Financial reporting outcomes under lobbying versus non-lobbying in accounting standard setting process : the case of lease accounting

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MA_ Masters Thesis_2013/14 Page 1

FINANCIAL REPORTING OUTCOMES UNDER LOBBYING VERSUS

NON- LOBBYING IN ACCOUNTING STANDARD SETTING PROCESS

The Case of Lease Accounting

Margaret Annan

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Master Thesis in Accounting and Control University of Amsterdam Business School

Thesis Details

Draft Version: 11August 2014

Student #: 10662979

First Supervisor: Dr. Sanjay Bissessur Second Supervisor: Dr. Sander Van Triest

Version: Final

1_{10662979@uva.nl}_{Accountancy and Control 2013-2014 Academic Year}

The author would like to thank Dr Sanjay Bissessur for his tremendous guidance and assistance throughout the thesis.

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MA_ Masters Thesis_2013/14 Page 2 PREFACE

This thesis is submitted in fulfillment of the requirement of the University of Amsterdam to obtain my Master degree in Accountancy & Control. The experience obtained during the research process of this master thesis was a respectful one. It provided in depth knowledge and increases my market value specifically on such a crucial business relevant topic as leases. This process required extensive reading, self motivation, planning and enthusiasm and after all these dedication, I managed to accomplish my dream, which is to obtain the Master degree.

First of all, I would like to thank God for the strength and enablement to achieve this goal today,

without whom I would not have had the energy to complete.

Secondly, I would like to Dr. S.W. Bissessur, my thesis supervisor, for his immense support, quick

responses and useful thoughts during the whole process and Professor Brendan O' Dwyer for his insight into current lease issues.

Last but not the least,, I would like to thank my entire family and friends for the support and

inspiration throughout the entire master program, especially not forgetting my wonderful and talented daughters, Valerie and Mirabel Annan, who helped immensely with analysis and proof reading. Margaret Annan

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ABSTRACT

One of the major projects in the convergence of FASB US GAAP and IASB IFRS has been the change of the Current Lease Standard. The two overarching reasons why boards will add a project to their agenda is firstly, when the financial report from the incumbent standard does not give an objective and complete reflection of the underlying economics and secondly when the benefit from information improvement to users exceeds the cost to preparers for providing this information. By adding lease proposal to the agenda, it means that these two conditions have been satisfied.

Since the introduction of the lease standard change in Discussion Paper DP2009, there have been reactions from different interest groups about the pros and cons of both the current and the proposed lease standards. The current standard has been criticized for allowing lease transactions to be classified as operating lease instead of capital/finance lease. Collin et al (2012) examines lease classification ratios and finds differences in their lease classification median but no difference in the dispersion of their lease classification between preparers from US GAAP and IFRS regimes. Goodacre (2003) finds the proposal significantly impacting leverage and debt covenant.

The proposed standard has been branded as “the solution” to the existing challenges of the current standards but different stakeholders have concerns about whether the boards’ objective will be realized due to its administrative complexity, economic consequence and “the duck effect”. With the boards concern about the risk of being lobbied “off course”, this research uses a hybrid of qualitative and quantitative analysis to firstly, investigate whether regime or other drivers have some influence on the lobbyist position and arguments put forward by respondents. Secondly, I empirically test if ex-post financial reporting outcomes influence lobbying decision.

I use comment letters submitted to the RED842 as dataset, content analysis, and matched pair design methodology for archival study. I compare financial outcomes over 1998 to 2012 (66569 observations) Lobbying decision is proxied as submission or non-submission of CL with predictors being Lease classification ratios and controlling for ROA, LEV, and MTB, Auditor and FIRM SIZE.

The result of the content analysis shows that the proposed standard brings visibility in the financial statement proper of preparers, but its administration and complexity is perceived to impede the accomplishment of the two prime objectives stated above. The result of the archival study show that there is no difference in the lease utilization and classification between lobbyist and non-lobbyist but there is difference in dispersion. The results also confirm the size effect of lobbying and support the existence of free riding. It also supports the regime effect as claimed by Collin et al (2012). This suggests that the issues, reasons, effects and solutions expressed in the content analysis are a representative of a wider community. The boards are urged to undertake further consultation and engagements with stakeholder groups to redress issues flagged. Future standard should be benchmarked against set objective to ensure a balance between efficiency and legitimacy. (Prada 2013)

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Chapter 1 Introduction

This paper compares the financial reporting outcomes of companies that lobbied on Lease Re-Exposed Draft Topic 842, in the proposed lease standard setting process, with a matched sample that did not lobby to see if there is a relationship between their ex-post financial reporting outcome and the propensity to lobby in a certain way.

The paper is organized as follows: Chapter 1 gives a background to and a summary of the entire research followed by a literature review in Chapter 2. The standard setting process is discussed in Chapter 3 followed by the development of hypothesis in Chapter 4. In Chapter 5 I provide the research methodology followed by analysis of data and results in Chapter 6. I conclude with a summary, limitations and recommendation for future research in Chapter 7.

1.1 Background

The increasing complexity of today’s Capital Market, the changing expectations of the actors therein, coupled with recent scandals like Enron, have mounted pressure on financial regulators (hereafter referred to as standard setters) to review and in some instances revamp accounting standards due to their “economic consequence2” (Zeff 1978).The objective of these standard setters is to develop high quality, understandable, enforceable and globally acceptable standards to ensure that the regulated firms produce transparent3 and comparable4 financial information useful for decision making, and reduce information asymmetry5.Changing accounting standards presumably create changes in the set of policy choices available to firms with implicit effect on the firms’ performance. Thus ‘the more a [proposed] standard interferes with existing contracts or reduces accounting policy choice [the more likely it is for interested and divers groups to react]’. (Scott 6e edition, p 319) or even reject the standard. Standard setters6 therefore have a challenge to weigh the cost/benefit of new standards to overcome the unwillingness of constituencies7 to accept the standard. To encourage consensus, due process mechanisms are developed and structured to engage all constituencies in a ‘delicate balancing’ act (Zeff, 1978). In other words, the responsibility of these standard setters is twofold. Firstly to find the right accounting solutions to reduce market participants asymmetry and secondly to make healthy choices among the different views of groups and individuals’ conflict of interest (Wyatt 2004, p.28).

Prada (2013) describes it as balancing efficiency and legitimacy. To this end, Standard Setters “invite individual and organization to send written comments on all matters in the Exposure Draft

2_{Zeff (1978) defines Economic consequence as the impact of accounting reports on the decision making behaviour of}

business, government and creditors. Thus accounting reports can affect real decisions of managers and others rather than simply reflecting the results of these decisions.

3

Transparency: When an information is a faithful representation of the underlying transactions

4_{Comparability: The quality of information that enables users to identify similarities in and differences between two}

sets of economic phenomena (FASB 1980, 9; IASB 2010, A36).

5

Information Asymmetry: When parties of a business transaction or potential transaction have an information advantage. Information asymmetry is twofold in standard setting and can sometimes be conflicting. The first is the asymmetry between providers of financial capital and the regulated firms and the second is between the regulators and the regulated Firms. Standards set must reduce both asymmetries for their standard to be acceptable by all constituencies

6_{Standard Setters refers to Accounting Regulatory bodies International Accounting Standards Board and Financial}

Accounting Standard Board, specifically to their convergent project

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MA_ Masters Thesis_2013/14 Page 8 of a proposed standard” (Aug 2010 ED Lease Topic 840). This gives a political tweak to the standard setting process.

One of such standard in the process of revamp by the FASB and IASB in their major convergence project is Lease Accounting8 . In 1996, the G4+1 published a report, Accounting for Leases: A new Approach advocating for a conceptual approach to lease accounting with all leases reflected in the Balance Sheet. In 2003 the SEC conducted a study on the adoption of principle based standards. They conjectured that whereas too much rules as in US GAAP provided an opportunity to circumvent the intent of a standard, too much principles, as in IFRS, did not give enough guidance or structure for exercising judgement by preparers and auditors, making legal enforcement difficult. In June 2004, the IASB and the FASB agreed that accounting for leases was in need of a fresh look following criticisms that the current standard failed to provide complete and transparent information. In 2005, the SEC issued a report on off-balance sheet activities and recommended that the existing lease accounting requirement be reviewed to ensure greater transparency in financial reporting. Several academic studies have made similar recommendations. According to FASB ‘there has been a widespread request from “users” (investors and analysts) of financial statements and other stakeholders to change the accounting guidance so that lessees would be required to recognize assets and liabilities arising from leases.’(Joint Lease Project update May 2014). In 2009 the Boards jointly proposed changes to Lease Accounting with the view to increase transparency and comparability among organizations and to ensure disclosure of key lease related information. With the global annual estimated value of leases signed being enormous ($640 billion in 2008 according to the World Leasing Yearbook of 2010), the proposal would affect a wide spectrum of industries and could impact on corporate behavior, making leases less attractive as a financing option (Fitch 9 Dec 2010). Barone et al (2014) document that any proposed [lease standard] change could potentially affect both preparers and users of accounting reports in terms of changes to financial ratios, assessment of risk and providing an audit of the accounting reports.

So what is leasing all about? Leasing is a means by which businesses in all industries: public, private, or not-for-profit organization; can gain easy access to assets, obtain financing and reduce the organization’s exposure to the risks that comes with owning an asset. Lease financing is prevalent now because it provides easy access to capital that enables businesses to acquire the necessary assets to grow their business. It covers a wide range of assets from real estate, airplanes, trucks, ships, and construction and manufacturing equipment to other assets for administrative support. According to the latest research from the Equipment Leasing & Finance Foundation- USA, total equipment and software investment for 2012 [was] expected to reach $1.28 trillion, with total equipment finance volume estimated at $725 billion, an increase of more than 9% on 2011 figures. A similar report is given by the FLA about new asset finance business in the UK which grew by 17% to £1.93bn over a period of one year to October 2012. The German Leasing Association (BDL) reported that 2012 investment in the sector totaled €49.3bn, a marginal rise of 0.5% on 2011. The auto sector accounted for most of the new equipment business transacted. In

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Lease Accounting standard SFAS 13 was enacted on 1st January 1976 by US FASB. Under UK GAAP accounting for leases and hire purchase contract was issued in September 1982, effective 1st July 1984 and amended in February 1997 as SSAP 21. Under International Accounting Standards it is IAS17 exposed in October 1980 (E19) and April 1997(E56), issued in December 1997 effective 1st January 1999, with 2 revisions in December 2003 and April 2009 with the last revision effective on 1st January 2010

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MA_ Masters Thesis_2013/14 Page 9 Germany, ‘leasing increased its share of the overall investment market, accounting for 53% of all externally financed investments.’ (Brendan Gleeson, 2013)

The proposal has received many and diverse comment letters more than during the IASC regime. This has been attributed to the directives by the European Commission for all European Union listed Companies to adopt the endorsed IFRS in Financial Reporting not later than 2005.In a recent survey by Deloitte on the perceived effect of the proposed lease accounting standards on their businesses, 284 executives reported the standards would have significant impact on debt-to-equity ratios (68%), debt covenants (44%), and the difficulty obtaining financing (40%)9. Comment Letter No. 283 puts it that ‘the proposed revised standard simply does not ensure greater transparency in the financial report for users…[and] appears to introduce a significant amount of subjectivity and judgment undermining one of the primary objective of the project.’ Assuming the perceived effects described above are representative of the leasing industry then one would expect constituents (in line with Scott p. 319) to use lobbying to influence the process and final outcome of the lease standard. Or, ceteris paribus, there will be an association between lobbying and financial reporting outcomes.

Richard Watchman, an industrial editor of Exaronews (19 Jan 2013), gives a dramatic description of the perceived controversy in the proposed lease standard. He stated that ‘powerful lobby groups and regulators are at loggerheads over how companies account for leasing liabilities amounting to billions of pounds but the IASB is committed to forcing what it sees as true borrowing levels to be identified properly’. Confronted with the reality of the power of lobbying, Hans Hoogervorst (chairman of IASB), in a speech to the London School of Economics made an appeal to interest groups to help with the lease project for fear of being ‘lobbied off course’.

"We will need all of the help we can get, to ensure that we do not get lobbied off course. We need national accounting standard-setters, regulators such as the SEC, investors and others to stand by their beliefs and help us to bring much-needed transparency to this important area," (Hans Hoogervorst , LSE November, 2012) Examples of a seemingly “off course lobbying” are seen in the case of PCAOB and AASB. ‘The PCAOB, a body created by Congress to police U.S. auditors in the wake of accounting scandals at Enron and Worldcom, recently dropped the idea of potentially imposing mandatory term limits on accounting firms after fierce lobbying by the industry’ (Reuter, April 2014). The release of AASB 1028 Accounting for Employee Entitlements followed a period of intense lobbying and debate, resulting in a standard that contained significantly less stringent requirements than those proposed in the preceding exposure draft.’

1.2 Research Question

There are different schools of thought about what propels Firms to lobby and there is extant research literature supporting diverse reasons why firms may indulge in lobbying during standard setting (see Chapter 3.4). Prior research on the economic consequence of lobbying examines behavior, size and leverage of the Companies. Watts and Zimmerman (1978) looks at the factors that influence management decision in the standard setting process. They conclude that with the

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Deloitte Survey: Only Seven Percent of Companies Are Well Prepared to Comply with New Lease Accounting Standards, Press Release, February 16, 2011

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MA_ Masters Thesis_2013/14 Page 10 exception of larger firms subject to political influence which will consider standards that reduce earnings, all other large firms will lobby if bookkeeping cost exceed lobbying cost. (see also Ang et. al, 2000; Francis, 1987; Schallow, 1995). Sutton (1984) attributes the size effect to the firms’ relatively lower lobbying costs, higher probability of influencing the process and greater benefits if successful and the outcome of the standard works in the favour of the lobbying firms. Dhaliwal (1982); Deakin (1989) on the other hand look at leverage and suggest capital structure of a firm as an important determinant of its management's lobbying position on an accounting standard. Sutton (1988); Schallow (1995); and Ang et al (2000) tested the effect of debt but, on the contrary, do not find any important correlation between debt and the process of lobbying. Burgstahler and Eames (2006) look at the causality from opportunistic perspective. They claim that big Corporations may lobby against a proposal either to influence the outcome or retain the ability to conceal unpleasant financial information or manage earnings. Another stream of research looks at the socio-political consequence by examining the language, culture, jurisdiction and legal settings (see Chapter 4.4). Among such authors are Jorissen et al (2013) who examine the effect of geographical representation of IASB constituents and cite language as a determinant for lobbying; Mora et al (2014) who examine cultural factors of the constituent’s country and cite regime as a determining factor (see Chapter 4.4). Overall, there is a lot of emphasis on those who lobby than those who do not lobby. What about those who do not lobby or the ‘silent participants’? Could they also hide behind those lobbying to conceal unpleasant financial information? Or could they save cost by free riding? Could the regime actually play a part? Georgiou & Roberts (2004) argue that during the process of lobbying, three categories of companies can be identified: those who lobby against the proposal, those who lobby for the proposal and those who don't lobby at all (see also Ws & Z, 1978).

In light of the preceding interesting but seemingly contradictory conundrum, the aim of this research is to investigate whether there is an association between the categories of Companies identified in the lobbying process by Georgiou & Roberts (2004) and Financial Reporting Outcome. This research is timely because the proposed lease standard will change lease accounting dramatically after 30 years and obviously, the boards are concerned about the possibility of being “lobbied off course”. Five years after the discussion paper, there have been over 1700 comment letters, several stakeholder engagements and focus group meetings but still no “consensus”. As of June 2014 the boards are still deliberating on aspects of the proposal.

The ensuing research questions are therefore as follows:

 Does the reporting regime influence the lobbyist position in a certain way?

 Do firms that Lobby differ in financial reporting outcome than those that do not lobby? 1.3 Motivation and Contribution

The overarching objective of the IASB/FASB convergence project has been to eliminate the variety of differences between IFRS and US GAAP. This grew out of an agreement between the boards in October 2002(the 'Norwalk Agreement'). Whereas some of the issues seem to fade quietly into absurdity, Leases, a major convergence projects, remains a ‘hot topic’ after years.

My primary motivation for this research stems from a lecture by Professor Brendan O' Dwyer at UvA Business School on the ‘hot topics’ of the joint project. In his lecture, he discussed the

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MA_ Masters Thesis_2013/14 Page 11 current issues of the proposed standard and the emerging challenges surrounding its change. He further outlined assertions by SEC (2003), David Tweedie (2008) and researches by Sunder (2009) and Agoglia et al (2007) experimental research which leads to an archival research by

Collins, et al (2012) to examine whether lease classification and dispersion varied according to Regime. I took interest in the topic and researched further into existing literature to find plausible areas to contribute to existing literature.

My second motivation was the research of Barth (2000) and Cooper and Robson (2006) in which they admonished academics to gain more insight into drivers and characteristics of participants in the standard setting process.

My third motivation was a statement made by Hans Hoogervorst:

“What’s more, the companies providing the financing are more often than not banks or subsidiaries of banks. If this financing were in the form of a loan to purchase an asset, then it would be recorded. Call it a lease and miraculously it does not show up in your books. In my book, if it looks like a duck, swims like a duck, and quacks like a duck, then it probably is a duck. So is the case with debt – leasing or otherwise.” (Hans Hoogervorst, November 7, 2012)

This statement summarizes but arouses a lot of debate on current practice, proposed standard and lobbying and gives pointers for research. Mora and Molina (2014) examine strategies for lobbying based on 302 comment letters received in response to the lease ED 2009. They use several hypotheses to look at participation and position of constituents in the standard setting process. They further examine arguments used by respondents to justify their support or objection to the standard. They conclude that preparers are the most likely group to oppose the standard due its economic consequence. Comiran (2013) also conducts content analysis on the 1421 comment letters on ED 840/842. He finds that most respondents opposed the change. The proposed lease has sparked a stream of ex-ante research on its effect on different constituents. There has also been research on the role of lobbying as just mentioned. Collins et al (2012) look at ex-post financial reporting outcome between rule based and principle based regimes but over a 2007 and 2009 using matched sample. I extend this research over a larger sample size and firm years and examine if the conclusions are reflected in preparers propensity to lobbying. I review the comment letters from a different perspective. Using both archival data and CL content analysis, I investigate the relationship between financial reporting outcomes and the propensity to or not to lobby.

This paper contributes to the ongoing international debate about the impact of the proposed lease standards and expounds the current understanding of the role of lobbying decisions in standard setting. This can help the Boards, other institutions and regulators in their deliberations on improving preparers’ engagements in the standard setting process. There is a general presumption that preparers lobby regulators ‘off course’ in a “resistance to change” manner (Hoogervorst 2012) though this may not necessarily be the case. By conducting a detailed examination of the issues, reasons, effect and solution in the comment letters I wish to reassess, demystify or otherwise, this premonition and provide information that might be used constructively by regulator or policy makers’ in future standard setting projects. I extend the archival research of Collins et al (2012) in sample size, firm years and add lobbying as a new dimension. This will increase confidence with respect to generalizability of their findings. (Collins et al p.702)

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MA_ Masters Thesis_2013/14 Page 12 1. 4 Research data Selection and methodology

To answer the research questions, I employ methodological triangulation. This approach consists of quantitative and qualitative methods which help increase the reliability and validity of the results (Banister et al 1994).In terms of qualitative approach; I carry out a content analysis on CL obtained from the FASB website. Using the KWIC approach I identify emerging themes with the main focus being on preparers. These themes are then classified as issues, reasons, perceived effects and suggested solutions. A sub-sample of 215 is further analysed against the themes for similarities and differences among preparers.

To test the hypothesis quantitatively, financial outcomes such as lease classification metrics of Collins et al (2012) as dependent variables, and ROA, MTB, AT, BIG 4, LEV, SIZE are used as control variables. This allows me to empirically verify if their conclusions are applicable to lobbying decisions. I obtain the financial data for both CL and NCL from Datastream and use Stata for the analytics. The parameters for matching the samples are similarities in industry, size and fixed assets needs. I note that variations in lease classification and other variables may not be necessarily due to the aforementioned variables. Multivariate analysis and tests are therefore conducted to eliminate myriad of factors that could create noise in the inference from this study. This includes modified Levene’s test (Levene, H. 1960), the Wilcoxon sign-ranked test (Wilcoxon, 1945), Spearman’s Rank Correlation test (Spearman, C. 1904) and Logistic Regressions.

1.5 Findings and limitations

The content analysis of the comment letters show that, in line with Jorissen et al (2013), Mora et al (2014) the decision to lobby is influenced by the regime. The direction of taxonomies put forward in the sample analysed reveals that the proposed capitalisation of leases will radically change accounting but not without economic consequence (W & Z, 1978), or inciting opportunistic behaviour in practice. The empirical analysis reveals that there is no difference in the lease utilisation or classification of CL and NCL, so we accept free riding. Consistent to prior literature I did not find enough evidence to reject difference in dispersion. In line with prior literature, I also find an inverse relationship between firm size and the propensity to lobby (W&Z, 1978). I found a difference in the both the median and dispersion of ROA. I find an inverse but weak relationship between lobbying and leverage.

Chapter 2 provides the context for the study. I discuss extant empirical literature on leasing. Then I provide theoretical framework from FASB and IASB Lease Accounting Standards for both the current and proposed standards. This leads to a review of the standard setting process, followed by discussion on the rudiment this paper which is lobbying. The stage is then set for my hypothesis from the research questions.

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MA_ Masters Thesis_2013/14 Page 13 Chapter 2 Literature review and hypothesis development

I will begin this review by briefly considering how leasing has come about in today’s business world. Organisations create value through their business model. The model takes input from different capitals and increases, decreases or transforms them through the business activities into outputs and outcomes. The dynamics of business strategy requires changes in capacity, manufacturing or operating capital base of the business, which includes assets and equipment base. In a bid to obtain or expand these asset and equipment capacities businesses usually have three choices: purchase, rent or lease. The choice made is driven by several factors including: financial issues, as a strategic tool, uncertainties, convenience, the risk of obsolescence, exposure in new market, flexibility or the need to conserve working capital (Clark, Hindelang and Pritchard, 1979). These drivers or intent may not necessarily be observable. “Leasing [..] allow a business to use an asset over a fixed period, in return for regular payments. The business customer chooses the equipment he requires and the finance company buys it on behalf of the business.” (Mumbi et al, 2014). Once a decision to lease is opted for, there are two issues to address: (1) the structure of the lease arrangement and (2) the reporting of the lease in the financial statement. There are wide spectrum lease arrangements but the two often mentioned in literature: (1) arrangement that delivers temporal usage rights and (2) arrangement that provides ownership rights. Now, the structure of the lease arrangement can influence or be influenced by its reporting and the reporting regime will also impact on reporting. Under the FASB SFAS 13/ (IASB IAS 17) current standards, leases are accounted for as: Operating or (Finance) /Capital lease. There have been a lot of debates and discussions about whether the structure of the lease agreement determines the accounting or the reporting regime10 drives the lease structure. Either way the structure of the agreement will result in the lessee capitalizing as asset or ‘debt obligation’ in the Statement of Financial Position (Balance Sheet) or treating payments as ‘current’ rental expense (Carter, 1999). Some people attribute the increase in operating lease to the fact that it increases firm’s overall borrowing capacity (Beattie et al., 2000a). Schipper (2003) a believer of the regime effect argues that, the lease reporting volatility is due to lack of ‘specificity’ in standards (Niemeier, 2008). Sir David Tweedie, former IASB chairman, in a speech in 2008 asserted that lease classification is not affected by the reporting regime, but by the substance of the transaction. Agoglia et al, (2011) conducted an experimental research using experienced financial preparers, to find out how preparers made choices in lease classification under regimes with different degrees of precision. They found out that their subjects used operating lease under more precise (FASB) standards. Collins et al (2012) extended Agoglia’s research using archival data from matched sample of members of the Fortune Global 500 under US GAAP and IFRS. They investigated the association between the regime effect – IASB/FASB and lease classification decisions. They found strong evidence to conclude that firms under US GAAP are more likely to classify leases as operating than IFRS due to differences in the degree of specificity. Dell Atti et al (2014) also examined if firms’ preference for operating lease was due to the economics of the transaction or incentive to manage earnings. They conducted multinomial logistic regression test on 99 Italian Companies and found that there were 6.6 times more operating lease than financing. They did not find any evidence to believe that their subjects used operating leases to ‘loosen’ debt-covenants rather their results suggest that operating lease are used by large and healthy companies as a strategic tool whereas finance lease is used by small and high levered firms to extend their “debt capacity”. As

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MA_ Masters Thesis_2013/14 Page 14 mentioned earlier, the current accounting rules for operating and capital lease are different with operating lease future obligations disclosed in the footnotes. It is the intention of the Boards’ with the proposal, to record all lease transactions on balance sheet (i.e., capitalize all leases with lease terms of more than one year on lessees’ books). Lease accounting standards, over several decades have grown with amendments, additional interpretations. It has also become increasingly complex to address the many provisions in lease arrangements resulting in financial statement presentation that appears to depend more on legal form than economic substance of the transaction.

With this in mind, the rest of the review chapter is organised as follows. Firstly, I provide the theoretical framework on leases from the current lease standards under IASB IAS 17 and US GAAP original lease standard of SFAS 13 (codified ASC 840). It is structured in terms of the main features of current lease standard. I then mirror the structure of the features discussed for the proposed standard ending with a comparative table of the 3 standards. The preceding discussions clarify why ‘lobbying’ is important for this research. I then explain the standard setting process in general and the lease standard setting process in particular. This is followed by another literature review on lobbying and its role in standard setting process. Finally I introduce the hypothesis I will be testing to answer the research questions.

2.1 Current Lease Accounting

The current rules for financial accounting and reporting of leases under US GAAP is inconsistent with the rules under IASB. Whereas SFAS 13 is rule based with “bright lines” on recognition, classification and disclosure of leases, IAS 17 is principle based allowing for professional judgment. SFAS 13 defines a lease as an agreement that conveys the right to use property, plant, or equipment usually for a stated period of time. IAS 17 on the other hand defines a lease as an agreement whereby a lessor conveys to the lessee in return for a payment or series of payments the right to use an asset for an agreed period of time.

2.1.1 Lease Determination and Classification

SFAS 13 requires a lessee to recognize both an asset and a liability for a lease that transfers substantially all benefits and risks incident to the ownership of property. It sets out a quantitative threshold for distinguishing between a capital and an operating lease which depends on the substance of the transaction rather than the legal form. A capital lease is a non cancelable leases that meet any one of following general criteria (transfer of ownership, bargain purchase option, lease term ≥ 75 percent useful life, present value of future lease obligation ≥ 90 percent of asset’s fair value). IAS 17 on the other hand gives a qualitative threshold that requires judgment. Under IAS 17, a finance lease ‘is a lease that transfers substantially all the risks and rewards incidental to ownership of an asset. A finance lease term is for a major part of the economic life of the asset and the present value of the lease payment should amount to substantially all the fair value of the leased asset. Under both regimes, operating leases are excluded from the balance sheet of a lessee and the rent payments are expensed on a straight line basis. Capitalized assets under both regimes are depreciated over the lease term by the lessee. The liability on the other hand is classified as long Term Finance Lease liability. As the lessee fulfils their payment obligation, total payment is apportioned between interest expense in the Income Statement and repayment of principal in the balance sheet.

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MA_ Masters Thesis_2013/14 Page 15 2.1.2 Lease Recognition

Initial and Subsequent Treatment of finance/capital lease by a lessee are similar for both regimes. At the inception of a lease arrangement, a lessee is expected to recognize the underlying asset and liability of a finance lease in the Statement of Financial Position. This is measured at an amount equal to the fair value of the leased property or, if lower, the present value of the minimum lease payments plus any unguaranteed residual value. This is calculated using the interest rate implicit to the lease as the discount rate if practicable or otherwise, the lessee’s incremental borrowing rate. Any initial direct costs of the lessee are added to the amount recognised as an asset. The lessee, subsequently records depreciation expense on the asset over the lease term and interest expense on the liability

With regards to the operating lease the treatment in terms of initial and subsequent recognition are similar in both regimes. There is no initial recognition in the statement of financial position unless there are incentives like deferred payments or cash back. Rent expense under an operating lease accounting method is recognised on a straight-line basis on the income statement over the lease term unless another systematic basis is more representative of the time pattern of the user’s benefit. Incentives are capitalized and allocated to the repayment amount to ensure a straight line recognition of lease obligation.

. Concerning current requirement for variable lease payments, leases with variable lease payments do not require adjustment to the lease liability when payment tied to an index or rate change. However changes in rate and indices are reflected in payments as they occur with favourable and unfavourable impact on lease expense.

2.1.3 Disclosure Requirement

SFAS No. 13 requires lessees to disclose in the financial statement or footnotes at each reporting date the gross amount of assets recorded under capital leases as of that date. This is classified according to nature or function, future minimum lease payments as of that date, in the aggregate and for each of the five succeeding fiscal years, the total minimum sublease rentals receivable in the future under non-cancelable subleases as of the date of the latest balance sheet presented as well as the total contingent rentals (rentals on which the amounts are dependent on some factor other than the passage of time) actually incurred for each period for which an income statement is presented. IAS 17 requires a schedule of lease obligations split in three categories of up to one year, two to five years and over five years to be disclosed in the notes to the account..

2.1.4 Current Lease Accounting Impact Assessment

Biondi et al (2011) documents that off balance sheet financing over the period of 1980-2007 represented 745% of total debt increased and that if leased assets were brought onto the balance sheet over that period, average debt-to-capital ratios would increase by 50-75%.This is consistent with the findings of Durocher (2008) about the effect of operating lease capitalization on lessees leverage ratios. (see also Ashton, 1985; Imhoff, Lipe and Wright, 1991, 1992; Bennet and Bradbury, 2003).The current lease accounting standards is also criticized as allowing economically similar transactions to be accounted for very differently because of the distinction between operating and finance leases. This invariably makes it difficult for investors to compare different entities and the implications of different leases and potentially provides opportunities to

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MA_ Masters Thesis_2013/14 Page 16 structure transactions to achieve a particular accounting outcome. According to Jamal and Tan (2010) management under both regimes can use renewal options, terms and contingent payments to get round the intent of the standard. The lack of symmetry between lessees and lessors of the same contractual arrangement has been criticized as also reducing comparability and consistency. Hans Hoogervorst asserts that “investors take an educated guess to determine the hidden leverage from leasing.”

2.2 Proposed Lease Accounting

The objective of the proposed lease standard is to improve the quality and comparability of financial reporting by providing greater transparency about leverage, the assets an entity uses in its operations, and the risks to which [a firm] is exposed from entering into lease transactions. (IFRS Foundation, May 2013). Leslie F. Seidmanon the other hand explained that “The proposal is responsive to the widespread view of investors that leases are liabilities that belong on the balance sheet,” so the two boards “have worked together to develop a revised, converged proposal to address the inadequacies of current lease accounting and disclosures.” According to David Tweedie ‘..[FASB/IASB] proposals would result in better and more complete financial reporting information about lease contracts being available to investors and others. The section outlines the proposed changes and some of the perceived effect of the proposed lease standard on financial statement. The subsections are organized similar to that of section 3.1 to ease comparison.

2.2.1 Lease Determination and Classification

A lease, under the proposal, is defined as ‘a contract that conveys the right to use asset (an underlying asset) for a period of time in exchange for consideration’ (Lease ED 2013/6). The term right to use implies that the fulfillment of the contract depends on the use of an identified asset; and the contract conveys the right to control the use of the identified asset for a period of time in exchange for consideration. The lessee must also have the ability to derive benefits from the use of the identified asset. The lessee is expected to recognize a right-to-use (ROU) for all leases arrangement, except they elect at the inception of the lease to apply the recognition exemption for a maximum possible term of 12 months or less. This will be a simplified requirements that are similar to existing operating lease accounting standards is. Depending on the business model, some leases may have service or ancillary elements. The board distinguishes between a lease and a service contract. This is done using observable stand alone price in line with IFRS 15 Revenue Recognition. If the standalone price for any component is not available then the lessee will combine and accounted for as leases.

The revised exposure draft proposes a dual approach to recognition of lease expenses. It bifurcates leases into two classification namely type A and type B. It presumes an asset type (property or non property) based on the lease term in relation to the economic life of the asset, and payment in relation to the fair value of the asset. The determining factor between a Type A and Type B lease is the “level of consumption” of the asset’s value by the lessee during the lease term otherwise known as the consumption principle. The boards uses a rule of thumb: leases of assets other than real property would be treated as Type A leases by default unless one of the following is true: the lease term is insignificant compared to the total economic life of the asset, or the present value of the minimum lease payments is insignificant compared to the fair value of underlying asset. On the other hand, leases of real property (land and/or a building or portion

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MA_ Masters Thesis_2013/14 Page 17 thereof) are Type B Leases unless: the lease term is significant compared to the remaining useful life of the asset, or the present value of the lease payments amounts to substantially all the fair value of underlying asset (Figure 1). The Boards do not however quantify the terms “insignificant,” “major,” or “substantially all,” Companies therefore have to make their own judgments to justify the classification.

Figure 1: Lease Classification Model for Leases by Lessee (IASB May 2013)

2.2.2 Lease Recognition

Once the existence of a lease in a contract is identified, the lessee will initially recognize a ROU asset and a lease liability for its future lease obligation. This will be measured at the present value of lease payments. Payment arrangement may differ with different contract even with the same lessor or type of lease and the treatment is different from the current rules under both regimes. Variable lease payments linked to an index or a rate is included but those linked to sales, performance or use of the asset is excluded. The Lessor will at the inception of the lease derecognize the carrying amount of type A lease, recognize residual residual asset and lease receivable. Any resulting profit or loss will be recognized in the Income statement.

Subsequent measurement over the lease term and treatment will depends on whether the lease is type A and B lease. Type A leases liability will subsequently be measured on amortised cost basis whilst the ROU asset will be measured on a systematic basis, by the lessee, to reflect the pattern in which the lessee expects to consume the assets future economic benefit. This replaces the rent expense in the current standard with amortised expense of the capitalized asset and interest expense in line with the time value of the lease payment liability. In the income statement the unwinding of the discount on lease liability will be shown as interest expense, separately from the amortization of the ROU expense. Type B lease liability will be subsequently measured on an amortised cost basis. The ROU asset will be amortised in each period on a straight line basis over the lease term. In the income statement a single lease cost will be charged, made up of the unwinding of the discount on the lease liability and the amortisation of the capitalized right-of-use asset. Figure 2 below shows the income statement recognition pattern. Type A will result in frontloading with a downward trend and type B will result in straight line pattern for a lessee. The lessor will subsequently recognize an increase in lease receivable being an increase in unwinding of interest income (constant rate over lease term) and decrease in carrying amount to reflect lease payment, The residual asset will grow by an equivalent of the lessees interest income.

The Red cylinders represent Type A lease.

Over the lease period it is expected that relative to the economic life of the asset, substantially all or a more than significant portion of the asset will be consumed in the lease. Mostly Equipments and Vehicle Leases

The blue cylinders represent Type B lease

Over the lease term it is expected that relative to the economic life a less that insignificant portion of the asset will be consumed. Mostly Property Leases

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MA_ Masters Thesis_2013/14 Page 18 Re-measurement is required annually for the contingent rentals and residual value guarantees under an expected-outcome approach. Interest-and-amortization (I&A) approach applies if the lessee consumes a more than insignificant portion of the leased asset’s life. Under this approach, interest expense is accrued on the lease liability and the ROU asset is amortized over the life of the lease. Otherwise, the single-lease-expense (SLE) approach applies, with lease costs reported as a single line item on a straight-line basis and ROU asset amortization equal to lease costs less interest associated with the lease liability for a given period. If the SLE approach applies, minimal (or no) effects can be expected on the income statement and statement of cash flow. Where the I&A approach applies, interest expense will be based on a lease liability that declines over time, resulting in a front loading of the lease expense. In other words, a higher total lease expense (interest and amortization) than the currently reported rent expense, decreasing net income. Since total expenses related to the lease remain unchanged over the course of the lease’s life, the overall impact on net income will reverse in later years. In the statement of cash flows type ‘A’ lease payments will be treated as financing cash outflows. Type B leases operating lease rent payments are treated as operating cash flows. Though the focus of this thesis is on lessees it is worth mentioning that the changes in lessor accounting is symmetrical to changes being proposed in lessee accounting. Proposed treatment of variable lease payment will result in positive or negative changes in the lease liability (debited to expenses) without a corresponding symmetrical effect on the ROU asset.

Proposed Lease Accounting Overview

Figure 2: Lease Accounting and Recognition (IASB Lease Snapshot May 2013)

2.2.3 Disclosure Requirement

The objective of the proposed disclosure requirement is to assist information users to understand the amount timing and certainty of cashflow arising from leases. The lessee is required, at the end of the reporting period, to disclose a reconciliation of the opening and closing balances of the type A and type B lease liabilities. This is however optional for none public lessees. A lessee shall also disclose a maturity analysis of commitments for none lease components related to a lease showing undiscounted cashflow on an annual basis for each of the next five years and a total of the remaining years. Another disclosure requirement is an overview of the nature of the lease arrangement and the significant judgment and assumptions used to record all lease arrangements.

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MA_ Masters Thesis_2013/14 Page 19 2.2.4 Implementation

The proposed lease document RED 842 provides additional guidance in a master glossary to help explain terms that may seemingly be gray and to ensure consistent interpretation. It also provides operational examples some of which are industry specific as well as lease accounting guidance. Table 1 displays the key highlights of the current US GAAP and IFRS standard and the Proposed Lease standard. In terms of implementation, there is no grandfather clause with prospective approach but rather a full or modified retrospective approach. A grandfather clause allows the current status of something pre-existing to remain unchanged, despite a change in policy which applies in the future.

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Table 1: Key Highlights of the Current & Proposed Standards

Leases SFAS 13 (Codified 840) IAS 17 Proposed Lease Standard

Regime Rule Based Principle Based Principle Based

Classification Model based on the transfer of risk and reward of ownership

based on the transfer of risk and reward of ownership based on the nature of the underlying asset and the right to exchange

Recognition Approach Single Approach Single Approach A dual approach

Variable lease Payment: Reassessment Criteria

Reassess the lease if there is a change to the terms of the lease arrangement

Reassess at change in index or a rate used to determine the variable lease payment (contingent rent) and at year end

Lease classification criteria

Transfer of ownership A. Ownership is transferred by the end of the lease term

A. Ownership is transferred to the lessee by the end of the lease term

Dual + Consumption Approach: Based on Consumption of underlying asset

Bargain Purchase Option B. Lessee has an option purchase at the price lower than the fair value

B. Lease contains a bargain option and it is reasonably certain that the option will be exercised

Incentive Method: Include when economic incentive Exists Lease Term C. 75% rule - Lease term ≥ 75% of economic life

of the leased property

C. Lease Term is for the major part of the economic life of the asset

Type A: Substantially All the economic life of the Asset Type B: Less than a significant portion of asset life Lease Payment D. 90% rule - Present value of minimum lease

payments > 90% of fair value of the leased property

D. The Present Value of the minimum lease payment is at least equal to substantially all of the fair value of the leased asset

Present Value of lease payment discounted using lessees incremental borrowing rate. Include amount payable in optional renewal term

Specialised Asset E. The leased Asset are of a specialized nature such that only the lessee can use without modification

Classification Model Capital if A-D are satisfied or Operating Finance lease if any of A - E above are satisfied All leases are Capitalized expect Short Term- Type A & B

Accounting by lessee

Income Statement Presentation

Operating lease: Rent is charged to expense by the lessee

Recognize Lease Expense and Interest Expense Type A: Amortization of ROU and Unwinding Interest on liability Type B:Single Lease Expense

Balance Sheet (SFP) 1. Capital Lease: Recognized as an asset and a liability by the lessee.

2. Disclose Operating Lease as Foot Notes

1. Capital Lease: Recognized as an asset and a Financial liability. Depreciate Asset over Economic Life/Lease Term. 2.Operating Lease as Footnote

Type A and B: ROU asset and Lease Liability

Accounting by lessor

Income Statement Presentation

Operating lease: Recognize Rental Income Recognize Lease Income under Income on a Straight-line basis

Type A: Interest Income+ Profit at Inception Type B:Rental Income

Balance Sheet (SFP) 1. Derecognized Capital Lease Asset +

Recognize Lease Receivable + Unearned Interest. 2. Maintain Operating Lease + Depreciate

1. Derecognize Finance Lease Asset + Recognize Lease receivable + Unearned Interest Income

2. Maintain Operating Lease Asset + Depreciation

1. Type A: Derecognize Asset + Recognize Lease Receivable + Residual Asset + accretion of lease 2. Type B: Recognize Asset Impact of classification

model on income statement

US GAAP rarely permit decelerated amortization of asset

Finance Income = Constant Periodic Rate of Return on Net Investment

Amortization of ROU on a decelerated basis- Frontloading Expense for Type A

Disclosure Requirement Lessee & Lessor

Disclosure Nature, Timing & Amount of Cashflows of lease & Lease Obligations in 3 Timing Periods

Nature, Timing & Amount of Cashflow of lease & Future Minimum lease payment obligation in 3 Timing Periods- Reconciliation of Lease Balances - Restrictions imposed by lease arrangements–Contingent rentals expensed

Nature of lease arrangements - Reconciliation of Lease Asset - Short-term leases - Not capitalized expenses related to lease contracts - Amount and timing of future cash flows - Risk analysis of the undiscounted lease cash flows

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MA_ Masters Thesis_2013/14 Page 21 2.2.5 Proposed Lease Accounting Impact Assessment

The proposed lease has generated a lot of literature, discussions and research from around the world examining the impact from the perspective of different constituents. Researchers have mostly focused on the ‘ex ante impact analysis. The following are some results from such research on the perceived effect of the proposed lease standard.

Preparers Perspective

Bennett and Bradbury (2003) studied the effect of capitalising operating lease on reported liabilities and debt, current and ROA ratios of 38 New Zealand companies. They concluded that it would result in a significant increase in leverage but a decrease in liquidity and profitability. Goodacre (2003) investigated the perception of UK retail companies about capitalizing operating lease and concluded that it would have a negative effect on performance ratios. He argued that retail companies would circumvent this effect by substituting long rentals with short and more flexible ones. In 2009 Duke et al. in their research demonstrated that companies would misclassify as operating lease to enhance earnings, income and key ratios. Beckman and Jevis (2009) in their study of US construction and engineering industry agreed with capitalizing operating lease. They recommended a single model of lease capitalization as better for financial statement analysis. Fito et al. (2013) looked at the effect of capitalization from Spanish Companies perspective over a 3 year period up to 2010. They note Spain as having a lot of lobbying activities to either change or cancel the proposed standard as demonstrated in their comment letters (www.fasb.org;

www.iasb.org). They also conclude that capitalization of operating lease will significantly affect capital structure and debt covenant with a consequential effect on leverage ratios. They extend the analysis over a longer window and confirm Goodacre (2003) conclusion that companies will try to avoid the new regulation. Amanino Mckenna (2009) looked at the effect on EBITDA and argues that by significantly inflating Financial Position, companies will appear more highly leveraged and lessee's compliance with its debt covenants may be impacted. EBITDA would likely increase since lease expense will be replaced with interest and depreciation expense, both of which are not included in EBITDA.

Market Perspective

Lim et al.(2003), compared the impact on debt rating and new bond yields for 6800 firms over 19 years ending 1999 and concluded that, though operating lease reduces debt ratios, its location would not matter to bond yields as bond yields reflects off balance sheet disclosures. In line with Lim et al. (2003), Sakai (2010) compared market reaction capitalizing operating lease in comparison to prior disclosures on finance lease information. He concluded that footnote disclosures were adequate from the market’s perspective and that there was no difference between recognition and disclosure. Hales et al (2012) in an experimental research show that inclusion of the renewal options and contingent payments in lease liability does not only have negative effect on the debt capacity of companies but also decreases the reliability of financial statement. This was counteracted by Cotton et al (2013) with conclusion that rating would become more accurate under the proposed standard. Sengupta and Wang (2011) hypothesized that credit agencies consider off balance sheet in their analysis. They however did not find any empirical evidence to support the inclusion of operating lease on balance sheet. Dhaliwal et al. (2011) investigated whether the accounting treatment of leased assets and obligations affected market participants’ perception of

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MA_ Masters Thesis_2013/14 Page 22 their economic substance. They supported the assertion that enhanced disclosures with the current treatment would be better than capitalizing operating lease. Bratten et al. (2013) also concluded that capital market participants have the capacity to and they do process recognized (Finance lease) and disclosed (operating lease) information similarly. In a survey conducted by Beattie et al. (2006a,b) investment analysts and financial analyst agreed that deficiencies in the current standard could lead to similar transactions being accounted for differently.

Other Concerns

Durocher and Fortin (2009) examined the preference for capitalization from the users’ perspective and concluded that users are more advantaged to the proposal from a cost-benefit perspective. Grossman and Grossman (2010) are of the opinion that the complexity of the new accounting requirements could cause lease contracts to be avoided. The proposed lessee model is could trigger lessees to reconsider their lease versus buy decisions, thus negatively impacting the leasing industry. Singh (2011) suggests that firms will face a critical decision to reduce or continue leasing assets. Should lessees decide to buy then future growth of businesses could be slowed down or limited, as a result, especially for quickly growing firms, also inducing income volatility.

From the above review, it is worth mentioning that both the market and preparers do not perceive the proposed lease standard as having much relevance especially if it will come with an overwhelming cost but users may benefit from the capitalization of all lease obligations. Thus preparers and users differ in perception on the proposal.

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MA_ Masters Thesis_2013/14 Page 23 Chapter 3 Standard Setting Process

As indicated in section 2, the IASB/FASB follow a rigorous, comprehensive and independent open consultation process commonly referred to as ‘due process’ in order to develop any new standard. The aim is to encourage participation of all stakeholders and provide transparency into the process. All activities are held in public and are usually webcast. The two key documents which govern the IASB's activities are the due process handbook and the IFRS Foundation Constitution. The FASB’s activities are documented in the rule of procedures handbook

Standard Developing Process

. The due process is operationalised in a six step approach for both IASB and FASB. It is the duty of the trustees to ensure compliance at various points throughout. Figure 3 shows the 6 stages of the due diligence process. In some circumstances there are two additional stages as explained below.

Figure 3: Due Diligence Process of IASB/FASB

The project starts with a research program (issue of discussion paper, request for information or research paper) to identify and encourage debate on possible financial reporting matters, elicit comments from interested parties, collect evidence on the nature and extent of perceived shortcomings and assess possible ways of resolving the issues identified. Different interested parties participate in the process including academics, standard setting bodies and associations. Depending on the outcome the boards will decide whether or not to add a project to its standard-setting agenda. The boards outline two main circumstances under which a project is added to their agenda. The first reason is when ‘current financial reporting information is not portraying an objective and complete reflection of the underlying economics.’ The second is ‘when the expected improvement in the quality of the information provided to users—the benefit—justifies the cost of preparing and providing that information.’ They acknowledge that ‘Financial reporting comes at a cost—the cost to prepare, provide, and audit the information.’(FASB)

Setting the agenda Planning the Project Developing and Publishing the discussion paper Developing and publishing the Exposure Draft Developing and publishing the standard Post Impleme -ntation

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Figure: 4 Standard Developing Process (adopted from IASB)

Figure 4 above briefly describes the rest of the process. The conflict that results in standard setting is because investors want an ‘open window’ into corporations whilst corporate executives want a ‘closed door’. (The Summa by Professor David Albrecht, Jan 2010). Standard setters have a role to draw the line in such a place so as to serve as an effective compromise between them and achieve their overall objective. As mentioned earlier, ‘the [boards] solicit views and suggestions through its consultations with a wide range of interested parties and formally invite the public to comment on discussion papers and exposure drafts. The ‘Comment letters play a vital role in the [the boards] formal deliberative process. To be responsive to views received in comment letters, the [the boards] posts on the website a summary of its position on the major points raised in the letters, once they have been considered. In addition the [boards] responds to the main issues raised in comment letters’ (IASB Due Process Handbook)

3.1 Lease Standard Setting Process

This section provides timeline for the lease project. A discussion paper (2009 DP) titled ‘Lease: Preliminary view’ was issued on 19thMarch of 2009 outlining proposed changes to the lease accounting standards and inviting for comments till 17th July2009. “2009 DP” introduced the ROU model. In line with the due diligence process, the boards undertook several consultation, deliberations and outreaches meetings both public and private, fieldwork meetings, public roundtable discussions, in comment letters. In total 302 comment letters were received for “2009 DP”. Based on feedback received, the boards, on August 17, 2010 issued a joint exposure draft

Financial reporting outcomes under lobbying versus non-lobbying in accounting standard setting process : the case of lease accounting