J. C. Penney Company, Inc. Equity Valuation and Analysis As of ...

Potential Accounting FlexibilityA firm provides financial statements in order to give investors theinformation they need to make informed decisions regarding its investmentswithin the firm. This information should be relevant, reliable, and consistent.Flexibility within GAAP allows financial statement preparers the opportunity topresent their company’s financial information in a more informative, qualitativeway. This flexibility, however, can cause some information in a company’sfinancial reports to be distorted, making it seem more appealing to potentialinvestors. Some of the ways in which J. C. Penney has flexibility within GAAP arediscussed below.Operating vs. Capital LeasesOne of the main accounting policies that J. C. Penney has flexibility in iswhether to classify its leases as either operating or capital. With an operatinglease, the owner of the building or property only leases out the right to use it foroperating a business. When the lease term is up, the lessee can either returnthe property or renew his or her lease for an extended amount of time. Sinceownership does not transfer from the lessor to the lessee, the rent expenses areonly reflected on the income statement (as operating expenses) and not on thecompany’s balance sheet. When these expenses are not listed on the balancesheet, the company’s assets and/or liabilities can be significantly understated.This in turn causes the firm’s expenses to be understated, the net income to beoverstated, and the firm’s retained earnings to be overstated. When theretained earnings of a company are overstated, it appears more profitable than ittruly is. When a firm appears to be highly profitable, shareholders are moreinclined to invest in the business.Capital leases, on the other hand, do affect the firm’s balance sheet.They are listed as both a liability (lease payments) and an asset (additions toPPE). This is because the lessee assumes risks (e.g. taxes, payments) and also47