S plc is a large manufacturing company. The company needs to purchase a major piece of equipment which is vital to the production process. S plc does not have sufficient cash available to buy this equipment. It cannot raise the necessary finance by issuing shares because it would not be cost-effective to have a share issue for the amount involved. The directors are also unwilling to borrow because the company already has a very high level of debt in its balance sheet.
C Bank has offered to lease the equipment to S plc. The bank has proposed a finance package in which S plc would take the equipment on a two-year lease. The intention is that S plc will take out a second two-year lease at the conclusion of the initial period and a third at the conclusion of that one. By that time the equipment will have reached the end of its useful life.
C Bank will not require S plc to commit itself in writing to the two secondary lease periods. Instead, S plc will agree in writing to refurbish the equipment to a brand new condition before returning it to C Bank. This condition will, however, be waived if the lease is subsequently extended to a total of six years or more. Once the equipment is used, it would be prohibitively expensive to refurbish it.
S plc’s directors are very interested in the arrangement proposed by C Bank. They believe that each of the two-year contracts could be accounted for as an operating lease because each covers only a fraction of the equipment’s expected useful life.
Required

(a) Explain how the decision to treat the lease as an operating lease rather than a finance lease would affect S plc’s profit and loss account, balance sheet and any accounting ratios based on these. (6 marks)

(b) Explain whether S plc should account for the proposed lease as an operating lease or as a finance lease. (4 marks)
(C) The relationship between debt and equity in a company’s balance sheet is often referred to as the gearing ratio. Explain why companies are often keen to minimise the gearing ratio. (5 marks)

(d) It has been suggested that the rules governing the preparation of financial statements leave some scope for the preparers of financial statements to influence the profit figure or balance sheet position. Explain whether you agree with this suggestion. (5 marks)
CIMA, Financial Accounting – UK Accounting Standards, May 2001 (20 marks)