (to $201 million) Net income decreases by $10 million [$16 million pretax (1 0.35), the assumed marginal corporate tax rate] in 2004.
The balance sheet impact is more substantial. Total assets and total liabilities both increase markedly—by $3.321 billion at the end of 2004, which is the present value of the operating lease liability. The increase in liabilities consists of increases in both current liabilities ($261 million) and noncurrent liabilities ($3.06 billion). Exhibit 3.9 shows selected ratios for Best Buy before and after lease reclassification. The current ratio slightly declines from 1.27 to 1.20. However, reclassification adversely affects Best Buy’s solvency ratios. Total debt to equity increases by 65% to 2.50, and the long-term debt to equity ratio jumps from 0.21 to 1.11. Best Buy’s interest coverage (times interest earned ratio) decreases from 163.0 (because it is recording minimal interest expense prior to the reclassification) to 7.37, but it remains very strong even after the operating lease adjustment.
Return on ending equity is largely unaffected because of the small change in after-tax income (meaning equity is not markedly affected by reclassification). Profitability components, however, are significantly affected. Return on ending assets decreases from 8.1% to 5.8% due to the increase in reported assets and its consequent effect on total asset turnover. Financial leverage has increased to offset this decrease, leaving return on equity unchanged. Although ROE is unaffected, our inferences about how this return is achieved are different. Following lease capitalization, Best Buy is seen as requiring significantly more capital investment (resulting in lower turnover ratios), and is realizing its ROE as a result of a higher level of financial leverage than was apparent from its unadjusted financial statements
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