ACCOUNTING FOR LEASES: A REVIEW. Ana Isabel Morais

Transcription

1 ACCOUNTING FOR LEASES: A REVIEW Ana Isabel Morais Department of Accounting, Instituto Universitário de Lisboa (ISCTE-IUL), UNIDE, Av. das Forças Armadas, Lisboa, Portugal [email protected] Abstract The objective of this paper is to review empirical research on lease accounting. The first half provides background and a primer on accounting for leases. The IASB and FASB project to change lease accounting approach creates opportunities for future empirical research that are identified in the paper. The second half reviews existing studies in detail and offers suggestions for future research. Empirical research on lease accounting has focused mainly on five issues, the change of accounting standards and the economic consequences; the determinants of leases; the value relevance of information about leases; the valuation of leases; and the impact of leases on accounting ratios. Finally, I highlight areas that have not received much research attention. Keywords: Leases, lease accounting, finance leases; operating leases. 1

2 ACCOUNTING FOR LEASES: A REVIEW Abstract The objective of this paper is to review empirical research on lease accounting. The first half provides background and a primer on accounting for leases. The IASB and FASB project to change lease accounting approach creates opportunities for future empirical research that are identified in the paper. The second half reviews existing studies in detail and offers suggestions for future research. Empirical research on lease accounting has focused mainly on five issues, the change of accounting standards and the economic consequences; the determinants of leases; the value relevance of information about leases; the valuation of leases; and the impact of leases on accounting ratios. Finally, I highlight areas that have not received much research attention. Keywords: Leases, lease accounting, finance leases; operating leases. 1

3 1. Introduction In July 2006, the International Accounting Standards Board (IASB) and Financial Accounting Standards Board (FASB), as part of 2006 Memorandum of Understanding, started a project to develop a new approach to lease accounting. IASB and FASB published, in March 2009, a discussion paper (IASB, 2009a) and in August 2010 an Exposure Draft (2009b), that summarises the proposed approach to a new lease accounting standard. More precisely, the IASB decided that lessee in the future will have to recognise an asset representing its right to use the leased item for the lease term and a liability for its obligation to pay rentals. Thus, the planned revision of the standard will abolish the distinction between finance leases and operating leases. The IASB also proposes to change how lessors will recognise leases: if the lease contract substantially transfers risks and benefits of leased item to the lessee, the lessor will apply the derecognition approach (the leased asset is derecognised); if the lease contract does not transfer substantially risks and benefits of leased item to the lessee, the lessor will apply the performance obligation approach (the leased asset is not derecognised and the lessor will recognise an asset, for the right to receive lease payments, and a liability). IASB expects to publish a new IFRS about leases in June As shown by the majority of the 302 comment letters received by IASB during the comment period, the introduction of a new approach to lease accounting will be controversial. There are several reasons why this new approach to lease accounting causes so much controversy. Firstly, the new approach may create excessive complexity and burdens for preparers and may not enhance the quality and usefulness of financial information. Secondly, an extensive cost/benefit analysis is needed before moving forward in the standard setting process because the new approach increases 2

4 costs for preparers and may have impacts on regulatory capital. Thirdly, lease accounting should not be a priority for the Boards because of the financial crisis and because the users also do not consider it a priority. Fourthly, with the new approach the financial statements will not accurately reflect how management manages a business because companies may have leases because they want to benefit from a degree of flexibility without bearing the risks related to the asset or may want to manage the exposure to residual value risk. Finally, the new approach may raise some conceptual questions such as if the right to use a lease item fulfills the recognition requirements as it cannot be measured reliable or if the obligation to pay rent fulfills the definition of a liability at the commencement date. Empirical research on lease accounting has focused on five issues, which are interrelated: the change of accounting standards and the economic consequences; the determinants of leases; the value relevance of information about leases; the valuation of leases; and the impact of leases on accounting ratios. I will describe how research in these five areas has evolved and discuss the main results. Evidence from research on these topics is likely to be helpful in capital markets investment decisions, accounting standard setting and decisions on corporate financial disclosure. Leases represent a significant source of finance for many companies. Although leases volumes will have slowed in 2008, European leasing was still responsible for financing on average approximately 28% of European investment, excluding real estate (Leaseurope). The paper is structured as follows. In section 2, I provide an overview of the main conceptual issues in the accounting for leases and summarise how international leases accounting standards deals with these issues. Section 3 is the main section of the paper and describes the empirical research on lease accounting. The last section, section 4, provides the main conclusion and suggestions for future research. 3

5 2. Lease accounting: Conceptual issues and the development of accounting standards In this section, I will provide an overview of the main conceptual issues in the accounting for leases and I summarise how international leases accounting standards deal with these issues. In doing so, I will highlight questions that are contentious and are, therefore, of particular interest for empirical research. International Accounting Standard (IAS) 17: Accounting for Leases, first issued in 1982, required lessees and lessors to classify their lease contracts as a finance leases or operating leases, at the inception of the lease. The substance of the transaction rather than its form determines the classification of a contract as a finance lease or an operating lease (IAS 17, 10). Finance leases are defined as those leases that transfer substantially all the risks and rewards incidental to ownership of an asset (IAS 17, 4). Leases that do not transfer substantially all the risks and rewards are accounted as operating leases. IAS 17: Leases (1997) and IAS 17: Leases (2003) maintained the same approach to accounting for leases. The accounting for finance leases is usually characterized as being in substance similar to the buying by the lessee of the leased asset. Therefore, lessees should recognise finance leases as an asset and a liability, in its statement of financial position, with an amount equal to the fair value of the asset leases or the present value of the minimum lease payments, if lower. Finance lease payments should be apportioned between the finance charge and the reduction of the outstanding liability 4

6 and the depreciation policy for finance leased assets should be consistent with that for owned assets. On the other hand, lessees should not recognise similar assets and liabilities for operating leases. The lease payments should be recognised as an expense on a straight-line basis over the lease term unless another systematic basis is more representative of the time pattern of the user's benefit (IAS 17, 33). Lessors should recognise a finance lease in the statement of financial position as a receivable, at an amount equal to the net investment in the lease (IAS 17, 36). The finance income should be recognised based on a pattern reflecting a constant periodic rate of return on the lessor's net investment in the finance lease (IAS 17, 39). Lessors must present assets held for operating leases in the statement of financial position according to its nature. Lease income is generally recognised over the lease term on a straight-line basis. Under this approach ( substantially transfer all the risks and rewards approach ), similar leases transactions would be accounted differently in financial statements, depending on the classification of the lease contract as finance or operating. Table 1 summarises the evolution of the accounting standards about lease issued by IASB. 5

7 Table 1 about here Table 1 Lease accounting standards issued by IASB Standard Exposure Draft (ED) 19, Accounting for Leases (1980) IAS 17: Accounting for leases (1982) ED 56: Leases (1997) IAS 17: Leases (revised) (1997) IAS 17: Leases (revised) (2003) IAS 17: Leases (amended) (2009) Main aspects The distinction between finance lease and operating lease was based on the extent to which risks and rewards related to ownership of a leased asset belong to the lessor or the lessee. A lease contract to be considered a finance lease must verified one of four conditions: according to the lease contract, the ownership of the asset is transferred to the lessee by the end of the lease term; the lessee has the option to buy the asset at a price which is expected to be sufficiently lower than the fair value at the exercise date; at the beginning of the lease contract, it is reasonably certain that the option will be exercised; the lease term is for the major part (normally 75 percent or more) of the economic life of the asset. Title may or may not eventually be transferred and the present value at the inception of the lease of the minimum lease payments is greater than or equal to substantially all (normally 90 percent or more) of the fair value of the leased asset net of grants and tax credits to the lessor at the beginning of the lease. IAS 17 (1982) is similar to the ED 19, with some changes. The most important change was the removal of the bright-line tests, ie, the quantitative definition of major part of the economic life of lease (normally 75%) and substantially all (normally 90%). IOSCO had suggested that the IASC should consider a new approach for lease capitalization, in particular the addition of new criteria to distinguish finance and operating leases, which would lead to an increase number of contract being classified as finance leases; the recognition of operating leases on the lessee s balance sheet, to the extent of the non-cancellable rentals therein and the increase of the disclosure requirements. In ED 56, IASC decided not to change the existing approach and decided to consider the new approaches for lease capitalization later. IAS 17 (revised 1997) maintained the same accounting approach for leases. This standard included additional indicators to facilitate the classification of finance leases. The change of the fundamental approach to the accounting for leases included in IAS 17 was not considered in this revision. This revision is limited and is part of its project on Improvements to IAS/IFRS. Classification of a lease of land and buildings was clarified and accounting alternatives for initial direct costs in the financial statements of lessors were eliminated. Leases of land are classified as either finance or operating using the general principles of IAS 17. Prior to amendment, IAS 17 generally required a lease of land with an indefinite useful life to be classified as an operating lease. In United States of America (USA), the accounting treatment of leases is described in Statement of Financial Accounting Standard (SFAS) nº 13: Leases (1976) (U.S. GAAP Codification of Accounting Standards Codification Topic 840: Leases). SFAS nº 13 (1976) required lessees to classify their lease contracts as capital leases or operating 6

8 leases, at the inception of the lease. Capital leases are those leases that meet one or more the following four conditions: the lease transfers ownership of the property to the lessee by the end of the lease term; the lease contains a bargain purchase option; the lease term is equal to 75 percent or more of the estimated economic life of the leased property; or the present value at the beginning of the lease term of the minimum lease payments (excluding that portion of the payments representing executory costs such as insurance, maintenance, and taxes to be paid by the lessor, including any profit thereon), equals or exceeds 90 percent of the excess of the fair value of the leased property to the lessor at the inception of the lease over any related investment tax credit retained by the lessor and expected to be realized by him (SFAS 13, 7). Operating leases are all other leases. Before SFAS 13 (1976), Accounting Principles Board (APB) Opinion Nº 5, "Reporting of Leases in Financial Statements of Lessee" (1964); APB Opinion Nº 7, "Accounting for Leases in Financial Statements of Lessors" (1966); APB Opinion Nº 27, "Accounting for Lease Transactions by Manufacturer or Dealer Lessors" (1972); and APB Opinion Nº 31, "Disclosure of Lease Commitments by Lessees" (1973) were in effect. On November 1973, became effective the Securities Exchange Commission (SEC) Accounting Series Release (ASR) nº 147 that required the registrants' disclosure of their "off-balance sheet" financial commitments, especially: total rent expense; minimum rental commitments aggregated for the next five years, each of the next three five year periods and the reminder of the leases term, the basis for calculating rent, renewal options, escalation clauses, guarantees and obligations, dividend or debt restrictions and for all non-capitalised leases, the present value of minimum lease commitments by category, the weighted average interest rate, the present value of rentals to be received in subleases and the impact upon net income for each period if all non-capitalised financing leases were capitalised, related assets amortized on a 7

9 straight line basis and the interest cost accrued on the basis of the outstanding lease liability. ASR nº 147 maintained the same approach for lease accounting. Table 2 summarises the evolution of the lease accounting standards in the USA. Table 2 about here Table 2 Lease accounting standards in the United States Standard ARB 38: Disclosure of Long-Term Leases in Financial Statements of Lessees (1949) ARS 4: Reporting of Leases in Financial Statements (1962) APB Opinion Nº 5: "Reporting of Leases in Financial Statements of Lessee" (1964) APB Opinion Nº 7: "Accounting for Leases in Financial Statements of Lessors" (1966) APB Opinion Nº 27, "Accounting for Lease Transactions by Manufacturer or Dealer Lessors" (1972) APB Opinion Nº 31 "Disclosure of Lease Commitments by Lessees" (1973) Main aspects The standard recommended capitalization for certain leases that were, in substance, installment purchases. Although it referred specifically to the installment purchase analogy, it was more applicable to leases that were de facto conditional sales agreements. The capitalization criteria were any of the following: the existence of a bargain purchase option at the lease term; covenants that permitted the application of lease rentals to the purchase price; or a rental payment so high that a purchase plan was evident. No details were given in the standard concerning the measurement of either the leased asset or lease obligation. ARS 4 took a legalistic approach to determining whether a lease was in substance a purchase. ARS 4 argued that non-cancellability of the lease contract creates legal property rights warranting capitalization. This standard did not accept the basic argument in ARS 4 and reaffirmed the material equity argument of ARB 38. However, it did introduce noncancellability, except upon the occurrence of some remote contingency, as a precondition for capitalization. This standard had been criticized on the grounds that it excluded many leases that should be capitalized. The equivalent of lease capitalization was required, but the criteria differed from APB Opinion No. 5. In addition, separate criteria existed for sales-type and financing-type leases. Sales-type leases were capitalized if three conditions were satisfied: credit risks were reasonably predictable, the lessor did not retain sizable risks of ownership, and there were no important uncertainties regarding either costs or revenues under the lease contract. These three conditions differed from the lessee tests under APB Opinion Nº 5. As a result, it was possible for a lease contract to be capitalized by either the lessee or lessor, but not by both. This asymmetry between lessee and lessor accounting was criticized. The objective of this standard was to broaden the criteria for capitalization. The new criteria were: the collectability of payments was reasonably assured; no important uncertainties surrounded costs yet to be incurred on the lease; title passed at end of lease term, a bargain purchase option existed, the leased asset or similar asset was for sale and the present value of required rentals plus any investment tax credits was equal to or greater than normal selling price, or the lease term was substantially equal to the remaining economic life of the asset. This standard expanded disclosure of non-capitalized leases. The disclosures required by APB Opinion No. 31 included the amounts of future rentals at both future values and present values. The effect of this disclosure requirement was to create adequate supplemental disclosure to permit users to informally capitalize non-capitalized lease obligations if 8

10 SFAS Nº 13: Leases (1976) they so desired. Although this disclosure expanded the reporting of information concerning non-capitalized lease obligations, it did not go so far as to formally place them in the balance sheet. Criteria for lessee capitalization were revised again and there was a change in both concept and capitalization criteria. Non-cancellability and material equity were abandoned in favor of broader tests representing substantive transfers of ownership benefits and risks. SFAS No. 13 identified four capitalization tests applicable to both lessees and lessors: property passes to the lessee at the end of the lease term; the lease contract contains a bargain purchase option; the lease term is at least 75 percent of estimated useful life (with the lease term covering more than 25 percent of the original economic life when new); and the present value of minimum lease payments is 90 percent of the fair market value of the lease property at the inception of the lease, less any applicable investment tax credit. The United Kingdom (UK) standard, Statement of Standard Accounting Practice (SSAP) nº 21: Accounting for leases and hire purchase contracts (1984) also includes a bright classification test for financial leases. A finance lease is defined as a lease that transfers substantially all the risks and rewards of ownership of an asset to the lessee (SSAP 21, 15). A lease is presumed to be a finance lease if the present value of the minimum lease payments at the inception of the lease, including any initial payment, amounts to substantially all of the fair value of the lease asset (normally 90 percent or more) (SSAP nº 21, 15). An operating lease is a lease other than a finance lease (SSAP nº 21, 17). In 1996, the G4+1 issued a special report entitled Accounting for leases: a new approach, in which it is identified three main deficiencies in existing lease accounting standards: material assets and liabilities arising from operating lease contracts are not recognised, similar transactions may not receive the same accounting treatment since small differences in the contract terms may result in a classification of financial or operating leases and the all or nothing approach to the capitalisation of leased assets does not reflect complex transactions. The approach recommended in the G4+1 special report was described as asset and liability approach. Under this approach, assets and liabilities that arise for lessees and lessors are recognised. In 2000, the 9

11 G4+1 published a discussion paper entitled Leases: implementation of a new approach. This paper recommended that, at the inception of the lease contract, the lessee recognised an asset (the right to use the asset for the term of the lease) and a liability (the obligation to make the payments required by the lease) that represented the fair value of the rights and obligations that arise from the lease contract. G4+1 considered that this approach would improve financial reporting. On March 19, 2009, the Financial Accounting Standards Board (FASB) and International Accounting Standards Board (IASB) issued a Discussion Paper (DP): Leases: Preliminary views. Later on August 2010, IASB and FASB issued an Exposure Draft (ED): Leases outlining the boards preliminary views on a new accounting model. This new accounting model will require, for all leases that the lessee recognise an asset, that represents the lessee s right to use the leased item for the lease term ( right-of-use asset ) and liability, which represents its obligation to pay rentals arising in all lease contracts. The most significant changes to the existing lessee accounting model is that the distinction between operating and finance/capital leases will be removed and operating leases will no longer be off-balance sheet. Additionally, a lessee would not recognise the components of a lease contract separately, such as options to renew or contingental rental arrangements. Instead, the lessee would recognise a single right to use asset that includes rights acquired under options and a single obligation to pay rentals that includes obligations arising under contingent rental arrangements and residual value guarantees. The proposed model requires the lessee to initially measure the right-of-use asset at cost, defined as the present value of the lease payments discounted using the lessee s incremental borrowing rate. The right-of-use asset is subsequently amortized over the shorter of the lease term or the economic life of the asset or the economic life of the 10

12 asset if the lessee is expected to obtain title at the end of the lease term. In addition, although the boards believed that the right-of-use asset should be reviewed for impairment, but in the ED they have yet to reach a preliminary view on how to perform that determination. In the discussion at the June 2009 IASB Meeting, the Board agreed to apply IAS 36: Impairment of assets, for International Financial Reporting Standards (IFRS) preparers, and Statement of Financial Accounting Standards (SFAS) nº 144: Accounting for the Impairment or Disposal of Long-Lived Assets, for U.S. GAAP preparers for impairment accounting for right of use assets. The lessee subsequently amortizes the liability by using an amortized cost-based approach in which interest is accrued on the outstanding obligation to pay rentals. The ED (2010) discusses whether the incremental borrowing rate used to discount lease payments should be reassessed to reflect current market conditions. However, in the DP, the FASB and the IASB did not agree on reassessment of the incremental borrowing rate. The FASB believed that the rate should not be reassessed, while the IASB believed it should be reassessed because it may affect the lessee s obligation to pay rentals. In the November 2009 Joint IASB-FASB Meeting, most Board members agreed to prohibit incremental borrowing rate reassessment in such cases as they believed it is inconsistent with an amortised cost model. 3. Lease accounting research It is possible to identify several different areas of investigation about lease accounting: The change of accounting standards and the economic consequences; The determinants of leases; 11

13 The value relevance of information about leases; The valuation of leases; and Leases and the impact on accounting ratios The change of accounting standards and the economic consequences Economic consequences were defined as the impact of accounting reports on the decision-making behavior of business, government, unions, investors and creditors (Zeff, 1978). The essence of the definition is that financial statements not only reflect the results of managers decisions but also can affect the real decisions made by them. This first area of investigation analyzed the economic consequences of change leasing accounting standards and three different approaches have been used in this investigation: ex-post analysis of reported accounting numbers, analysis of market reaction to accounting change and analysis of questionnaire surveys in order to evaluate the managers and other interested parties views. First, the direct link between accounting changes and companies response has been investigated, usually by an ex post analysis of reported accounting numbers company (Abdel-Khalik, 1981; Imhoff and Thomas, 1988; Garrod, 1989; Goodacre, 2001; Godfrey and Warren, 2005). In general, those studies found that companies reacted to the change of accounting standards by reducing their finance leases. Abdel-Khalik (1981) found that companies respond to the changes in lease accounting caused by SFAS 13 (1976) by structuring new lease contracts and renegotiating existing lease contracts to avoid capitalization of leases. There was evidence that more 12

14 assets were bought or constructed instead of being leased and also evidence of changes in capital structure. Three possible reasons for this reaction by company managers were proposed: managers belief that users are informationally inefficient, the impact on managers compensation, and the avoidance of debt covenant violation. Imhoff and Thomas (1988) also examined whether financial statement preparers change their behavior in response to new accounting standards (SFAS 13). They examined lease note disclosures of approximately 150 companies prior to SFAS 13 and they estimated the amount of leases that would have been capitalised if companies had not changed their capital structure. They found that management modifies existing lease agreements to avoid crossing the threshold for capitalization. They documented a systematic substitution from capital leases to operating leases and non-lease source of finance, suggesting that renegotiation of lease contracts is a lowcost alternative for avoiding undesirable financial statements effects. Godfrey and Warren (2005) examined whether the capital structures of lessee companies did change in response to the requirement of Australian Accounting Standard (AAS) 17, Accounting for Leases (AAS 17, 1987) and Approved Accounting Standard ASRB 1008, Accounting for Leases (ASRB 1008, 1987). Both Standards required that lessees capitalize finance leases. They found that companies responded to the Standards by reducing their reliance upon finance leasing and increasing their reliance upon non-lease debt and shareholders' funds. However, companies did not appear to have renegotiated finance lease contracts to operating lease contracts, as occurred in the US. In the UK, Garrod (1989) found weak evidence that managers reacted to the introduction of SSAP 21 by reducing their non-lease debt prior to first disclosure of their lease information. 13

15 Goodacre (2001) assessed the potential economic consequences of the G4+1 proposed changes to lease accounting by examining companies in the UK retail sector over the period. He found that capitalisation of operating leases would have a major impact on nine key accounting ratios, the ranking of companies changes markedly for asset turnover, interest cover and the three capital-based gearing measures, and especially for general retailers. Another set of studies investigated management motivations for the timing of adoptions (early adoptions versus late adoption). Thornton (1992) investigated whether debt convenants that are based on the GAAP measures influenced the timing of adoption of the Canadian Accounting Standard on Capitalization of Leases. This standard allowed companies to choose between prospective or retroactive adoption. He found that lessees that used GAAP measures in their lending agreements chose prospective capitalization probably to delay the effect of new accounting rules on their lending agreements. El-Gazzar and Jaggi (1997) expanded Thornton s study (1992) by analysing the impact of expected debt convenants violations on the timing adoption of SFAS 13. The results show that late adopters of SFAS 13 would have experienced significantly higher increases in closeness to violating the debt restrictions if they decided to adopt SFAS 13 earlier. They also found that late adopters issued more equity or retired debt in order to reduce the effect of capitalizing the off-balance sheet leases on financial statements. Wilkins and Mok (1990) found that Australian companies were more likely to use the transitional provisions as their leverage increased. The transitional provisions included a four-year transition period that gave the lessees the opportunity to mitigate the consequences of AAS 17: Accounting for leases (1987). Morris and Carnegie (1988) found that most of the companies surveyed used AAS 17 transitional provisions and did not immediately capilise finance leases. 14

16 Second, an indirect approach has been chosen, involving the analysis of market reaction to accounting changes, usually using the event study methodology (Ro, 1978; Bowman, 1980; Murray, 1982; El-Gazzar, 1993; Ely, 1995; Imhoff et al., 1993, 1995; Whisenant, 1998). In general, those studies found that information disclosed about leases is reflected in the market value of companies. Ro (1978) investigated whether the disclosure of lease information in the footnotes in accordance with SEC Accounting Series Release (ASR) 147 is evaluated by the markets and he found that information disclosed is evaluated. Bowman (1980) also found that estimated lease liabilities based on ASR 147 disclosures are positively associated with market-based measures of equity risk. Murray (1982) investigated the market reaction associated with changing lease disclosures from footnote to the body of financial statements. He found that there was no reaction to this change in accounting rules, which means that disclosing information in footnotes or on balance sheet is of equal value. El-Gazzar (1993) investigated the association between lessees market returns and their changes in the tightness of the debt covenant constraints resulting from compliance with SFAS 13. He found that capitalizing off-balance sheet leases increased the probability of technical default. This increased is correlated with changes in security prices that accompanied the regulatory events of SFAS 13. Similarly, Ely (1995) and Imhoff et al. (1993, 1995) found that estimated operating lease liabilities based on SFAS 13 disclosures are positively associated with measures of equity risk. Whisenant (1998) found that the market value of equity reflects estimated operating lease liabilities based on SFAS 13 disclosures. 15

17 Third, ex post surveys of users perceptions of the impact of accounting changes have been undertaken, as well as ex ante surveys of interested parties views on potential accounting changes (Reither, 1998; Collins et al., 2002; Beattie et al., 2006; Taylor and Turley, 1985; Prakash and Rappaport, 1977; Drury and Braund, 1990; Blake et al., 1995). Reither s survey (Reither, 1998) presents a compilation of characteristics that FASB constituents identified when making judgments about high and low-quality pronouncements and shows that SFAS 13: Leases was voted the worst standard. The main arguments were: many leases that substantially are finance leases are recognised as operating leases and the accounting standard is complex and difficult to apply. Collins et al. (2002) used content analysis to identify the particular characteristics of SFAS 13 that led to be considered the worst standard and they found that that the lack of economic reality and clarity, lack of implementation guidance, the need of frequent amendments and the ability to manipulate SFAS 13 s classification criteria to avoid recognizing legal obligations as liabilities were the main characteristics. Beattie et al. (2006) elicited and compared the views of users and preparers on a range of issues surrounding lease accounting reform proposed in G4+1 Lease accounting discussion paper. They found that the views of expert users and preparers differed significantly. Both groups considered the UK lease-accounting standard deficient in a number of aspects, such as the classification of deliberately structured leases as operating leases. They also found that expert users were strongly in favor of G4+1 proposal but preparers showed only moderate support. Users and preparers considered that the recognition of all leases in the balance sheet will lead to renegotiation of borrowing covenants, reduction in credit ratings for some companies and; improvement of users evaluation of long-term financial commitments and 16

18 improvement of companies comparisons. Preparers also anticipated that the new rules would lead to additional compliance costs and administrative burdens. Taylor and Turley (1985) investigated the opinions of UK management on lease accounting following Exposure Draft (ED) 29, the exposure draft that preceded SSAP21. They found that only a minority of managers believed that internal financing or investment decisions would be significantly affected by the proposed accounting standard. However, managers believed that users decisions, including risk assessment, were likely to be affected, suggesting that managers behavior could be influenced by information inductance (Prakash and Rappaport, 1977). Managers also anticipated that future lease contracts would be structured as operating leases to avoid capitalisation; a similar response was reported by Drury and Braund (1990) in their (post-ssap21) general survey of the leasing decision. Blake et al. (1994) surveyed 82 Spanish managers and they found that those managers apear to anticipate negative impact arising from the requirement to capitalise finance leases. Later, in 1995, Blake et al. (1995) reported the results of a survey in Spain of two key groups, company financial managers and bank financial analysts, after the introduction of the requirement for lessees to capitalize finance leases. The brief questionnaire was limited to several yes/no questions. The study concluded that leasing companies successfully lobbied for changes in the accounting rules which actually proved adverse to their economic interests. Company managers and bank analysts misunderstood each other's reactions to the capitalization of finance leases. Preparers generally felt that the finance lease accounting rules would result in operating leases becoming more attractive and that all leases should be accounted for as rental agreements. However, bank analysts did not feel that leasing activity would be reduced. 17

19 Table 3 summarizes the main findings from these papers and positions them in the literature. TABLE 3 ABOUT HERE Table 3: Summary of Extant Literature Change of accounting standards and economic consequences Main areas Main conclusions and studies - Companies renegotiated lease contracts (Abdel- Khalik, 1981; Imhoff and Thomas, 1988) and structured new lease contracts (Abdel-Khalik, 1981; Godfrey and Warren, 2005) in order to avoid capitalisation; Companies responses to lease accounting changes - Companies delayed the adoption of lease standards that required capitalisation of leases (Thornton, 1992; El-Gazzar and Jaggi, 1997; Wilkins and Mok, 1990; Morris and Carnegie, 1988), especially companies that used GAAP measures in lending agreements (Thornton, 1992), have debt restrictions (El-Gazzar and Jaggi, 1997) or are more leveraged (Wilkins and Mok, 1990). Market s reaction to lease accounting changes - Information disclosed in the notes about leases is evaluated by the markets (Ro, 1978; Bowman, 1980; Murray, 1982; El-Gazer, 1993; Ely, 1995; Imhoff et al., 1993, 1995; Whisenant, 1998). Users perceptions of the impact of lease accounting changes - SFAS 13 was considered the worst standard because of the lack of economic reality and clarity, lack of implementation guidance, the frequent amendments, the complexity and the ability to manipulate the classification of finance and operating leases (Reither, 1998; Collins et al., 2002); - Users strongly supported G4+1 Lease accounting discussion paper but preparers showed only moderate support (Beattie et al., 2006); - Only a minority of managers believed that internal financing or investment decisions would be affected by lease accounting changes (SSAP 18

20 21) (Taylor and Turley, 1985) but managers tend to structured finance lease as operating leases in order to avoid capitalization (Drury and Braund, 1990). Future research can investigate companies reaction to the change in lease accounting in several different ways. The first way is to analyze the content of the comment letters to the IASB Discussion Paper (2008) in order to identify the main arguments for and against the new approach of accounting for leases and to examine whether the approval or dissent of respondents is related to a country or professional (user, preparer or academic) grouping scheme. The second way is to investigate the companies response to the changes in lease accounting, especially in terms of capital structure. As mentioned above, several papers showed that companies change their behavior in response to new accounting rules. 19

21 3.2. Determinants of leases Previous literature has focused on studying the determinants of leasing decisions, generally using two different approaches: first, the determinants of the decision between leasing and buying; second, the determinants of the decision between finance leases and operating leases Determinants of buying versus leases There is a large empirical literature investigating the determinants of the decision to lease or to buy. Many authors have devoted their effort to examining the role of leases as an alternative to corporate financing (Myers et al., 1976; Marston and Harris, 1988; Mukherjee, 1991; Lasfer and Levis, 1998; Bayliss and Diltz, 1986; Beattie et al., 2000; and Yan, 2006). However, the overall empirical evidence is mixed, since some authors (Ang and Peterson 1984; Adams and Hardwick (1998); Bathala and Mukherjee, 1995; Krishnan and Moyer, 1994; Lewis and Schallheim, 1992) found that leases are a complement, not a substitute, to debt financing. Therefore, the true nature of the relation between debt and leases remains an empirical issue and the leasing puzzle defined by Ang and Peterson (1984) has not been yet solved. Leases as substitute of debt financing Myers et al. (1976) developed a theoretical model of lease or buy (borrow) and defined a parameter, λ, that represents the substitution between debt and leases. For Myers et al. (1976) the values for λ range between 0 and 1 (leases as substitutes of debt), but they did not consider the possibility that λ could be less than 0 (leases as complements of debt). 20

22 The most frequently advanced view is that leases and debt are perfect substitutes (λ equal to 1). That is, an increase in leasing activity reduces borrowing on a same amount. Other papers (Marston and Harris, 1988; Beattie et al., 2000; Yan, 2006) proposed that although there is a substitution effect, its magnitude is less than a full trade-off because some risk-sharing occurs between the lessee and the lessor (λ between 0 and 1). Marston and Harris (1988) used financial statement data and OLS regression approach to examine the changes in debt and lease obligations (finance and operating leases). They found that the estimated coefficient of substitution between leases and debt was significantly positive and between 0 and 1 ($1 of leasing displaces about $0.60 of nonleasing debt), showing that companies reduced non-lease debt when leases increased but did so on less than a dollar-for-dollar basis. Beattie et al. (2000) investigated the degree of substitutability between lease and non-lease debt financing using comprehensive measures of leases (finance lease and operating lease) and debt. To estimate total operating lease liabilities, they used the method of constructive capitalisation suggested by Imhoff et al. (1991). They found that lease and debt are partial substitutes, with 1 of leases displacing approximately 0.23 of non-lease debt, on average, consistent with the argument that lessors bear some risks which are not inherent in debt contracts. Yan (2006) and Deloof et al. s (2007) results yielded evidence that leases and debt substitute each other empirically rather than acting as complements. Yan (2006) took the cost of debt into consideration and interprets rising interest rates paid on outstanding debt with rising leases as evidence of the substitution-theory and argues that this interpretation is in line with the trade off theory of capital structure. He found that the degree of substitutability is greater for companies that pay no dividends (more asymmetric information), companies that have more investment opportunities (higher agency costs from underinvestment), or companies with higher marginal tax rates (transferring tax shields is less valuable). Deloof et al. 21

23 (2007) investigated the lease debt relationship for Belgian small and medium-sized companies and their results provided support for the substitution hypothesis, ie, more debt is associated with less leases. However, some of these studies (Bayliss and Diltz, 1986; Marston and Harris, 1988; Beattie et al., 2000; Yan, 2006) suffer from the difficulty to control for different asset base associated with leases in cross-sectional tests. Finally, Klein et al. (1978) argue that leased assets are riskier than other assets, exposing the lessee to additional liquidity and bankruptcy costs and causing the value of debt-to-lease displacement ratio to exceed 1. Bayliss and Diltz (1986) conducted a survey of bank loan officers presenting them with companies that used varying lease obligations and measure their willingness to make loans to these companies. They also estimated debt-to-lease displacement ratio as high as Although, Bayliss and Diltz (1986) controlled for debt capacity, there were problems with low reliable response rate and the survey methodology which caused some doubt on the results obtained. Leases as complement of debt financing Although the above studies proved that leases may be substitute of debt financing, the overall empirical evidence is mixed, since some authors (Ang and Peterson 1984; Bowman, 1980; Finucane, 1988; Adams and Hardwick, 1998; Krishnan and Moyer, 1994; Lewis and Schallheim, 1992; Bathala and Mukherjee, 1995; Branson, 1995; Kang and Long, 2001) found that leases are a complement, not a substitute, to debt financing (λ less than 0). Using Standard & Poor s Compustat data for 1976 through 1981 on approximately 600 US companies and several different econometric models, Ang and Peterson (1984) demonstrated a positive correlation between leases and debt that led them to conclude 22

24 that debt and leases appear to be complements, ie, greater debt is associated with greater leases, even after controlling for the differences in debt capacity. The Compustat data set used by Ang and Peterson (1984) contains companies from diverse industries and, therefore, with diverse debt capacity. The addition of the nondebt explanatory variables may not adequately control for diverse debt capacities that may explain the complementary relation between debt and leases. A second criticism is that Ang and Peterson (1984) fail to include operating leases, focusing exclusively on capital leases. Graham et al. (1998) indicate that this may be a serious omission. An earlier study by Bowman (1980) also demonstrates a positive association between debt and leases. A major critic that can be appointed to these studies is that only a cross-sectional relation was examined. Thus the findings are consistent with the result that companies with high external financing requirements use debt and leases indifferently and it is not possible to reject the hypothesis that debt and leases are substitutes. The study of Ang and Peterson (1984) was updated by Branson (1995) using Compustat data from 1983 through 1988 and reached the same conclusion. Additional studies also reached the same conclusion: Finucane (1988) found that leases are positively related to the company's debt ratio, number of bond issues and bond rating although he also found that leases are negatively related to the company's ratio of subordinated debt to assets; Kang and Long (2001) also found that companies with high levels of regular debt also have higher levels of leases; Mehran et al. (1999) found that the estimation of Tobit suggested that debt and capital leases are complementary but they did not find evidence of a significant interaction between debt and operating leases. 23

25 Lewis and Schallheim (1992) framed the lease choice within the optimal capital structure choice. They showed that lease can actually increase a company's debt capacity, by selling excess non-debt tax deductions, and that leases and debt can be complementary within an optimal capital structure. Eisfeldt and Rampini (2007) provided another argument for increased debt capacity due to lease. They argued that leases provide the lessors with a benefit that consists on the ability to repossess the leases asset. They concluded that it is easier for a lessor to acquire a leased asset than it is to foreclosure on the collateral of a secured loan. This means that leases proportionate higher debt capacity than secured lending. However, leases can originate agency costs because of the separation of ownership and control of the leased assets. For these reasons, they concluded that leases tend to be more used by companies that are more financially constrained. Lasfer and Levis (1998), based on a large number of British companies, classified by size, concluded that leases and debt are complements for large companies. Tsay (2003) investigated the relation between debt and leases and identified the effect of both the tax liability and the residual value risk in the analysis of lease-or-buy decisions. He found that when the earning and residual value processes are negatively correlated, the debt and leases are substitutes and the company is better off buying the assets rather than leasing. When the correlation of earnings and residual value is positive, debt and leases can be complements and it is better for the company to lease in order to eliminate the redundancy of nondebt tax shields. Despite all these studies, the available databases and the various models used in the studies are not comparable so the substitute/complement of leases versus debt controversy continues. 24

26 TABLE 4 ABOUT HERE Table 4: Summary of Extant Literature Determinants of buying versus leases Leases versus debt Leases as substitute of debt financing Leases as complement of debt financing Debt-to-lease Studies displacement ratio 0<λ<1 Marston and Harris, 1988; Beattie et al., 2000; Yan, 2006; Deloof et al.(2007). λ>1 Klein et al. (1978); Bayliss and Diltz (1986). λ<0 Bowman (1980); Ang and Peterson (1984); Branson (1995); Finucane (1988); Kang and Long (2001); Mehran et al. (1999); Lewis and Schallheim (1992); Eisfeldt and Rampini (2007); Lasfer and Levis (1998); Tsay (2003) Determinants of leases One area that has been researched intensively is the determinants of leases. Previous research investigated the determinants of finance leases (Lasfer and Levis, 1998; Ang and Peterson, 1984; Deloof and Verschueren, 1999) or the determinants of operating leases (Sharpe and Nguyen, 1995; Graham et al., 1998, Duke et al., 2002) separately. Other studies did not distinguish between distinguish between operating and finance leases (Mehran et al., 1999; Adams and Hardwick, 1998; Graham et al., 1998). However, the determinants may not be the same for operating leases and for finance leases, because of the accounting treatment of each type of leases is different. Smith and Wakeman s study (1985) is one of the most relevant studies about the determinants of leases. They identified eight reasons for leasing besides tax motivation: (1) asset values are not tied to use and maintenance, (2) assets are not 25

27 specialised for the company, (3) the useful life of the asset exceeds the lessee's expected period of use of the asset, (4) the lessee's bonds contain specific financial policy convenants, (5) management compensation is a function of return on invested capital, (6) the company is closely held, (7) the lessor has market power, and (8) the lessor has a comparative advantage in disposing of the asset. Other studies investigated the relation between leases (finance and/or operating leases) and the characteristics of lessee companies. The main characteristics studies were: size, industry, nature of assets, leverage and financial constraints, taxes, management compensation, accounting quality and ownership structure. Size Most of the studies about leases determinants included size as an independent variable. However, the results are mixed. Most of the studies found a significant relationship between size and lease intensity, however some studies (Sharpe and Nguyen, 1995; Graham et al., 1998; Adams and Hardwick, 1998; Mehran et al., 1999) found a negative relationship while others (Lasfer and Levis, 1998; Deloof and Verschueren, 1999) found a positive relationship. Few studies found a non-significant relationship between size and leases (El-Gazzar et al., 1986; Ang and Peterson, 1984). Size is generally considered an important variable to explain the use of leases for several reasons. First, size is related to the costs of obtaining external funds. Smaller companies tend to bear higher cost for getting external financing, due to information asymmetry (Graham et a., 1998). Lessor/lenders may choose to reduce the uncertainty surrounding their claims by leasing rather than lending to small companies. Leases are preferred 26

28 because the lessor's security is tied to the asset itself rather than to the general credit of the lessee. Thus, other things held constant, smaller companies are predicted to lease relatively more, suggesting a negative relationship between size and leases. Second, size is related to diversification. Larger companies tend to be more diversified than smaller companies. Mehran et al. (1999) investigated the relationship between total leases and size, measured as total sales. They argued that company size might be a proxy for the cost of issuing securities and for a company s investment flexibility and diversification possibilities. They found that size had a strong positive effect on debt financing and was positively related to the leases share of total capital costs. Lasfer and Levis (1998) argued that company size can be a measure of the extent to which companies have the ability to redeploy assets internally, and this might indicate that large companies are less likely to lease assets. They included size (they used three different measures of size: total assets, market value of equity and sales) as explanatory variable and as a measure to differentiate between different types of companies (UK quoted and unquoted). Their results showed that the determinants of the financial leases decisions, such as tax reasons and growth opportunities, depend on the size of the companies. In large companies, profitability, leverage and taxation were found to be positively correlated with leases, whereas in small companies the leasing decision did not appear to be driven by profitability or taxation reasons, but by growth opportunities. Deloof and Verschueren (1999) also investigated the determinants of the financial lease decision and they used total assets as a measure of size. Their results showed that the coefficient of size is significant and positive for the entire sample, but also when the sample is split between small and large companies. Third, size can be used as a measure of political costs. Efficient contracting theory assumes that managers choose accounting policies so as to minimise political exposure and agency costs. The political costs view states that larger companies are 27

29 more likely to face political exposure penalties than smaller companies (Watts and Zimmerman, 1978; Holthausen and Leftwich, 1983; Cooke, 1989), as they have greater available wealth to be taxed by the government or appropriated by special interest parties (Hand and Skantz, 1998). In general, these studies showed that large companies have greater incentives to adopt income decreasing methods, so as to reduce the expected costs of political visibility. Applied to leases, this suggests that larger companies will tend to avoid operating leases because they are more likely to adopt accounting methods that decrease current period income. Fourth, annual turnover can be used as a measure of size. Adams and Hardwick (1998) investigated whether a change in company size had the same effect on the total leases share for companies of all sizes. The results showed that the coefficient of the size variable (sales) was significantly less than zero which provided support for the view that small companies are more likely to lease than large companies. Their results also showed that the leases share tended to fall as company size increased, but increased for larger companies. Finally, Sharpe and Nguyen (1995) used size as a proxy for the flexibility of companies investments and they found that small companies lease more than large companies, showing a statistical negative relationship between size and lease intensity. In order to control for endogeneity, they used the log of the number of employees as a proxy for the size of the company. The results showed that while large companies are more likely to have alternative uses for equipment that is no longer used or that they might have a well-developed mechanism for remarketing equipment, smaller companies have great uncertainty regarding their future need for equipment or buildings. They also found that companies with higher costs of external capital tend to lease more. Similar, Graham et al. (1998) hypothesized that larger companies tend to use more debt financing (instead of operating leases) than smaller companies. They presented three 28

30 main reasons: larger companies are more diversified and therefore cash flows have a greater stability; larger companies have more economies of scale when issuing securities; and because of information asymmetry, smaller companies have to bear higher costs for obtaining external funds. They used the natural log of market value of equity of the company as a proxy for company size and they found a significant negative relationship between size and operating leases to the market value of a company. Ang and Peterson (1984) and El-Gazzar et al. (1986) studies did not find a significant relationship between leases and size. Ang and Peterson (1984) used as a measure of size the total assets at year-end. They did not find concrete results, since results changed each year during the period between 1976 and 1981: the sign of the relationship between size and lease intensity changes and only in 1976 and 1981 was the relationship negatively significant. El-Gazzar et al. (1986) investigated size as a measure of political cost, using total sales as a measure of size, and found a positive relation, however insignificant, between company size and leases. Industry The determinant industry is related to the investment opportunity set and the type of assets used by the company. Several studies show that leases tend to be more prevalent in some industries than in others although Ang and Peterson (1984) showed that companies that used leases were not concentrated in a few industries, and that leasing occurred in every one of the 22 Industry groups considered in the sample, and that non-leasing companies were found in 21 of the industries (all industries except amusements industries). However, Ang and Peterson (1984) investigated only the existence of lease contracts in those industries and not the possibility of different levels of leasing (lease intensity). 29

31 Other studies have shown the industries in which leases are more dominant, compared to other industries. Finucane (1988) showed, by using the mean ratio of financial leases to total assets over a five-year period for each industry (52 industries), that companies in certain industries, including air transport and retailing, use more lease financing than others. He identified several reasons for this: certain industries have more specific assets, industry-wide differences in investment tax credits, the availability of assets as collateral, the rate of obsolescence of company-specific assets, the characteristics of secondary asset markets, marginal tax rates and debt capacity. Adams and Hardwick (1998) showed that companies from services and utilities used more leases and companies from construction tend to lease less. Gosman and Hanson (2000) also found that leases are prevalent in airlines and in retailer s stores. Finally other studies investigated the intensity of the use of leases not by industry but if the company is regulated or not or if the company belongs to a monopolist sector or not. Graham et al. (1998) included industry in their study as a control variable for industry effect and to investigate the role of leases in regulated companies (in their sample, telecommunications and gas and electric utilities). They found that all industry variables showed negative and significant relation with operating leases, which seemed to suggest that the industry excluded from the model (trade) showed a higher operating lease intensity than the other industries. Coase (1972) and Bulow (1986) argued that a durable goods monopolist may lease in order to avoid time inconsistency, and Hendel and Lizzari (1999, 2002) showed that it may lease to reduce competition or adverse selection in secondary (used goods) markets. Nature of assets The nature of the asset is also a variable that can determine the use and intensity of leases. Previous research found that, in general, companies tend to lease assets that 30

32 are less specific and more general purpose. Fixed assets of general usage (such as real estate, aircraft, trucks and automobiles, electronics and computer equipment) are readily transferable and as a result have greater availability on the leasing market. With few alternative uses, the economics of specialized assets suggest conventional debt (or equity) financing. Consistent with these predictions, Graham et. al (1998) and Sharpe and Nguyen (1995) report a negative relation between leases and proxies for asset specificity. Klein et al. (1978) argued that more specific assets are more likely to be owned (vertical integration) and more general purpose assets are more likely to be leased. Krishnan and Moyer (1994) also found that companies in manufacturing employ less leasing than retailing, transportation and mining, whose assets are less company specific. Smith and Wakeman (1985) also suggested that companies are unlikely to lease assets highly specific to the organization, because the resulting bilateral monopoly problem would create conflicts and agency costs between lessor and lessee. They predicted, for example, that companies are more likely to lease generic office assets than company-specific production or research assets. Williamson (1988) argued similarly that more easily redeployable assets (e.g., aircraft or trucks) are better suited both for leases and for use as collateral in debt contracts. Erikson (1993) found that asset specific factors, as proxied by industry, may be the single most important determinant of lease use. Gavazza ( 2010), using data from commercial aircraft, found that the liquidity of assets affect leases decision. He found that more liquid assets make leases, in particular operating leases, more likely. Leverage and financial constraints Several studies included leverage as an independent variable for the use or intensity of leverage. In general, most of the studies found that higher leverage companies will 31

33 tend to use leases instead of other forms of financing, since those companies have less debt capacity. Eisfeldt and Rampini (2008) and Sharpe and Nguyen (1995) found that companies facing greater financing constraints, due to information asymmetries, have a higher propensity to make off-balance sheet lease investments (operating leases). Sharpe and Nguyen (1995) and Eisfeldt and Rampini (2008) argue that leases provide creditors with more security, higher priority in bankruptcy, and an effective way of reducing adverse selection and moral hazard problems that arise from information asymmetries. Slotty (2009) found that the share of total annual lease expenses attributable to either finance or operating leases is considerably higher for financially strained as well as for small and fast-growing German SME, those likely to face higher agency-cost premiums on marginal financing. Companies are found to lease to avoid debt financing (e.g., Myers, Dill and Bautista (1976), Ang and Peterson (1984), and Marston and Harris (1988)), to obtain a lower cost of financing by passing the tax allowances the company cannot claim when buying the asset to the lessor (e.g., Barclay and Smith (1995), Sharpe and Nguyen (1995), and Graham, Lemmon and Schallheim (1996)) and to mitigate the agency conflicts, namely the asset substitution problem (e.g., Stulz and Johnson, 1985; Smith and Wakeman, 1985). Bathala and Mukherjee (1995) found that lease covenants appeared to be less restrictive than those imposed by other creditors. Abdel-Khalik (1981) investigated potential explanations for companies to engage in operating leases and they found that violations of restrictive debt covenants in lending agreements, 32

34 managers' beliefs about analysts' and users' perceptions of the effects of finance leases, and the structure of management incentive plans were determinants. Small companies appeared to favor operating leases for off-balance sheet advantages. El-Gazzar et al. (1986) also investigated the relation between leverage (measured by debt-equity ratio, the change in debt-equity ratio, and the industry adjusted debt-equity ratio) and leases and they found that companies with financial ratios that are nearer the limits of covenants tend to choose operating leases instead of finance leases. Leasing theory predicts that financially distressed firms obtain more favorable financing terms from lessors than from traditional creditors because of the priority of lessors claims in bankruptcy proceedings. In the US, Kare and Herbst (1990) found financial gearing to be higher for leasing firms. Krishnan and Moyer (1994) also found leasing companies to have higher levels of long-term debt, as well as higher growth rates, lower retained earnings, lower interest coverage and higher operating risk. They concluded that as bankruptcy potential increases, lease finance becomes attractive. Krishnan and Moyer (1994) empirically investigated the relation between capital (onbalance-sheet) leases and the costs of bankruptcy and find that capital leasing activity is positively related to the costs of bankruptcy. Graham et al. (1998) found that this positive relationship extends to operating (OBS) leases. Leasing theory also predicts that companies with higher costs of external funds reduce investment costs by leasing assets. Finance theory and empirical evidence further suggest that the cost of external funds is higher when information asymmetry, agency problems, and underinvestment 33

35 problems are more severe (Myers and Majluf, 1984; Sharpe and Nguyen, 1995; Graham et al., 1998). Fawthrop and Terry (1975) investigated how UK corporate financial managers perceived and used leases. They found that the relevance of factors in determining the use of leases varied across companies and concluded that leasing policies are a product of individual financial circumstances. Sykes (1976) found leases to be used mainly because of cash flow advantages, although large companies attached some importance to tax allowances. Tomkins, Lowe and Morgan (1979) found that only a minority of small companies engaged in leasing mainly to avoid capital outlay, or because no other sources of finance were available. Hull and Hubbard (1980) concluded that non-tax paying reasons for leasing are important and that incorrect lease evaluation affects leasing use. Mayes and Nicholas (1988) found that UK small companies tend to use leases to avoid large capital outlays. These results were confirmed by Drury and Braund (1990) that also concluded that the relative cost of leases, as well as tax motives, seemed to be a determinant of the decision to lease for large companies. Smaller companies tend to give more importance to other factors such as cash flow. Thomson (2005), based on a survey on the leases decision across UK listed companies, found that avoiding large capital outlay and cash flow considerations are important for companies in the decision to lease all asset types. Taxes Taxes are generally pointed out as an important factor of the decision of leasing instead of buying, especially in the literature that focused the decision of lease or buy 34

36 on tax incentives (Miller and Upton, 1976; Lasfer and Levis, 1998). The argument is that if a company is not in a full tax paying position, buying and depreciating the asset allow to deduct less tax than to lease because, in this case, the company can deduct not only the depreciation but also the finance costs. Miller and Upton (1976) showed that companies are indifferent between leases and buying, except when they face different tax rates. El-Gazzar et al. (1986) used the effective tax rate as a measure of political costs and as a proxy for tax incentive. Their results did not support the first hypothesis on political costs but supported the tax incentive hypothesis. They found that low tax rate companies are more likely to use operating leases instead of finance leases, which is consistent with the hypothesis that companies with high effective tax rates are more likely to adopt income decreasing strategies, such as finance leases. Sharpe and Nguyen (1995) also focused on the advantages of operating leases in shifting tax advantages from lessee to lessor. They used two different variables for the tax status of a company (tax expense divided by pre-tax income and tax-loss carryforwards). They expected that companies that pay little or no taxes are more likely to take on operating leases. They found a significant positive relation between high-loss carry-forward and leases. They also found that capital leases are used more in companies for which tax benefits of buying appear low and low tax rate companies tend to have more operating leases. Later, Graham et al. (1998) questioned the findings of Sharpe and Nguyen (1995) arguing that their tax results were caused by the endogeneity of corporate tax status because using leases can lower a company s observed tax rate. Therefore, as a better proxy they used a dummy variable that indicates the presence of high- or low loss 35

37 carry-forward. Companies with significant tax-loss carry forward will be tax-exhausted for a period of years, and thus able to take full advantage of tax benefits of ownership, including accelerated depreciation and investment tax credits. High carry-forward is defined as tax-loss carry-forward exceeding current-year EBITDA. With respect to the tax rate, no significant relationship with leasing was found. Lasfer and Levis (1998) showed that leasing is substitute for debt financing and is driven by taxes for large companies only. Their main conclusion was that companies that use leases are more likely to have tax losses, although this is not the major determinant for small companies. They investigated if the tax differential between lessee and lessor is one of the three main reasons for the existence of leases. They included in their model five different tax variables (Tax charge/earnings before taxes; Tax carried forward/total assets; recoverable advanced corporate tax/market value of equity; Provision advanced corporate tax/ market value of equity and written of advanced corporate tax/market value of equity). The major critic that can be pointed out is that tax differential between lessee and lessor relates most to operating leases and Lasfer and Levis (1998) focused on finance leases. Graham et al. (1998) investigated if low tax rate companies lease more than high tax rate companies. They argued that the use of operating leases should be negatively related to a company s tax rate. To avoid endogeneity s problem, they simulated the before-financing decision marginal tax rate, based on a simulation, assuming the company s taxable income follows a random walk. They found a significant negative relation with the operating-lease intensity. Based on the approach of Graham et al. (1998), Mehran et al. (1999) estimated a before financing marginal tax rate, so as to explain the relationship between all leases and the tax rate. They argued that companies with little or no tax liabilities would be 36

38 less likely to use debt financing, but would be more likely to lease assets. They found results contrary to those of Graham et al. (1998), that they justified because of the larger sample of Graham et al. (1998) study. However, Graham et al. (1998) used operating leases and Mehran et al. (1999) used indistinctively operating and finance leases. Yan (2002) found empirically that the degree of substitutability between debt and leases increases for companies facing more agency problems, or for companies having more redundant tax shields. Yan (2002) focused in operating leases due to the diminishing importance of finance leases. Duke et al. (2002) included the effective tax rate of a company in their model based on the theoretical prediction of Smith and Wakeman (1985), and on the previous empirical results of El-Gazzar et al. (1986) and Sharpe and Nguyen (1995) studies. Their results showed a significant negative relationship between the effective tax rate and operating lease intensity. O Brien and Nunnaly (1983), based on a US companies sample, found that tax and the risk of residual values and obsolescence were determinants in the leases decision. Mukherjee (1991) also found that avoiding the risk of obsolescence appeared to be the most important advantage to leases, followed by a lower cost compared to borrowing. The tax and off-balance sheet advantages to operating leases seemed to be insignificant. Management compensation In several companies, management compensation is based on accounting measures which motivates the management of a company to choose accounting policies that best fulfils their interests (Smith and Wakeman, 1985; El-Gazer et al., 1986; Imhoff and 37

39 Thomas, 1988). The preference for operating leases has generally been associated with management compensation schemes Smith and Wakeman (1985) predicted that leases are more likely if management compensation is based on return on invested capital. If managers reward is based in return on invested capital and no adjustment is made to reflect operating leases, managers will prefer operating leases to capital leases or to buy, because operating leases can produce the same operating results without increasing the denominator (total assets). Imhoff et al. (1993) investigated whether the management compensation committee adjusted income for operating leases, considering the footnote disclosure of operating leases. They found that management compensation committees did not take operating leases in account when determining management compensation, since the capitalization of operating leases did not provide incremental explanatory power in determining management reward. El- Gazzar et al. (1986) also included management compensation in their study and they predicted that companies whose incentives plans are based on income after interest would choose operating leases instead of finance leases. They used a bonus dummy that assumes the value 1 if the company had incentive plan based on net income and 0 otherwise and they found a positive and significant relationship between management compensation plans and the use of operating leases. Contrary to their predictions and the results obtained by Smith and Wakeman (1985), Duke et al. (2002) found that the existence of management compensation plans based explicitly on return on capital seemed not to be related with the use of operating leases. They used the same dependent variable used by El-Gazzar et al. (1986), a dummy variable that assumes the value one if the company had a compensation plan which rewarded managers based on income after interest, and zero otherwise. These results seem to suggest that markets are not completely fooled by the non-recognition of operating leases. 38

40 Following Imhoff et al. (1993), Lückerath-Rovers (2007) tested whether the change in management compensation was explained by a change in operating lease intensity and whether this differed between companies that lease more or less. Although the univariate analysis showed a significantly positive relation between operating leases intensity and the absolute amount of management compensation and that an increase in management compensation (which makes the variable a relative measure instead of an absolute measure) is positively related to an increase in operating leases intensity in the same year, the absolute amount of management compensation in the regression models did not show a significant relationship. Finnally, Robicheaux and Fu (2008) examined whether companies that attempt to control the agency costs of equity through strong governance structures, including Chief Executive Officer compensation alignment and board structure, are more likely to use an agency cost reducing debt structure, such as leases. They found that companies that use more incentive compensation and have more outside directors also tend to use more finance leases, suggesting these agency cost reducing measures are complements. Most of previous studies focused on financial position perspective, ie, the effect of capitalisation of operating leases on the amount of assets and liabilities. However, the impact of the capitalisation of operating leases on the earnings is not yet well studied. Accounting quality Beatty et al. (2009) found that low accounting quality companies may buy fewer assets but they lease more, suggesting that these companies may substitute purchased assets for leased assets. They also found a lower association between accounting 39

41 quality and leases when banks have higher monitoring incentives and when loans contain capital expenditure provisions. Ownership structure Prior research showed that higher levels of managerial ownership tend to be associated with higher levels of debt and finance lease (Alchian and Demsetz, 1972; Flath, 1980; Smith and Wakeman, 1985) and operating leases (Duke et al., 2002). Flath (1980) and Smith and Wakeman (1985) investigated the role of ownership structure in the decision to lease assets. Flath (1980) found that companies that are more closely held tend to have more lease contracts. The main argument is that debt and leases expose the owners of the companies to financial risk. However, when an asset is leased for a period shorter than its useful life, the lessor supports most of the risk of obsolescence or other changes in asset value. On the other hand, a lessor company with both a diversified asset portfolio and widely dispersed ownership may be able to bear such risks more cheaply. Smith and Wakeman (1985) pointed out that the potential benefits are enhanced if the lessor has any comparative advantage in disposing of assets in the second-hand market. Alchian and Demsetz (1972) showed that leases involve agency costs due to the separation of ownership and control of capital; a lessee may not have the same incentive as an owner to properly use or maintain the capital. Mehran et al. (1999) also investigated the relationship between leases and ownership and they found that companies whose CEOs have a larger ownership tend to use more leases in order to reduce their exposure to obsolescence and other asset-specific risks. 40

42 Duke et al. (2002) found a positive relation between operating leases and ownership concentration. Table 5 summarises the determinants of leases investigated in previous research. TABLE 5 ABOUT HERE Table 5: Summary of Extant Literature Determinants of leases Main determinants Main conclusions and studies Size Prior studies found mixed evidence about the relationship between size and leases; Some studies found a negative relationship between size and operating (Sharpe and Nguyen, 1995; (Graham et al., 1998) or total leases (Adams and Hardwick, 1998; Mehran et al., 1999); Other studies found a positive relationship between size and finance leases (Lasfer and Levis, 1998; Deloof and Verschueren, 1999). Industry Leases tend to be more prevalent in some industries than in others (Finucane, 1988; Graham et al., 1998; Adams and Hardwick, 1998; Gosman and Hanson, 2000; Coase, 1972; Bulow, 1986; Hendel and Lizzari, 1999, 2002); Leases are more prevalent in air transport and retailing (Finucane, 1988; Gosman and Hanson, 2000), trade (Graham et al., 1998); services and utilities (Adams and Hardwick, 1998), durable goods monopolist (Coase, 1972; Bulow, 1986; Hendel and Lizzari, 1999, 2002). Nature of assets Companies tend to lease assets that are less specific, more general usage and more liquid (Graham et al., 1998; Sharpe and Nguyen, 1995; Smith and Wakeman, 1985; Williamson, 1988, Erikson, 1993; Gavazza, 2010; Krishnan and Moyer). Leverage and financial constraints Higher leverage companies will tend to use leases instead of other forms of financing, since those companies have less debt capacity (Eisfeldt and Rampini, 2008; Sharpe and Nguyen, 1995; Slotty, 2009; Myers et al., 1976; Ang and Peterson, 1984; 41

43 Marston and Harris, 1988; El-Gazzar et al., 1986; Finance leases become more attractive when bankruptcy potential increases(krishnan and Moyer, 1994; Myers and Majluf, 1984; Sharpe and Nguyen, 1995; Graham et al., 1998). Taxes Prior research found that taxes are an important factor of the decision to lease (Miller and Upton, 1976; Lasfer and Levis, 1986; El-Gazer et al., 1986; Sharpe and Nguyen, 1995). Management compensation Prior studies found mixed evidence about the relationship between management compensation and leases; Some studies found a positive and significant relationship between management compensation plans and the use of operating leases (Smith and Wakeman, 1985; El-Gazzar et al., 1986) Other studies found that the existence of management compensation schemes based explicitly on return on capital did not appear to be related to the use of operating leases (Duke et al., 2002; Lückerath-Rovers, 2007); Management compensation committees did not take operational leases in account when determining management compensation (Imhoff et al., 1993). Accounting quality Low accounting quality companies tend to substitute purchased assets for leased assets (Beatty et al., 2009). Ownership structure Higher levels of managerial ownership tend to be associated with higher levels of debt and finance lease (Alchian and Demsetz, 1972; Flath, 1980; Smith and Wakeman, 1985; Mehran et al., 1999). 3.3 Value relevance of leases Most of previous studies about the value relevance of leases investigate the value relevance of footnote information, i.e. finance lease recognised in balance sheet and operating lease information disclosed in footnotes. Ro (1978) and Bowman (1980) showed that markets evaluate the footnote information of as-if capitalised finance leases under ASR No.147. Ely (1995) and Lindsey (2006) examined the value 42

44 relevance of footnote information of as-if capitalized operating leases under SFAS No.13. Those results showed that, in general, footnote information on leases was evaluated in determining stock price. Sakai (2010) investigated the market reaction associated with the movement of the finance lease disclosures from footnotes to the body of financial statements, for a Japanese sample. He found that it is not necessary to extend the range of recognition of uncertain assets and liabilities because the footnote information is not inferior to the recognised information. Ely (1995) found that investors perceive operating leases as assets. Equity risk is found to be significantly related to the debt-equity adjustment for operating leases. The results also show that the relationship between equity risk and asset risk is influenced by return on assets adjustments. Lindsey (2006) examined the value relevance of operating and capital leases in order to investigate whether equity investors value operating lease disclosures in the notes to the financial statements and capital lease amounts recognised on the statement of financial position differently. He found that investors view both operating and capital leases as economic liabilites of the company. Cheng and Hsieh (2000) evaluated the value relevance of SFAS 13 from an income statement perspective. They found that earnings decreases when operating leases are capitalized. In contrast, operating income increases because it excludes capital lease interest expense. However, the earnings response coefficient is estimated using 43

45 linear regression, the coefficient on the income effect is not significantly different from zero Valuation of leases The theoretical valuation of leases, in particular operating leases, has been studied extensively in previous studies (Myers et al. (1976), Franks and Hodges (1978), Ang and Peterson (1984), Lewellen and Emery (1980), Trigeorgis (1996)). The valuation of leases is typically conducted by one of two major capitalisation approaches: the Discounted Cash Flow (DCF) and the multiple approaches. Discount Cash Flow approach The discount cash flow (DCF) approach calculates the capitalised value of a lease by discounting N cash outflows back to the current time. Since the lease cash flow consists of just N payments and no other positive cash inflow, the discount of the lease outflows aims to eliminate the interest included in the rents. Myers et al. (1976) were the first to present a lease valuation formula. They defined the value of lease contracts as the advantage of leases versus debt. In theory and in a perspective of lessee, a lease is preferable to debt, when the present value of a lease compared to normal debt is positive. Myers et al. (1976) determined the present value of a lease by considering all changes in cash flows due to the decision to lease. The value of the lease at inception is the initial investment, minus the present value of the lease payments, minus the tax disadvantage of no depreciation and plus the after tax interest advantage of no debt: 44

46 CFt (1 T ) depr. T i T D V 0 = I (1) n n n t t 1 + t t t t= 1 (1 + i) t = 1 (1 + i) t = 1 (1 + i) where, V0 = the value of the lease at inception n = the total term of the lease, which is most or all of the asset s economic life, I = the original investment in the leased asset, CFt = the lease payment during year t, T = the marginal corporate income tax rate, i = the firm s marginal borrowing rate, deprt = the depreciation in year t, Dt-1 = the debt displaced by the asset leased. Trigeorgis (1996) included in the equation the options that may exist in a lease contract. He determined the value of options using theoretical option valuation models. For Trigeorgis (1996), the value of the lease at the beginning of the lease contract is the difference between the present value of the financial advantages and disadvantages of the lease as compared to normal debt. Hamill et al. (2006) also applied a real option literature based model to valuing the option element of a noncancelable lease without an early exercise provision. The findings showed that the value of the option inherent in an automobile lease is approximately two to six percent of the original asset cost. In a series of studies, Imhoff et al. (1991, 1993, 1995, 1997) described ways of determining the amounts that should be recognised as assets and liabilities in the financial position statement if operating leases were capitalised ( constructive capitalisation of operating leases ). The base for determining the amount of assets and debt is the operating lease disclosures. In the first paper, Imhoff et al. (1991) developed a uniform set of procedures for estimating the impact of capitalising operating leases. They used a sample of seven pairs of companies in different industries. Companies were paired based on size, but they were different in their use of operating leases. The 45

47 amount of assets and liabilities that would be capitalised was estimated using uniform assumptions: an interest rate of 10% for discounting the required minimum lease obligation; an average remaining life of 15 years for operating leases; end-of-year cash flows; the unrecorded asset equals 70% of the unrecorded debt; a combined effective tax rate of 40%; and the net effect on the current period s net income of zero (Imhoff et al., 1991). Based on information disclosed in the notes, Imhoff et al. (1991) estimated the incremental borrowing rate and remaining lives of the leased assets. With this procedure, it was possible to estimate the present value of the remaining lease obligations under operating leases (amount of liability that would be recognised) and the amount of unamortized asset (amount of asset that would be recognised). Imhoff et al. (1991) also considered that the lease rental payment equal to the sum of the depreciation and the interest expense. This assumption is not adequate for all the companies since the amount of depreciation and interest expense and the amount of rental can be different. Despite this assumption, they found robust results that show that operating leases have a significant effect on risk and return measures. The following papers of Imhoff et al. (1993, 1995) used company-specific procedures, and the 1997 paper investigated the income statement impact of lease capitalisation. Imhoff et al. (1993) used footnote disclosure and constructive capitalisation so as to calculate the appropriate adjustment to leverage ratios. They used two different approaches to determine the value of capitalising operating leases. First, they estimated the average total life, remaining life and interest rate of companies operating leases agreements to the information disclosed of future operating lease payments. Second, they used an ad hoc multiplier adjustment for operating leases: the factor method. 46

48 Beattie et al. (1998) used a similar approach but their major contribution is the differentiation two assets categories, land and buildings and others, because they have different maturities. Ely (1995) analysed whether investors view operating leases as assets. According to Ely (1995), the user s perspective toward a lease is instrumental in determining its accounting treatment (balance sheet recognition or footnote disclosure). Ely (1995) related equity risk to two ratios that are often adjusted by investors to include operating leases: the debt-equity ratio and the return on assets. She considered that the present value is equal to the first minimum lease payments multiplied by a constant (the multiple method), if leases are entered into regularly (companies enter new leases every year) and when the payment per lease is constant. Lennard and Nailor (2000) questioned the completeness of the information disclosed about operating leases. They argued that if operating lease capitalisation is needed for financial analysis, then capitalisation of operating leases should be considered in financial statements by preparers instead of using constructive capitalisation by financial statement users. Multiple Approach The multiple methods estimat the capitalised value of an operating lease by multiplying a company s next year lease obligation with a fixed multiple. The major distinction between the multiple methods and the present value methods is the usage of the next year s lease payment to determine the lease liability instead of all future lease payments. 47

49 The multiple method can also be divided in two different approaches. First the multiple methods using a constant (for example 6 or 8 times rent) and second, the multiple methods using a formula (UBSWarburg (2001) and Ely (1995)). The multiple methods using a constant may be a simple method. Multiple methods using a formula (UBS Warburg (2001) and Ely (1995)) do incorporate different interest rates and operating lease terms, as opposed to the multiple methods using a constant. The rating agencies have been adjusting financial statements for lease obligations because it is important for rating agencies to consider the overall capitalisation of a company and the claim that rent payments have on future cash flows. The adjustment model has the objective of reflecting in a more accurate way the companies financial ratios an provide more comparable to one another by taking into consideration all financial obligations incurred, whether on or off balance sheet. Prior to 2006, Moody s used a modified present value method to develop a proxy for the contractual value of future lease obligations and Fitch applied a simple 8 times multiple current rate. However, in 2006, Moody s released new methodology that represents a change in philosophy as well as a desire to make lease adjustments more transparent to users and easier to achieve its stated goal of comparability. The new methodology is based on a multiple of current rent expense to capitalise operating lease obligations. Fitch also changes its method in The new methodology allowed for either the factor method (8x multiple) or present value method, if sufficient information is available about the terms of operating. 48

50 Standard & Poor s uses the present value method to adjust leverage and capitalisation measure to include obligations related to leases. Standard & Poor s capitalises operating leases as addition to assets and corresponding debt by calculating the present value of reported minimum lease commitments in notes to financial statements. Prior to 2005, S&P used a 10% discount rate, but since then S&P started to use as a discount rate the issuer s actual borrowing rate (average interest rate from the company s most recent annual statements) Leases and the impact on accounting ratios Nelson (1963) initiates a pilot study on the capitalization of off-balance sheet lease (operating leases) obligations, by adjusting the balance sheets of eleven US companies that voluntarily disclosed additional lease information by increasing assets and liabilities by the present value of the off-balance sheet obligations. The objective of his study was to investigate if the estimated values of the assets and liabilities related operating were included in financial ratios, those ratio would become more meaningful and more relevant for decision making. The results showed that the information about operating leases is relevant and the reliability of the information increases when operating leases are capitalised. Following Nelson s study (1963), Ashton (1985) investigated whether lease capitalisation had a significant impact on six indicators of financial performance, considering a sample of 23 companies. He found that only the leverage ratios changed significantly and that correlations between pre-capitalisation and pos-capitalisation of operating leases ratios were high. As pointed out by Goodacre (2001), Ashton s conclusion that inter-company comparisons of performance would not be affected significantly by capitalisation may be related to sample selection bias. 49

51 Imhoff et al. (1991) selected seven U.S. companies where the ratio of operating lease cash flows to total assets was relatively high and seven similar companies (matched on size and industry) where this ratio was relatively low. Assuming a constant borrowing rate, a constant useful life, and leased assets equal to 70 percent of the capitalized operating lease amount, they found that constructive capitalization of operating leases decreased return on assets by 34 percent for high-lease companies, but only 10 percent for low-lease companies. In addition, debt-to-equity increased by 191 percent for high-lease companies, but only 47 percent for low-lease companies. Their results seemed to suggest that constructive capitalisation of long term material operating lease may be necessary before an accurate evaluation of financial results within or across companies and industries can be performed. In a subsequent study, Imhoff et al. (1997) used the constructive capitalization method that virtually treats operating leases as finance lease contracts right from the lease inception. A value difference between lease asset and lease liability is modeled, allowing for equity and net income adjustments after deferred taxes. In this paper, they confirmed the results of 1991 study from two lease-intensive sectors, retail and transport, and highlight the relevance of the lease accounting treatment for financial analysis. Beattie et al. (1998) investigated if the capitalisation of operating leases had a major impact on the profit margin, return on assets, asset turnover and three leverage ratios found in their analysis of a larger random sample of 232 UK listed companies. They concluded that the requirement of capitalizing operating leases may affect interested parties decisions and company cash-flows. 50

52 Goodacre (2001) found that the capitalisation of operating leases would have a major impact on nine ratios (operating margin, three return on capital ratios, asset turnover, income gearing and three capital gearing ratios) of retail sector companies. Bennet and Bradbury (2003) investigated New Zealand companies and they found that the capitalisation of operating leases not only negatively impacts leverage ratios, but also decreases liquidity and profitability. Mulford and Gram (2007) found that excluding operating leases from the balance sheet causes a material distortion of the financial position of the company, which is further evidenced in understated EBITDA and overstated income from continuing operations. Additionally, key cash flow metrics are understated by the exclusion of operating leases. Fuelbier et al. (2008) identified a significant capitalization impact for a considerable number of companies in general, and for certain industry groups (fashion and retail) in particular. Changes in financial ratios occur primarily for assets and liability relations, since minor effects were observed for profitability ratios and valuation multiples. Duke et al. (2009) applied constructive lease capitalization to operating leases of companies in the 2003 S&P 500 index, and found that companies can hide billions of liabilities, enhance retained earnings, income, and liquidity, leverage and performance ratios by reporting leases as operating. Durocher (2010) used a refined constructive capitalization method, in which companyspecific assumptions (interest rate, total/expired/remaining lives of leased assets, and tax rate) were used to compute the impact of operating-lease capitalization on key financial indicators for a sample of Canadian public companies. The results indicated 51

53 that capitalizing operating leases would lead to the recognition of important additional assets and liabilities on the balance sheet. It would therefore significantly increase the debt-to-asset ratio and significantly decrease the current ratio. These results were noted across all industry segments in the sample. Income statement effects were generally less material. Significant impacts on return on assets, return on equity, and / or earnings per share were noted in only three industry segments: merchandising and lodging, oil and gas, and financial services. 6. Summary and Opportunities for Further Research This paper reviews empirical research on lease accounting. A number of empirical studies investigate the decision between buying or leasing and the determinants of leases. Taken together, the results from this line or research indicate that there is not a consensus if debt and leases are complements or substitutes. Results on the determinants show that are some factors that affect the choice between leases and debt, such as size, taxes, nature of assets, financial constraints and management compensation. Another line of research shows the importance of considering the information about operating leases and, in particular, the importance of capitalizing operating leases. This capitalisation affects the determination of some important ratios and is value relevant, but raises the problem of determining the amount to be considered as an asset and a liability. This supports recent changes proposed by IASB to recognise all leases as assets and liabilities in the statement of financial position. 52

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