Evaluating Constructive Lease Capitalization and Off‐Balance‐Sheet Financing: An Instructional Case with FedEx and UPS

This case illustrates the effects of the proposed new lease standard by the Financial Accounting Standards Board and the International Accounting Standards Board on existing outstanding operating leases. Specifically, the case examines the effects of the proposal that all firms report existing operating leases as capital leases upon the initial adoption of the proposed standard. By applying a constructive capitalization model to two firms who rely on operating leases for financing, FedEx and UPS, we found that both companies would have to record billions of dollars of liabilities that had only appeared in the footnotes of their financial statements under the current lease standards. In addition, the firms would experience a decline in retained earnings and key financial ratios, such as the debt‐to‐equity, return‐on‐assets, and interest coverage ratios, by reporting operating leases as capital leases under the new proposed standard. Furthermore, the magnitude of the lease capitalization impact is much smaller for UPS than for FedEx.     

Canadian Evidence on the Constructive Capitalization of Operating Leases*

One type of relevant ex ante research supporting the accounting standard‐setting process is the study of a proposed standard's impact on reported figures. The International Accounting Standards Board recently decided to review the lease accounting standard, which will naturally involve consideration of the G4 + 1 recommendation to capitalize all noncancellable lease contracts, including operating leases. National evidence of the impact of the G4 + 1 proposals provides feedback for the international standard‐setter. This study developed and used a refined constructive capitalization method, in which company‐specific 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 indicate 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. Intercompany comparability would not be affected overall nor within industries, because of similar rankings for each financial indicator before and after operating‐lease capitalization.     

Lessee Reactions to Regulation of Accounting for Leases

This study examines lessee firms’ responses to Australian Accounting Standard 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, thus bringing the finance leases of many firms‘on balance sheet’ and increasing reported leverage. If the capitalization requirement altered firms’ equilibrium contracting cost distributions sufficiently, firms would take actions to mitigate its effect, possibly by altering their capital structures. The study examines whether the capital structures of these firms did change in response to the requirement, and if so, how. The results indicate that firms responded to the Standards by reducing their reliance upon finance leasing and increasing their reliance upon non-lease debt and shareholders’ funds. Firms do not appear to have used definitional interpretations to classify leases as operating rather than finance leases. As expected, the firms previously disclosing finance leases in footnotes experienced increases in non-lease debt reliance while the control sample (firms that previously capitalized the lease obligations) experienced decreases. Differences between control firms’ and footnote disclosure firms’ reactions to the Standard are generally consistent with contracting theory predictions. Control firms reacted to the loss of the potential to off balance sheet finance. Footnote-disclosure firms reacted to the loss of an already utilized off balance sheet financing technique.     

Proposed Changes in Lease Accounting and Private Business Bankers' Credit Decisions*

This study contributes to the debate on lease accounting currently ongoing at the international level and to future discussions at the Canadian level for private enterprise standards following a potential revision of lease accounting in international financial reporting standards (IFRS). A user perspective is adopted to examine private business bankers' preferences on the issue of capitalizing all noncancelable lease contracts, including operating leases, as suggested by the G4+1. While bankers use both capital and operating lease information, they give significantly more consideration to the former when analyzing private business loan requests. Accordingly, operating lease information receives less attention than capital lease information in the credit‐granting decision process. In addition, private business bankers consider a number of aspects of the current lease accounting standard to be inadequate and are in favor of the principles governing the approach suggested by the G4+1. They feel that the capitalization of operating leases would improve their ability to evaluate lessees' long‐term financial commitments and increase their estimates of the risks involved in providing financing to lessees. This study also demonstrates that the capitalization of operating leases would have a significant impact on key financial indicators of a sample of Canadian private companies. Bankers perceive that these realistic changes in financial indicators would affect their assessment of borrowers' capital structure/solvency, liquidity, ability to repay, and risk rating. From a cost‐benefit perspective, the findings provide standard‐setters with an indication of the benefits of the G4+1 proposals to users.     

The Impact of IFRS 16 on Key Financial Ratios: A New Methodological Approach

In January 2016, the International Accounting Standards Board issued a new standard for lease accounting: International Financial Reporting Starndard (IFRS) 16. IFRS 16 will lead to the capitalisation of the majority of current operating leases by lessees. We analyse the impact of the new accounting model on entity’s key financial, contributing to research by making significant changes in the Imhoff et al. [(1991). Operating leases: Impact of constructive capitalization. Accounting Horizons, 5(1), 51–63. Retrieved from http://search.ebscohost.com/login.aspx?direct=true&;db=buh&;AN=9604010111&;site=ehost-live; (1997). Operating leases: Income effects of constructive capitalization. Accounting Horizons, 11(2), 12–32. Retrieved from http://0-search.proquest.com.fama.us.es/docview/208896121?accountid=14744] methodology used by previous authors. We change how the lease term is estimated (more aligned with the final approved standard), and how the discount rate is obtained. Furthermore, we use a more comprehensive sample (646 quoted European companies). In line with previous research we find important systematic impacts on key balance sheet financial ratios (mainly leverage ratios), on a magnitude that depends on the operating lease intensity of the sector in which the entity operates. Our estimated impact is generally higher than that obtained in previous studies. The most affected sectors are retail, hotels and transportation. We do not find a consistent result with regard to the effect on profitability ratios.     

The valuation and reliability implications of FIN 46 for synthetic lease liabilities

We examine whether adoption of FASB Interpretation No. 46/R (FIN 46), Consolidation of Variable Interest Entities–an Interpretation of ARB No. 51, changed the market valuation and related measurement reliability of synthetic lease liabilities. Adopted in 2003, FIN 46 requires financial statement recognition of many previously off-balance sheet structures, including synthetic leases. Synthetic leases are hybrid financing structures that, prior to FIN 46, allowed firms to maximize the benefits of asset ownership for tax purposes while retaining operating lease treatment within the firm’s financial statements. We identify a sample of 125 synthetic leasing firms impacted by FIN 46. Utilizing methodology consistent with Dhaliwal et al. (2011), we constructively capitalize these lease liabilities in the period preceding FIN 46 and compare market valuation of these liabilities with capitalized leases after adoption of the standard. We find that the market places greater weight on synthetic lease obligations recognized within the body of the financial statements than it does liabilities disclosed within the associated notes. Finally, we rely on econometric procedures developed in Barth (1991) and extended in Choi et al. (1997) to examine whether the differential market valuation of lease liabilities post FIN 46 is due in part to perceived differences in measurement reliability. The results indicate there is a post FIN 46 reliability effect for all lease liabilities examined. However, while the synthetic lease amounts are the most unreliable examined, they also experience the greatest increase in reliability post FIN 46, indicating that perceived measurement reliability explains in part differential market valuation associated with FIN 46. Our findings have the potential to inform the ongoing standard setting debate surrounding the possible capitalization of all leases. Further, our study also has economic implications for managers concerned with the potential constraints on asset financing options imposed by accounting regulation.     

Do firms lease to hedge? CEO risk-taking and operating lease intensity

Operating leases are used extensively for financing, but their ability to separate ownership and use also creates hedging opportunities. We investigate whether firms recognize such opportunities by examining the relation between chief executive officer (CEO) risk-taking incentives and the use of operating leases. Consistent with firms using operating leases to hedge, we find higher CEO risk-taking incentives lower operating lease intensity. To address endogeneity, we use the adoption of Statement of Financial Accounting Standards 123R as an exogenous shock to option compensation, dynamic panel generalized method of moments, simultaneous equations, and change regressions. Our results are robust to placebo and alternative tests.     

Recognition versus disclosure of finance leases: Evidence from Japan

This study examines whether credit market participants—bond investors and credit rating agencies—treat recognized and disclosed finance leases differently when assessing firms’ credit risk in Japan. I use firms’ credit risk, measured by bond spreads and credit ratings, to investigate the relations between recognized versus disclosed finance lease obligations and firms’ credit risk following the adoption of Statement No. 13, Accounting Standard for Lease Transactions. For a sample of firms issuing new bonds, I find that, unlike recognized finance leases, disclosed finance leases are not associated with bond spreads. Moreover, the associations between recognized versus disclosed finance leases and bond spreads are substantially different. Conversely, recognized and disclosed finance leases are associated with credit ratings and are processed similarly when credit ratings are determined. Taken together, my results suggest that the sophistication of capital market participants influences their credit risk assessments of recognized versus disclosed finance leases.     

Location and lease intensity

U.S. firms lease assets extensively. We find that, during 1980–2011, the average U.S. firm has a lease intensity of about 40%. Or, the average firm has present and future (up to five years) rent commitments equal to 16.6% of their total assets. We investigate whether agency costs between the lessor and the lessee affect the lease intensity of firms. To do so, we examine the impact of firms' location on the use of operating leases. The main idea of our paper is that, because obtaining information and monitoring is costly for potential lessors, especially when a lessee is relatively far away from financial centers, rural firms are less likely to use operating leases. Consistent with this hypothesis, we show that rural firms tend to have lower lease intensities than similar urban and small city firms. In addition, we find that firms with higher levels of debt capacity lease less and firms that face more financial constraint lease more. Our findings are robust to industry and lease maturity controls and consistent with the existence of an agency problem associated with leasing.     

The Effect of Firm Characteristics on the Use of Percentage Retail Leases

Choice of lease payments has been widely studied in the literature. There are three—not necessarily exclusive—explanations that have received attention. The first attributes the choice of fixed versus percentage lease payments to risk-sharing preferences. The second explanation views percentage-of-sales lease agreements as a way discriminating monopolists can appropriate economic rents. The third attributes percentage-of-sales lease agreements to a metering and bonding argument. This paper examines the proposition that the choice of percentage retail leases is driven in part by managements' desire to circumvent the cost of violating debt covenant restrictions. The evidence presented here supports the prediction that retail firms with higher debt–asset ratios are more likely to adopt percentage lease agreements.     

Market Perception of Goodwill: Some Empirical Evidence

Accounting and reporting for goodwill has been on the agenda of the Financial Accounting Standards Board, the International Accounting Standards Committee, the UK's Accounting Standards Board, and the US Congress. Goodwill has also been the subject of Securities Exchange Commission rulings directed at specific companies. The attention directed towards goodwill would suggest that it is a material asset for a large number of firms. This article analyses the market perception of goodwill as an asset in the determination of the firm's valuation. Also explored is whether the market values goodwill to the same degree as it values other assets. The results of this study found that the market perceives goodwill as an asset and incorporates the information in the valuation of a firm. The findings of this study could be of importance to those involved in and affected by standard-setting deliberations involving goodwill.     

Economic consequences of accounting standards: The lease disclosure rule change

We examine capital structure changes to investigate the impact of SFAS No. 13 on lessees. While this accounting standard essentially rearranged capital lease disclosures (from footnotes to the balance sheet), mandated capitalization substantially altered key accounting ratios. Our results document a systematic substitution from capital leases to operating leases and nonleases sources of financing. In addition, lessees appear to reduce book leverage by increasing equity and reducing conventional debt. The magnitudes of these responses are cross-sectionally related to preadoption levels of footnoted capital leases.     

How to improve IFRS for intangible assets? A milestone approach

This study focuses on the decreasing relevance of financial information associated with current financial reporting standards for intangible assets. We summarize and compare three approaches to improving financial reporting standards for internally generated intangibles—the recognition approach, the fair value approach and the disclosure approach, among which we focus on the recognition approach. We investigate the impact of current International Accounting Standard 38 on the R&D capitalization policies of the high-tech industry, particularly among medical device firms in China. We conclude that the current recognition criteria are so stringent that they disincentivize firms from capitalizing their R&D investments. A large variation exists in capitalization timing within the medical device industry. Accordingly, we propose the milestone approach to revising financial reporting standards for intangible assets. We suggest that determining the capitalization criteria for intangibles based on the R&D cycle and capitalization timing should be moved forward.     

A Critical Look at SFAS 34: Capitalization of Interest Cost

In 1974, the Securities and Exchange Commission (SEC) noted that an increasing number of companies were capitalizing interest costs, and that this practice was not being adequately disclosed (FASB, 1979, par. 26). In light of the alternative practices concerning the accounting for interest and lack of adequate disclosure by companies that were already capitalizing interest, the SEC recommended that the Financial Accounting Standards Board (FASB) consider the issue of accounting for interest cost. As a result of the SEC's initiative, in 1979 the FASB issued Statement of Financial Accounting Standards [SFAS] No. 34, Capitalization of Interest Cost, which mandated uniform interest capitalization rules in accounting for interest costs associated with the acquisition of qualifying non-current assets. The purpose of this article is to examine SFAS 34 in terms of its financial statement impact, the congruence of its assumptions with economic behaviour, its effect on subsequent standards related to interest capitalization, and its implications on financial accounting standard setting. To explore these issues we first illustrate the extent to which interest capitalization affects financial statements. We then empirically analyse the measure employed in SFAS 34 for the capitalization of interest cost in cases where debt is not directly linked with the acquisition of qualifying non-current assets. In addition, we critically examine the treatment accorded interest cost in subsequent FASB standards. Our research suggests that SFAS 34′s rationale for interest capitalization is incompatible with firm behaviour, and that the rules for interest capitalization as reflected in various accounting standards are inconsistent. These findings suggest that in the case of interest capitalization the benefits of comparability in financial reporting are not realized. A policy recommendation is then offered to alleviate some of these difficulties. The recommendation is to disallow the capitalization of interest cost in the absence of a direct link between the debt and the acquisition of qualifying assets.     

Converging to International Accounting Standards: Views from Japan

Many countries, including the European Union member states and Australia, adopted international accounting standards in 2005. This year was also critical in Japan for convergence activities. Based on a review of 2005 financial statements and a survey of securities analysts, this study identifies key issues for convergence of Japanese and international accounting standards. We find that accounting requirements relating to fair value measurement, comprehensive income items, leases and business combinations are relevant to Japanese firms. A survey of 974 members of the Security Analysts Association of Japan about these issues indicated support for convergence and the use of fair value measurement, disclosure of comprehensive income, recognition of leases and use of the purchase method for consolidation. We report support for several positions favoured by the International Accounting Standards Board (IASB), a positive signal for achieving convergence goals in Japan, which will be of interest to capital market participants in Japan and other countries .     

The Treatment of Non-Recurring Items in the Income Statement and their Consistency with FASB Concept Statements

This study provides evidence on the consistency of Accounting Principles Board Statement No. 30 (APB, 1973) classification criteria with the objectives of the Financial Accounting Standards Board's Concept Statements Nos 1 and 2 (FASB, 1978, 1980). It is hypothesized that the current APB 30 requirement to classify items of a non-recurring nature in the operating section of the income statement decreases the predictive ability of income before extraordinary items. A random sample of 50 firms with non-recurring adjustments to income, which were included in the operating section of the income statement, was selected from Standard and Poor's Corporation Records. Naive models were used to generate earnings per share forecasts for the year in which the adjustment to income occurred, the prior year and subsequent year.
The results indicate a statistically significant decrease in the predictive ability of earnings per share before extraordinary items associated with the year that the adjustment occurred and a significant increase in the variability of earnings per share. Also, differences in predictive ability were noted between small and large firms and firms with positive and negative adjustments to income.
The results of this study also imply that the managers of most firms with negative adjustments to income are not using the adjustments to smooth income for either the purpose of decreasing the variability of earnings or increasing predictability. The results are more consistent with the 'big bath' theory. These conclusions appear to be more relevant for smaller firms than larger firms.     

A note on value relevance of mark-to-market values of energy contracts under EITF Issue No. 98-10

This paper examines whether marked-to-market values of energy trading assets and liabilities of companies that enter into energy contracts are related to market value of equity. The Emerging Issues Task Force of the Financial Accounting Standards Board ruled in November 2002 to ban the use of mark-to-market accounting for energy contracts out of concern that fair values can be easily inflated. We find that the excess of fair value over original value of energy trading assets and energy trading liabilities is not relevant for valuation. It may be inferred that fair values which are subject to management estimates and not verifiable are poor signals of worth and performance (Watts, R., 2003. Conservatism in accounting Part I: Explanations and implications. Accounting Horizons 17, 207–221).     

IFRS Ten Years on: Has the IASB Imposed Extensive Use of Fair Value? Has the EU Learnt to Love IFRS? And Does the Use of Fair Value make IFRS Illegal in the EU?

Abstract

This paper is a commentary on issues related to the first decade's mandatory use of International Financial Reporting Standards (IFRSs) in the EU. Three specific but related questions are addressed, as in the paper's title. On the first (imposition and use of fair value (FV)), I conclude that the International Accounting Standards Board has not substantially extended the use of FV in its 15 years of work and that most companies hold few assets or liabilities on the FV basis. On the second question (adoption in the EU), I analyse a consultation exercise which strongly suggests that the EU's imposition of IFRSs will continue. On the third question (legality of IFRSs), I explain why recent UK legal opinions that question the legality of reporting under IFRSs are not persuasive.     

Goodwill impairment as a reflection of investment opportunities

We exploit a unique opportunity to examine whether goodwill impairment write‐offs reflect firms’ investment opportunities during the first years of the US goodwill impairment accounting regime. We find that impairment write‐offs are negatively associated with firms’ underlying investment opportunities. We also find associations between goodwill impairment write‐offs and traditionally applied leverage, firm size and return on assets variables, although the leverage and firm size results are less robust. The results support the International Accounting Standards Board and Financial Accounting Standards Board contention that an impairment test regime can reflect firms’ underlying economic attributes, while simultaneously indicating that managers use discretion to reduce contracting costs.     

Market Value Margin für die Fair Value-Bilanzierung versicherungstechnischer Verpflichtungen : Ableitung auf Basis des CAPM

The International Accounting Standards Board (IASB) started a project on Insurance Accounting to apply the principles of fair value to insurance businesses. The so called ?asset and liability approach“ would focus on the balance sheet, with both assets and liabilities being reported at fair values, while income and expenses are defined in terms of changes in the values of those assets and liabilities. Indeed, there are no deep and liquid markets for insurance liabilities. Thus, the fair value has to be calculated as a theoretical value, using assumptions concerning future events, risk provisions and discount rates. Both in theory and in practice a generally accepted modelling of fair value is missing. Particularly with regard to the deviation of a Market Value Margin (MVM), which reflects the premium that a marketplace participant would demand for bearing the uncertainty inherent in the cash flows, there is a need for adequate modelling. Transforming the CAPM for determining risk loads in insurance will mean measuring the correlation between insurance companies’ returns from underwriting and market returns on its shareholders’ equity. The criticism on an underwriting beta focuses on (a) the basic assumptions of the CAPM, (b) the absence of active markets for insurance liabilities and (c) the unreliability of estimating underwriting betas.