University of Amsterdam
Amsterdam Business School
MSc Accountancy & Control, variant Accountancy Faculty of Economic and Business, University of Amsterdam
Financial reporting quality of leases
A case study of value relevance regarding the proposed
lease standard
University of Amsterdam
Accountancy & Control
2013 – 2014
Master Thesis in Accountancy
Author:
Faisel Ramdas
Date of final Version: 10 July 2014
Student #:
10043349
First Supervisor:
Dr. Sanjay Bissessur
1 Content of thesis
Preface ... 3
Executive summary ... 4
Chapter 1 Introduction ... 6
1.1 Background information of lease standards ... 6
1.2 Research question ... 8
1.3 Motivation and contribution... 9
1.4 Research method ... 10
1.5 Summary of findings and implications ... 11
Chapter 2 Literature review ... 12
2.1 Value Relevance and leasing ... 12
2.2 Prior academic research regarding value relevance of lease information ... 15
2.3 Types of value relevance studies ... 16
2.3.1 Relative association studies ... 17
2.3.2 Incremental association studies ... 17
2.3.3 Marginal information content studies ... 17
2.4 Recognition versus Disclosure ... 18
2.5 Interest Group Theory ... 20
2.6 Standard setting (lobbying) ... 21
2.7 International Accounting Standard (IAS 17) ... 24
2.7.1 Classifications of leases ... 25
2.7.2 Accounting method for finance lease ... 26
2.7.3 Accounting method for operating lease ... 26
2.8 Leasing exposure draft 2013 ... 27
2.8.1 Lessee accounting under proposed lease standard ... 30
2.8.2 Lessor accounting under proposed lease standard ... 30
2.8.3 Project time line of new lease proposal ... 31
Chapter 3 Hypothesis and Methodology ... 32
3.1 Hypothesis Development ... 32
3.2 Research design ... 35
3.2.1 Qualitative data collection ... 35
3.2.2 Quantitative data sample selection ... 39
3.2.3 Value relevance regression models ... 40
Chapter 4 Empirical Results ... 42
2
4.2 Empirical analysis….. ... 45
4.2.1 Earnings regression model results... 49
4.2.2 Balance sheet regression model results ... 49
4.2.3 Book value and earnings regression results ... 52
Chapter 5 Conclusion ... 54
References ... 56
3 Preface
This thesis is submitted in fulfilment of the requirement of the University of Amsterdam to obtain my Master degree in Accountancy & Control. The experience obtained during the writing process of this master thesis was a great and respectful one, which provided in depth knowledge and increases my market value specifically on leases since this part of accounting is very crucial and common in today’s business world. Thus, this process requires extensive reading, motivation, planning and enthusiasm. After all these dedications, I finally managed to accomplish my dream, which is to obtain the Master degree.
First of all, I would like to thank God for giving me the strength, knowledge, perseverance
and health to accomplish this goal today, without him this would be definitely a failed project.
Secondly, I would like to send special thanks to Dr. S.W. Bissessur, who was my thesis
supervisor, for all his support, quick responses and useful thoughts during the whole process.
Thirdly, I would like to thank my whole family and friends for the support and inspiration in
every means possible during the whole master program, especially when I encounter difficulties in life.
Faisel Ramdas
Amsterdam, 10 July 2014
4 Executive summary
This research is concerned about the value relevance of the proposed lease standard in comparison to the current lease standard. The value relevance concept is mainly about the extent to which accounting information assist in market value prediction. Many prior research regarding capitalization and disclosure argue that accounting information, which is recorded or capitalized rather than disclosed is more value relevant. The current standard makes a distinction between financial and operating lease. Under the financial lease accounting model a lease is recognized on the balance sheet, whereas under the operating lease accounting model a rent charge is recognized in the profit and loss statement and discloses information about future lease payments. Thus, under current lease standard capitalization is not required for operating lease therefore we also see that many companies often structure their leases to fall within this category thereby moving away from recording related liabilities.
In May 2013, the IASB and FASB (the boards) issued an exposure draft (ED 2013/6) which contains a proposal for a new lease accounting method and was open for comment only until 13 September 2013. Under the lease exposure draft 2013, almost all leases are required to be capitalized which might provide a better reflection of the economic phenomena. Within standard setting, before a standard is issued the board engages in extensive discussions and deliberations with constituencies, this process is often referred to as “due Process”. The constituencies who participate by sending comment letters based the exposure drafts of the boards are also called the “lobby group”. As we know from prior research this group often lobby the boards (standard setters) for their own interest, therefore the Interest Group Theory (ITG) is adopted in this study.
The objective of this study is to measure the extent to which the proposed lease standard is more value relevant and to see what the incentives of the lobby groups are to participate in this due process.
In order to conduct my empirical analysis two samples are selected in this study, a lobby
sample and a peer sample. The lobby sample comprise the companies which comment on the
exposure draft 2013 whereas the peer sample comprise companies in the same type of industry and country as the lobby sample. The accounting information is retrieved from Stata and the time series is between 2001 and 2012 and comprise 30 countries from Europe and United States.
The data collection process within this study is twofold. First, the comment letters of only the preparers of financial statements (lobby group) were analyzed based on four main categories i.e. issues, reasons, effects and solution. Subsequently, this resulted in some emerging themes. This process is called the qualitative data analysis. Second, the data from both samples are retrieved from Stata and analyzed accordingly. This analysis is referred to as a quantitative analysis.
A value relevance measure is used to determine the whether the proposed exposure draft reflects the market value sufficiently. The value relevance of the exposure draft 2013 was examined with the three regression models based on the study of Hail (2013).
5
The first model comprises an earnings relation where I look at the relation between net income and changes therein affecting return as dependent variable. Second, I look at the balance sheet relation since the exposure draft is mainly about capitalizing leases thereby affecting liabilities and assets. This second model looks at the whether the assets and liabilities of a firm predict the stock prices of a firm sufficiently. Thus, by making the comparison between both samples evidence is provided, which standard is more value relevant.
Third, I look at the book value and earnings relation within both samples. Here I examine whether book value of equity and net income predicts market value more easily and effectively.
The obtained results provide evidence that accounting information under the exposure draft 2013 is more value relevant compared to accounting information under current accounting model. Results from the regressions that were performed on the firm-year observations corrected for scale effects suggest that the financial lease accounting (ED2013/6) model is more value relevant and therefore will assist investors in a more sufficient way to predict a firm’s market value. There is also evidence that the firms who lobby the boards are focused on their own interest instead of public interest. To this end, these firms have great incentive to lobby the boards since they are concerned about a drop in their market value and financial ratios due to capitalization requirements of the exposure draft 2013.
Key words: value relevance, current lease standard, exposure draft 2013, capitalization, disclosure, interest group theory, lobby group, peer sample.
6
Chapter 1 Introduction
1.1 Background information of lease standards
Accounting for Leases is a major Financial Accounting Standards Board (FASB) and International Accounting Standards Board (IASB) convergence project. Generally, convergence refers to the process of narrowing differences between IFRS and the accounting standards of countries that retain their own standards.
This thesis focuses mainly on recent literature that can be related, directly or indirectly to the proposed changes by IASB and FASB in lease accounting. This review is particularly timely, as the comment letter period on the latest Exposure Draft (ED) on lease accounting recently closed (September 2013) and the FASB and IASB will be finalizing the content of the accounting standard in the near future.
Since 2006, the IASB and the FASB have been engaged in a joint project to develop a new single approach to lease accounting resulting in all assets and liabilities arising from a lease recognized in the balance sheet (or statement of financial position). ‘The objective of the lease project is to develop a standard that establishes the principles that lessees and lessors shall apply to report useful information to users of financial statements about the amount, timing and uncertainty of cash flows arising from a lease (Barone et al. 2014).
Finally, in May 2013 the latest Exposure Draft (ED/2013/6) of Leases was published by the International Accounting Standards Board (IASB) which is about to replace IAS 17. This draft requires firms to provide a more complete and understandable picture of a firm’s leasing activities and the associated rights and obligations. Current lease accounting standards classify leases as either operating or finance leases. Operating leases do not require recognition of lease assets or lease liabilities on the balance sheet. Proposed changes to lease accounting would require a lessee to recognize assets and liabilities for most leases over 12 months and may improve the quality and comparability of financial reporting of the entity. Within the participation process (due process) 640 comment letters were received representing companies, NGOs, accounting standards boards, government regulators, professional bodies, accounting firms and academics and individuals. Initial analysis of the comment letters reveals that most respondents are not in favour of the changes to lease reporting (Barone et al., 2014).
Since commenting within this participation process is costly and time consuming it is assumable that the firms which commented have significant interest in the revising process of the new lease standard. Within this thesis the focus will be on value relevance of accounting information with respect to the firms which commented on the proposed standard.
More specifically, the objective of this study is to examine to what extent users of financial statements can use accounting information to determine the market value where lease standard is regarded as a piece of accounting information. Value relevance is the ability of financial statement information to capture or summarize information, that affects share values and empirically tested as a statistical association between market values and accounting values (Hellstrom et al.2006).
Generally, if more relevant information is recognized rather than disclosed this should improve financial reporting. In case of the proposed lease standard most of the leases will be
7
capitalized, which will provide a better view of the risk profile, debts and ratios of the firm. Finally, this picture is more relevant and easier for investors to predict future market value. A value relevance measure of Hail et al. (2013) is used to determine the accounting quality of the lease accounting models. Value relevance is closely related to the concept of earnings quality, since it uses changes in share prices surrounding earnings releases to measure the extent to which financial statement information assist investors to predict future firm value. Many prior studies provide empirical evidence concerning value relevance of accounting information such as Earning per Share (EPS), Net Assets Value Per Share (NAVPS), and Return On Equity (ROE) and Price Earnings Ratio (P/R) to Share Prices (SP). However this study will focus on leases to determine value relevance of financial reporting, thus it extends prior studies. In this respect Vijitha et al. 2014 shows that earnings and book values simultaneously are relevant information in explaining stock prices.
Oyerinde (2009) investigated the value relevance of accounting data to determine if there is a relationship between accounting numbers and share prices among top 30 companies in the Nigerian Stock Market (NSM) over the years 2001 to 2004. He explained the correlation between accounting information such as EPS, ROE, Earning Yield (EY) and Market Price per Share (MPS). Germon et al, 2001 conducted another analysis of NSM consisting top 30 companies from 2001 to 2004. They found that the relationship between share price and EPS is high but the ROE is very low. Svenson and Larsson (2009) examine the value relevance of earnings in Sweden. Earnings and market values from 30 companies and over 10 years from 1999 to 2008 were collected for this study. They found that earnings are value relevance and earnings can explain 9.3 percent of the market return in Sweden.
Abayadeera (2010) tested the value relevance of financial and non-financial information in high-tech industries in Australia with a sample size of 91 companies running through various sectors of the Australian economy. His studies showed that value relevance declined in earnings but increase in book value. He also found, with overall evidence, that the book value is the most significant factor and earnings are the least significant factor in deciding share prices in high-tech industries in Australia. This study further supports other studies which showed that value relevance declined in book value but increase in earnings.
The value relevance of the lease accounting models within this thesis was examined with a regression model based on the Hail (2013) model. Since the comment letters are provided only by those who have incentives regarding the revision of the lease standard to lobby for or against the standard, the interest group theory will be adopted to examine this study.
Due to the fact that this topic is ongoing and interested in a broad setting this thesis will provide valuable insights and extend prior studies in this respect. This thesis also has practical relevance, because it examines whether the comment letter process of the FASB and IASB is a properly working mechanism. The standard setters rely a lot on this comment letter process, but how useful is this system when participants mostly react in their own interest instead of in an objective and reliable way.
This study shows that firms that engaged in the participation process on a particular standard do not comment in public interest, but in their own interest. So the comments received by the standard setters do not only include objective feedback, but also a lot of self- interest, which makes it difficult to estimate how effective a new standard will be.
8
The rest of section 1 will cover the research question, motivation of this study, abstract of the research method and a brief summary of the findings and implications. In section 2 the literature review regarding value relevance of lease, standard setting process and the lease exposure draft 2013 will be discussed. Section 3 will describe the development of the hypothesis, dataset and the research design in a broad setting. Section 4 and 5 will cover the results and conclusion respectively.
1.2 Research question
This study examines to what extent the leasing exposure draft 2013 improves the accounting quality of financial reports. More specifically, I will look at how the accounting information is perceived by the firms who lobbied in respect to the prediction of market value of a firm. Many prior research found that current lease standard specifically operating lease does not provide full information about assets and liabilities because of the off-balance sheet issue and therefore leading investors to make false prediction of economic values.
Because the new leasing standard is still in a development phase, it is a challenging project to examine how the new standard is going to affect the quality of financial reports.
Basically, this examination is about whether the companies which provide comments on the proposed standard perceive the standard as value relevant or not.
In this case, it is about examining the effects of capitalization of lease assets and liabilities. This is the case because the proposed standard requires capitalization of almost all leases on balance sheet which refers to capital lease. Biondi et al 2011 clearly states that the new model seeks to report all leases on the balance sheet based on the present value of lease obligations without any bright line tests, and no sharp on or off the balance sheet classifications.
Current accounting standards for leases (FASB No. 13), Accounting for Leases, issued in 1976, and IAS 17, Leases, issued by the IASC in 1982, adopt an ‘‘ownership approach’’ based on the extent to which risks and rewards incident to ownership of a leased asset lie with the lessor or the lessee (Biondi et al 2011). Accordingly, a lessee should recognize both an asset and a liability for a lease that transfers substantially all benefits and risks incident to the ownership of property, and a lessor should recognize such a lease as a sale or financing. Vice
versa, a lease that does not transfer substantially all benefits and risks incident to the
ownership of property is classified as an operating lease by the lessee. Under operating lease classification, the lessee does not recognize any elements of the lease on its balance sheet rather, the lessee recognizes rental expense as it becomes payable. Although both standards have been amended several times, their most recent versions retain the ownership approach to the accounting for leases contained in the original standards, especially the fundamental distinction between ‘‘finance’’ and ‘‘operating’’ leases.
The exposure draft seeks to shift lease accounting from an ‘‘ownership’’ model to a ‘‘right-of-use’’ model. According to the right-of-use model, at the start of a lease, the lessee obtains a right to use the underlying asset for a period of time whereas the lessor has provided or delivered that right. Under the current ownership model, leases can be reported on balance sheet (finance leases) if certain tests are met, or off balance sheet (operating leases) if those tests are not met. Accounting for leases within the Right-of-use model would mean that a lessee would recognize an asset representing its right to use the leased asset for the lease term
9
and a liability representing the lease payments that have to be made to the lessor. This proposed accounting method is very similar to the current financial lease accounting method.
Based on the similarities or differences between the current accounting model and the proposed accounting model regarding capitalization, I will empirically examine whether the new standard improves accounting quality and therefore predict market values sufficiently. Moreover from an investor’s perspective, this study mainly focuses on value relevance of accounting information in order to predict market values.
This indication of value relevance is obtained by conducting an empirical study by using the proposed lease standard as a piece of extra accounting information in the prediction of market values. The main question in this respect is formulated as follows:
To what extent do companies who lobbied perceive the proposed lease standard to be value relevant in determining their market values?
1.3 Motivation and contribution
Accounting information plays an important role in valuing economic transactions. Consequently, the role of accounting information for firm valuation is subject to an ongoing debate.
Accounting standard setters view providing information that is useful for existing and potential investors, lenders, and other creditors to estimate the value of a reporting entity as a primary purpose of financial reporting (IASB 2013). Therefore, this study provides further evidence with regard to the value relevance of the proposed lease standard.
Originating with Ball and Brown (1968), academics in accounting and finance have extensively studied the relation between capital markets and financial statements, creating a rich body of research on the value-relevance of accounting numbers, equity valuation and fundamental analysis, the processing of accounting information by market participants, etc. (for overviews see, e.g. Kothari 2001, Richardson et al. 2010). However since the proposed lease standard of 2013 is still recent this study also contributes by providing recent evidence especially by using leasing specifically as a part of accounting information instead of accounting information as a whole.
By answering the formulated research questions this study can provide valuable insights and facts that will be useful in the current discussion between the standard setting Boards, users of financial statements and the preparers. Evidence from empirical academic research on lease accounting may be useful to regulators and their constituents as they re-deliberate reporting standards for lease transactions (Lipe et al 2001).
Leasing is now on the active agenda of the IASB. According to Beattie et al 2006, a major difficulty faced by standard setters lies in overcoming the preparer/user lobbying imbalance and obtaining ex ante evidence on the likely impact of regulatory reform. This paper contributes to the ongoing international debate by conducting an empirical examination on the accounting information of preparers to assess their views on proposals for lease-accounting reform and on the potential economic consequences of their adoption.
There are also limited studies available which specifically looks at value relevance of lease information to statement users. This study will add further insights and fills the gap in
10
existing literature. According to Biondi et al.(2011) several key leverage and capital ratios may be affected and interest coverage ratios would decline, but measures such as EBIT and EBITDA would improve because rental expense would be reclassified as interest expense, including the amortization charge. Therefore, this study might provide clear facts using the value relevance concept to determine the future market values of the sample firms since KPI’s and ratios are the core elements users are using to make their future capital decisions. To my knowledge, there are no studies yet which specifically examine value relevance with regard to the lease exposure draft 2013 from a company perspective. The companies, which engage in the lobbying process, certainly have a great incentive since this process is costly and time consuming. So therefore this study extends prior research and provides evidence regarding the main reasons why these companies perceive the exposure draft to be value relevant or not.
Capital providers and other stakeholders frequently estimate the intrinsic value of equity (book value) based on expected future performance and risks. Lipe et al. 2001 states that the analysis often uses measures of current and past earnings in developing expectations. This thesis will therefore also provide insights and evidence from a different perspective due to the fact that the new leasing standard (i.e. is similar to current finance lease) will be used as a part of accounting information to determine market values. In this respect, I will specifically look within leases if the requirement for companies to provide an information signal (i.e. capitalization of all leases on balance sheet) under the proposed standard, will actually help investors to predict market values. So therefore, the value relevance concept is very crucial in this thesis.
1.4 Research method
Following the aforementioned research question, the accounting quality of the proposed lease accounting method is examined using a value relevance metric of Hail (2013). Hail et al 2013 estimate four models for the concurrent relation between market value and accounting numbers, and then examine the pattern in explanatory power over time. Within the participation process, the boards received 640 responses including companies, associations, accounting firms and academics. Through these letters, they explained their specific concerns and vision regarding the proposed standard.
The 640 comment letters, which are published on the IASB website, are analyzed and regarded as a signal which companies provides to indicate their interest in the standard. These comment letters were analyzed based on 4 main categories i.e. issues, reasons, effects and solution. The focus is only on the comment letters that are provided by preparers of accounts due financial data availability and the underlying purpose of this study. Moreover, by participating in the due process of the standard these preparers showed direct interest since they will bear the costs, so therefore their incentive whether to change or retain current standard is expected to be high.
Finally, the financial data for the preparers are retrieved from Stata and analyzed accordingly. Value relevance of accounting information is one of the basic attributes of accounting quality (Francis et al., 2004). It is measured as the ability of financial statement information to capture or summarize information that affects share values (Francis and Schipper, 1999).
11
Therefore, by comparing the value relevance of financial accounting information of companies that engage in the commenting process (lobby group) and accounting information of companies in the same industry and country (peers), it is possible to assess whether capitalization of leases leads to higher accounting quality. In this respect, it will also become clear whether capitalizing all leases on balance sheet indeed can assist investors to predict market values more easily.
1.5 Summary of findings and implications
This study covers the value relevance of the proposed exposure draft 2013 compared to current lease standard.
The findings from this study support the opinion of the Boards that capitalizing all leases could result in more relevant lease information for investors and contribute in the discussion between the Boards and statement preparers who are against the right-of-use model. The explanatory power under all three models showed that the lobby group exceeds their peers in this respect. Furthermore, the lobby group showed a somewhat significant decrease in the last five years (2007 -2012) towards the release of the exposure draft 2013. This evidence means that current accounting information with respect to leases does not sufficiently assist in the prediction of a firm’s market value thus is of low value relevance. Consulting the beta coefficients under the earnings relation, I find no relation between independent variable and dependent variable because these were zero across all years. The beta coefficients under the balance sheet model showed on average lower values for assets and liabilities for the lobby sample opposed to their peers. The lower values mean that these lobby firms overall display low value relevance. Under the book value and earnings relation I find also a lower trend for the lobby groups under the book value (BV) variable, however, the under the net income per share (NIPS) variable a significant higher trend compared to their peers is noticed. Since net income is dependent on the level of liabilities the lobby firms are very concerned about the exposure draft because this will cause more liabilities on balance sheet thereby negatively affecting net income. Due to the high positive coefficients of NIPS, a decrease in net income will lead to a decrease in market values.
Finally, the sample size of the lobby group, the exclusion of the qualitative data analysis with respect to value relevance issues of the preparers and the non-industry type approach are considered some implications of this study.
12
Chapter 2 Literature review
2.1 Value Relevance and leasing
In recent times, the value relevance of financial information has been increasingly concerned by the researchers (Hellstrom, 2006). Current accounting earnings and current firm values are conceptually related, and reported accounting numbers contain information relevant for equity valuation. This gives rise to the so-called association or value-relevance studies (see, e.g. Francis and Schipper 1999, Holthausen and Watts 2001, Kothari 2001), which test for a contemporaneous correlation between accounting numbers and measures of market value. Value relevance is one of the basic attribute of quality of the financial statements. Value relevance is overall measured by the earnings response coefficient, which is the slope coefficient in a regression of the market returns on earnings.
The value relevance of accounting information can be examined by looking at the correlation between accounting information and the result in the capital markets. This is done by regressing accounting information data on share prices with the purpose to assess whether the accounting information are reflected systematically in stock market valuations.
The concept of the value relevance of accounting information is defined as ‘‘the ability of accounting numbers to summarize the information underlying the stock prices, thus the value relevance is indicated by a statistical association between financial information and prices or returns’’(Jianwei and Chunjiao, 2007). Barth et al. 2011 describes value relevance as an empirical operationalization of relevance and reliability because an accounting amount will be value relevant, i.e., have a predicted significant relation with share prices, only if the amount reflects information relevant to investors in valuing the firm and is measured reliably enough to be reflected in share prices.
Based on these views value relevance can generally be described as “how well accounting information reflects information used by equity investors in valuing a firm”.
Value relevance can be measured through the statistical relations between information presented by financial statements and stock market values or returns.
Listed companies use financial statements as one of the major medium of communication with their stakeholders. Generally accounting information should increase the knowledge of users and give decision makers the capacity to predict future actions.
In many studies, Ohlson model (1995) has been adopted to explore relationships among the market value of equity and two main financial reporting variables, namely the book value of equity per share (represents balance sheet) and earnings per share (represents income statement). Basically average investors are focusing on earnings but some sophisticated investors may demand extra or detail information to conduct further analysis and this information may be sometimes in the disclosures (footnotes). By using the leasing concept we recently have a situation where companies sometimes have specific lease information either on their balance sheet (finance lease) or in the footnotes (operating lease). Within this paper predicted market values of firms will be analyzed by the leasing concept as a piece of accounting information.
The value relevance of the proposed lease standard is determined by analyzing the accounting information of the companies which lobbied for or against the standard.
13
Value relevance is an important topic of numerous accounting studies and has different interpretations. It is important to cover these different interpretations and the different concepts of value relevance because the topic “value relevance” is vital in this study.
Francis et al.1999 described four different interpretations of the value relevance theory. The
first interpretation is that financial statement information leads stock prices by capturing
intrinsic share values toward which stock prices drift. Under this interpretation value relevance can be measured by the profits obtained through accounting-based trading rules. Under the second interpretation financial information is value relevant if it contains variables that are used in a valuation model or helps in predicting these valuation variables. For example, the value relevance of earnings used in a discounted dividend valuation model, or a discounted cash flow valuation model can be measured through the ability of earnings to predict future dividends or future cash flows.
The third interpretation is based on the concept that value relevance is determined by a statistical association between financial statement information and security prices or returns. This statistical association measures to which extent investors actually use the information to determine security prices, implying that value relevance is measured by the ability of financial statement information to change the total information mix in the marketplace. Under this interpretation information in financial statements is value relevant if it conveys “new” information which causes investors to revise their expectations resulting in a change of security prices. Implementing this interpretation in an empirical setting therefore requires taking into account the linked concepts of the timeliness of information and the formation of expectations by shareholders.
The fourth interpretation is also based on a statistical association, which specifically focuses on the association between accounting information and market values or returns over a long time window. Under this interpretation value relevance is measured by the ability of financial statements to capture or summarize information, regardless of source, used by the market to determine security prices. A significant statistical association between the accounting information and market values might mean that the accounting information is correlated with other information used by investors. This interpretation does not require financial statements to be the earliest source of information for information contained in these statements to be value relevant. It is consistent with the idea that financial statements are value relevant either through accounting information content that delivers new information or through a disciplinary role that verifies more timely disclosures.
Within this paper, the fourth interpretation is adopted for analysis of accounting information. The comment letters within the lobbying process can be seen as an information signal by the companies, therefore these are used to investigate the value relevance of lease information under the latest exposure draft 2013. Based on the assumption that the draft will improve overall accounting quality, the focus of this study is to assess whether the proposed lease accounting method does a better job in summarizing the effect of a lease transaction on firm value.
According to Barth et al. (2001), examining the value relevance of a lease accounting method can give an indication if capitalizing leases fulfills the objective of the Boards. A test of value relevance is one way to operationalize the criteria of relevance and reliability.
14
The primary purpose of the financial statements is to provide information about a company in order to make better decisions for users particularly the investors (Germon and Meek, 2001). Therefore, stock market regulators and accounting standards setters trying to improve the quality of financial statements in order to increase the transparency level in financial reporting. Financial Statements will consist of different type of information such as financial information or accounting information and non-financial information or non-accounting Information.
For years, users of financial statements, academics, and standards setters alike have criticized the current lease accounting standard as unnecessarily complex and ineffective in portraying liabilities arising from lease contracts in the balance sheets of lessee enterprises (Monson et al.2001). Since 2006, the IASB and the FASB have been engaged in a joint project to develop a new single approach to lease accounting resulting in all assets and liabilities arising from a lease recognized in the balance sheet (or statement of financial position). The objective of the lease project is to develop a standard that establishes the principles that lessees and lessors shall apply to report useful information to users of financial statements about the amount, timing and uncertainty of cash flows arising from a lease (Barone et al. 2014). Information is useful only if an accounting amount is relevant to financial statement users and it is capable of making a difference to user’s decisions. Current lease standard (IAS 17), especially operational leases shows that it provides low value relevance to investors due to the absence of assets and liabilities on balance sheet. To this end, investors are not provided with a full understandable and true economic picture of the underlying enterprise which may lead to inappropriate investment decisions. Although investors can adjust the financial statements to reflect the effects of operational leases, this might still negatively affect value relevance since these adjustments are arbitrary and often based on estimates and are also costly. Off-balance funding can lead to major distortions of the debt position of a company; therefore analysts/investors adjust the financial statement for these off-balance sheet items, i.e. by capitalizing the operational leases (Goodacre, 2001). Analysts/investors use the additional information disclosed as a footnote to the balance sheet as the starting point for their alterations. For many types of accounting adjustments the disclosed information is relatively limited.
The proposed standard as presented by the boards will capitalize all lease assets and liabilities on balance sheet which will fairly present all rights and associated liabilities of the firm. In this respect the financial statements can readily be used by investors without any adjustments and it is perceived to have captured all relevant information (i.e. key performance indicators) which will increase value relevance. As mentioned earlier, in the exposure draft (IASB/FASB, 2013) the boards stated that the goal of the new leasing standard is to establish principles that report relevant and representationally faithful (reliable) information regarding lease activities, to give statement users a complete and clear view of a firm’s lease portfolio. This objective is mainly achieved by the new standard through the recognition of all leases on the balance sheet.
If an accounting standard’s recognition, measurement and disclosure requirements produce information that is relevant and faithfully represented, the value relevance of the accounting information should increase with its adoption (Ahmed et al. 2013).
15
2.2 Prior academic research regarding value relevance of lease information
Most empirical research on financial reporting of leases concentrates on the lessee's use of operating versus capital lease accounting. The term operating lease accounting method means that the lessee recognizes rent expense on the income statement and does not recognize lease assets or lease liabilities in the balance sheet. Under the alternative capital
lease accounting method, the lessee initially recognizes a lease asset and a lease liability in
the balance sheet and subsequently records interest expense on the liability and depreciation expense on the asset. On average, lessees seem to prefer operating lease accounting, and much of the empirical research investigates the implications of unrecorded lease commitments (Lipe et al 2001). In addition to assessing risk, decision makers frequently estimate the intrinsic value of equity based on expected future performance. The analysis often uses measures of current and past earnings in developing expectations.
A common and often controversial decision faced by standard setters is the determination of information location, specifically, whether to recognize particular amounts on the face of the financial statements or disclose the amounts in accompanying footnotes. One rationale for relegating amounts to the footnotes is that the information is less reliable due to significant uncertainty associated with measurement of the amount (Johnson and Storey 1982).
The existing literature presents contradicting results about whether the value relevance of accounting information has decreased or increased over time. Recent empirical studies have revealed that value relevance of accounting information has declined over the past few decades (Khanagha, 2011; Perera & Thrikawala, 2010). Core et al. (2001) claim that the U.S.A. entered to a New Economy Period and traditional financial variables do not affect firm value in that period. They tested this claim for the period 1975-1999 and concluded that the ability of traditional financial variables to explain firm value decreased. Marquardt and Wiedman (2004) investigated the effect of earnings management on the value relevance of net income and book value in determining equity values. They observed a decline in value relevance of net income and they also found that when relevance of net income is low, book value has a greater effect in determining stock prices. Imhoff et al. (1993) find that, on average, net income decreases when unrecorded leases are capitalized. In contrast, operating income increases because it excludes capital lease interest expense.
Libby, Nelson and Hunton (2006) examine whether information in footnotes might lack reliability because auditors permit more misstatement in disclosed, as opposed to recognized amounts. In both the stock-compensation and lease settings, audit partners require greater correction of misstatements in recognized amounts than in the equivalent disclosed amounts. While prior literature suggests that amounts are often relegated to footnotes because they are less reliable, they found that the actual choice to disclose versus recognize can also reduce information reliability and therefore affect value relevance. In this respect, the FASB has indicated that disclosure is not a substitute for recognition, and that information that is more useful should be recognized (SFAC No. 5, FASB 1984). Davis et al. 1999, also examined whether the market values of a firm differs when accounting information is either disclosed or recognized. He provides modest and model-sensitive evidence that the recognized liabilities receive more weight than the disclosed liabilities in market value association tests.
16
Ro et al.1978 empirically examines whether the decision of the SEC taken in 1973 to adopt ASR 147 had an impact on the prices of securities. ASR 147 was issued by the SEC to improve the disclosure of leasing information (Cheng & Hsieh, 2000). The release required the mandatory disclosure of lease information that was not previously required by accounting regulations such as: the present value of the future lease commitments, the implicit interest rate used in computing the present value, and the impact on net income if such leases were capitalized (Ro, 1978). To determine if there was an impact on security price differences in stock returns he used a time series of 21 months (January 1973 till September 1974). Ro (1978) found that the disclosed lease information had an adverse impact on the prices of securities. Security prices started to be affected seven months before the decision was implemented, which indicates that market participants anticipated the effects of the decision. The lease information effect was only visible for firms that both disclosed the present value of non-capitalized financial leases together with the income effect. No significant return difference was found for firms that only disclosed the present value which means that this item did not supply investors with new information.
According to Ro this implies that either the balance sheet effect of non-capitalized leases was not substantial, or that this effect was already incorporated in the security price prior to the SEC’s disclosure decision. Ro (1978) also found strong evidence that the lease information effect is influenced by the level of risk of a firm. Results indicate that high level risk firms were more adversely evaluated by investors compared to low risk firms. Overall, the evidence suggests that companies with extensive unrecorded leases suffered declines in stock prices when lease accounting rules changed (Lipe et al 2001).
Lindsey (2006) determines whether investor’s price operating lease disclosures in the notes differently than capital lease amounts recognized on the balance sheet by examining the value relevance of operating and financial leases. He uses a regression analysis which evaluates if there is an association between the market value of equity of a firm and their financial and operating leases. Based on the results that found, Lindsey (2006) concludes that there is a significant negative relationship between operating lease liabilities and the market value of firms. Likewise, the results reflect a significant negative relationship between financial lease liabilities and the market value of firms. These results indicate that the market view both disclosed operating leases and recognized financial leases as relevant economic liabilities of firms that are similar to long term debt. Lindsey (2006) also finds that there is a difference in value relevance between the two types of leases. Investors value financial leases differently than operating leases in the valuation of a firm.
2.3 Types of value relevance studies
Over the last decade numerous accounting papers empirically examine the relation between stock market values (or changes in values) and particular accounting numbers for the purpose of assessing or providing a basis of assessing those numbers use or proposed use in an accounting standard. We call the group of papers that are at least partially motivated by standard-setting purposes, the ‘‘value-relevance’’ literature (Holthausen et al. 2001). Value relevance study can be divided in event studies and association studies. Within event studies
17
stock market reaction on some specific event (e.g. release of accounting information, CEO resignation) are analyze over a short time period around the event (several days). Whereas association studies analyze cross‐sectional association between levels or changes of accounting information and market prices measured over long-time periods (one year). To facilitate empirical analysis Holthausen et al. 2001 classify the value relevance studies in three main categories, which are:
Relative association studies,
Incremental association studies; and
Marginal information content studies
2.3.1 Relative association studies
This study compares the association between stock market values (or changes in values) and alternative bottom-line measures.
For instance, this study might examine whether the association of an earnings number, calculated under a proposed standard, is more highly associated with stock market values or returns (over long windows) than earnings calculated under existing GAAP.
These studies usually test for differences in the R² of regressions using different bottom line accounting numbers. The accounting number with the greater R² is described as being more value-relevant.
2.3.2 Incremental association studies
This study assess whether the accounting number of interest is helpful in explaining value or returns (over long windows) given other specified variables. That accounting number is typically deemed to be value-relevant if its estimated regression coefficient is significantly different from zero. Some incremental association studies make additional assumptions about the relation between accounting numbers and inputs to a market valuation model in order to predict coefficient values and/or to assess differences in the error with which different accounting numbers measure a valuation input variable. Differences between the estimated and predicted values are often interpreted as evidence of measurement error in the accounting number. For that reason those studies are called measurement studies.
2.3.3 Marginal information content studies
Marginal information content studies investigate if a particular accounting number adds to the information set available to market participants. These studies are usually short-term event studies. They research a specific event to determine if the release of an accounting number is associated with a value change of securities. A price reaction is perceives to be an indication that the accounting number is value relevant.
This study can be classified as a content (event) study since the accounting information under the proposed lease standard will be examined to see whether this standard is perceive to be more value relevant and can help investors to predict market values more easily and with more certainty. Despite the fact that Holthausen and Watts (2001) states that 94 percent of
18
value-relevance papers perform association studies (relative and/or incremental), I will still focus on event study since this suites my research properly.
To determine the difference in value relevance of the accounting numbers a version of Hail (2013) model is used. This model makes it possible to clearly determine the extent of value relevance of accounting numbers.
Based on a framework proposed by Beaver (1998), the connection between firm value and current accounting numbers flows through future expected cash flows via the dividend discount model as well as future expected accounting earnings via expected payout ratios and fundamental analysis. Hail et al. 2013, also used this framework to examine the contemporaneous association between reported accounting numbers and stock prices and returns.
2.4 Recognition versus Disclosure
Decisions about what to recognize as assets, liabilities, equity, revenue, expenses, gains and losses in firm’s financial statements, and what only to disclose in footnotes to the financial statements are fundamental to financial accounting (Barth et al. 2000).
There is an ongoing discussion whether or not disclosure is an adequate substitute for recognition. Up to now, there is no generally accepted theory of required disclosures, perhaps because there is no agreed-upon objective function for them. Recognition is required under existing standard only for capital leases whereas under the proposed standard all leases should be capitalized.
Recognition is defined as the process of incorporating an item into financial statements, while disclosures refer to information about the items in financial statements and their measures that may be provided by notes (FASB, 1984). The amount of financial reporting information that is communicated by means of required disclosures is significant, and has been increasing over time. Despite their abundance, required disclosures are frequently not well understood or analyzed incorrectly. According to Schipper et al. 2007 there is lack of a comprehensive theory of mandatory disclosures and many questions remain open as to how preparers, auditors, and users of financial reports view disclosures, particularly as compared to recognized items. In addition, even the Financial Accounting Standards Board (FASB)'s conceptual framework does not provide either a conceptual purpose for disclosures or criteria to support a sharp distinction between recognized and disclosed item.
Standard setters argue that the most useful information should be recognized, they believe that disclosure is not a substitute for recognition when an item meets recognition criteria. Consistent with this directive, prior research shows that investors find recognized values more pertinent than disclosed values (Aboody 1996, David-Friday et al. 1999, Ahmed et al. 2006).
However, it remains unclear whether reporting items are recognized because they are more relevant for investing decisions, or whether the recognition of items itself focuses investor attention to these items.
Therefore, whether recognition versus disclosure affects users decisions has been an issue of considerable interest to standard setters, practicing professionals, and academic researchers
19
(Ahmed et al 2006). Furthermore, in efficient markets1 with minimal information-processing costs, one would not expect the accounting treatment (i.e., recognition versus disclosure) to matter. However, if there are (1) costs of processing information (Barth et al. 2003), (2) systematic biases in how investors process information, such as limited attention (Hirshleifer and Teoh 2003), or (3) differences in perceived reliability of recognized versus disclosed items, this choice can matter to user. Bernard and Schipper (1994) propose that reliability is an important determinant of the decision to recognize, rather than disclose, a financial statement item. In addition, the recognition criteria contained in Australian GAAP implies that market participants will rationally infer that items recognized in the balance sheet are more reliably measured than those disclosed in footnotes. Cutter and zimmer (2003) predict and find that managers are more likely to recognize (rather than just disclose) asset revaluations when the revaluation estimate is more reliable. They also conduct an analysis of share market effects and finds that the market discounts disclosure compared to recognition of real estate revaluations. However, this effect becomes insignificant when controls for the reliability of revaluations are included in the analysis, and therefore they conclude that the value relevance of recognized revaluations is not due to recognition per se, but rather to the fact that the assets being revalued are more reliably measured.
Under current lease accounting, disclosure of assets and corresponding liabilities would suffice if these fall into the operational lease category. Therefore, this method provides false signals and may be misleading because there debt position and risk profile is incorrect especially when they have a large amount of operational leases, which appears to be off balance sheet.
The proposed lease standard 2013 indicates a switch from disclosure to recognition since this standard requires capitalization of all leases. Basically, the difference between the two lease accounting models boils down to whether a company fully recognizes lease information in the financial statements or whether it recognizes the yearly payment in the profit and loss statement and disclose information about the future lease payments in the footnotes of the financial statement. The recognition vs disclosure debate is very important for this study since this is the main difference or change between the two standards. Moreover, I am examining the value relevance of the proposed standard in which recognition is critical. Michels (2013) found that users of financial reports fixate on recognized items while failing to fully incorporate disclosed items into prices. This finding is consistent with disclosed values requiring a greater level of effort or expertise to understand and to analyze. Prior studies (e.g., Davis-Friday et al. 1999; Ahmed et al. 2006) on the value relevance of recognition versus disclosure generally assume that the value relevance of disclosed information is the same across firms and that recognition of previously disclosed accounting items affects all the firms homogenously. However, the extent to which users of financial reports understand disclosed information may differ across firms. The FASB stated that only the most sophisticated investors could understand the implication of disclosed stock option information, while individual investors and other users could not (Yu et al. 2013).
1
An investment theory that states it is impossible to "beat the market" because stock market efficiency causes existing share prices to always incorporate and reflect all relevant information. According to the EMH, stocks always trade at their fair value on stock exchanges, making it impossible for investors to either purchase undervalued stocks or sell stocks for inflated prices.
20
Ahmed, Kilic, & Lobo (2006) examine the value relevance of the reported fair values of derivative financial instruments. Specifically they examine, if investors valuate derivative financial instruments differently depending on whether the fair values of these instruments are recognized or disclosed. In 2000 the FASB implemented SFAS 133. According to Ahmed et al. (2006) this new standard required recognition of the fair value of all derivatives on the balance sheet as an asset or liability. Prior to the implementation of SFAS 133 the accounting treatment of the underlying asset, liability, or transaction to which the derivative instrument is designated, determined if derivatives were recognized at fair value in the financial statements or disclosed in the footnotes. Ahmed et al. (2006) investigate the difference in value relevance between recognized and disclosed fair values by comparing these values in the pre- and post-SFAS 133 periods. Their results indicate that the coefficient of the recognized derivatives is positive and significantly different from zero meaning that the recognition of the net fair value of derivatives is value relevant. Furthermore, the coefficient of the disclosed derivatives is not significant, suggesting that the fair values of disclosed derivatives are not value relevant in determining the market value of equity. Overall results suggest that the disclosure of derivative instrument is of less importance for the market than the recognition of these derivatives. Opposed to these views, from a preparer’s perspective, recognition under the proposed lease standard seems to be a great concern since all leases are required to be capitalized. In this respect I can assume that they are concerned that this will negatively affect their market values and leverage position. Ryan et al 2001 conduct a research on whether balance sheet recognition of operating leases would be more useful for decision-making purposes than the current disclosures of minimum lease payments.
He finds that the usefulness of lease information to decision-makers would not be reduced and might be improved by recognition rather than disclosure of all leases.
2.5 Interest Group Theory
Stigler introduced the interest group theory of regulation into economics in 1971. Subsequently, Posner (1974), Peltzman (1976), and Becker (1983) contributed to the theory, which takes the view that industry operates in the presence of a number of interest group or constituencies (Scott 6e edition, page 499). Generally, various interest groups will lobby the regulator for various amounts and types of regulation. For example, some firms may lobby against price controls whereas their customers are lobbying for them. Some managers may also lobby against a new accounting standard for their own purposes. Economic interest group theory is also known as private interest group theory.
In an economic competitive market, there are conflicts between different groups thus the benefits of one group can possibly be the expense of the other.
In other words, the interest group theory states that there are particular interest groups or constituencies that lobby for regulation that best suits their own particular needs. The political authority itself is a regulatory body established to supply an appropriate amount of regulation. This regulatory body attempts to supply regulation at a point when the demand from interest groups is large enough to warrant a reaction from the regulators. In essence, this theory describes regulation as nothing but a commodity regulated by supply and demand. Stokes, Craig Deegan (1990) has investigated the interests of audit firms to lobby on proposed
21
disclosure requirements. He found that the higher expected costs of non-conformity with legislative disclosure requirements is the major reason behind their lobbying in favour of increased professional disclosure requirements. Within the development process of the proposed lease standard it is also very clear that those companies which provide comments lobby the boards in order to finalize a standard which best suits their own needs. This participation process requires resources of time and money.
2.6 Standard setting (lobbying)
Accounting standard setters determine the rules under which organizations report their financial results to investors, creditors and other external parties.
During the late 1970’s, accounting regulators became increasingly aware that economic consequence arguments were being used explicitly in the standard-setting process and became sensitive to the ‘economic consequences’ of a change in accounting method on the behaviour of the various users (Zeff, 1978).
Since the late 1970’s, the potential impact of changes in accounting standards on interested parties has become an important influence on decisions by standard setters worldwide. Moreover, the constitutions of standard-setting bodies such as the Accounting Standards Board (UK), the Financial Accounting Standards Board (US) and similar bodies reflect this by seeking direct representation from the various constituencies of interested parties, including users, in the standard-setting process (Goodacre et al 2001). Similarly, the process itself enables interested parties to contribute formally at various stages from initial discussion paper through exposure draft to promulgation of a final accounting standard.
According to Watts and Zimmerman (1978), interested parties, including corporate managers, accountants, auditors, and investors will expend considerable resources to influence the setting of accounting standards because of the expected economic benefits they may gain. The general idea of participation is based on the cost-benefit approach. This approach basically, means that people will only take action when the expected benefits of their actions will be bigger than the costs they need to face. When calculating the expected benefits of participation, the probability that the participation will have an effect on the standard setting process is also taken into account. When this is applied to participation, firms will only lobby for a particular standard when the expected benefits of this participation process will be bigger than the costs they face during this participation process. Related to this, also the amount spent on participation will be based on the potential benefits of participation. The greater the opportunity cost of not participation, the larger the expenditure on participation will be (Sutton, 1984; Francis, 1987). To be persuasive, a lobbyist must be well informed about the policy area in which he wishes to exert influence. Therefore being a lobbyist requires a lot of information gathering, which makes the cost of participation relatively high (Downs, 1957).
Solomons et al 1978 also describes that standard-setting is not a sole technical or theoretical issue but has become a political process. Zeff et al. 1978, defines "political" as self-interested considerations or pleadings by preparers and others that may be detrimental to the interests of investors and other users, a phenomenon that has been associated with the term "economic consequences”.
22
All related interested parties like preparers of financial statements, auditors and users have different and often conflicting interests. These conflicting interests make it almost impossible to develop an accounting standard that is satisfactory to all parties. Therefore, interested parties will try to persuade the standard-setters to make rules that maximize their utility. In May 2013, the IASB and FASB issued ED 2013/6 leases, which closed for comment in September 2013. There were an initial 640 comment letters representing companies, NGOs, accounting standards boards, government regulators, professional bodies, accounting firms and academics and individuals. Since every participant is lobbying the regulator for or against regulation this is consistent with the interest group theory. Initial analysis of the comment letters reveals that most respondents are not in favor of the changes to lease reporting (Barone et al. 2014). Researchers investigating the lobbying behavior of respondents to exposure drafts in the private sector have generally found that the predominant respondents to exposure drafts are account preparers and auditors (Sutton, 1984). Account preparers are usually the most frequent respondents especially where the particular proposed accounting standard has the potential to adversely affect cash flows (Mian and Smith 1990). Auditors also respond on a frequent basis and usually adopt the position of their client (Puro 1984). Users of financial statement seldom respond to exposure draft and this low involvement can be explained by the absence of economic consequences for this group. Generally each accounting standard which is about to become effective are going through a comprehensive and independent process that encourages broad participation, objectively considers all stakeholder views, and is subject to oversight by the Financial Accounting Foundation’s Board (FASB) and/or the International Accounting Standard Board (IASB). The IASB is the independent standard-setting body responsible for the development and publication of the IFRS standards (i.e. principle based). The FASB is the standard setter for US-GAAP standards (i.e. rule-based). These two organizations are cooperating more and more to make the different accounting standards in the world more consistent with each other. The FASB’s mission is to improve U.S. financial accounting standards for the benefit of present and potential investors, lenders, donors, creditors, and other users of financial statements. The FASB believes that pursuing convergence, to make global accounting standards as similar as possible, is fully consistent with that mission. Investors, companies, auditors, and other participants in the U.S. financial reporting system should benefit from the increased comparability that would result from internationally converged accounting standards. In addition, more comparable standards would reduce costs to both users and preparers of financial statements and make worldwide capital markets more efficient. The IASB develops, in public interest, a set of high quality, understandable, enforceable and globally accepted international financial reporting standards (IFRSs) based on clearly articulated accounting principles. For convenient purposes the IASB and the FASB will be subsequently referred to as standard setters or the boards. Basically, standard setters are organizations founded for establishing standards of financial accounting that govern the preparation of financial reports. Together the Boards issued a revised Exposure Draft on Leases in May 2013.
Due to some complexities or ambiguities in the current standard to make a choice between
