Amsterdam Business School
What is the potential impact of the proposed lease accounting
changes on financial statements?
Evidence from Dutch listed companies
Date 13-06-2014
Student name Vivian Schoonderbeek Student number 10463089
Supervisor dr. Georgios Georgakopoulos 2nd supervisor dr. Sanjay Bissessur
Abstract
The purpose of this research was to investigate the potential impact on the financial statements after capitalizing operating lease commitments. As a result from this, another aim was to find out how significant this impact would be on the financial ratios. Most prior research on capitalizing operating lease commitments has been undertaken on US data. The total sample consists of 106 observations from Dutch listed companies. Before determining the impact on the financial ratios, the lease liability and asset after capitalization has to be calculated. This calculation is based on the research of Imhoff et al. (1991). The first action, according to Imhoff et al. 1991, is to calculate the lease liability based on the present value of the future cash flows. Second, based on the outcome of the lease liability the lease asset can be estimated. To apply the new estimated lease liability and asset, the impact on the financial statement can be calculated. The findings of this research show that all three ratios decreased, due to increase in lease asset and liability. The consumer discretionary, financials, and industrials sector will be affected the most, as they have a larger amount of operational lease commitments.
Contents
1 Introduction 4
2 Literature review 7
2.1 Convergence of IASB and FASB 7
2.2 Current leasing standard 8
2.3 Current effects on the financial statements 11
2.4 New leasing standard 12
2.5 Hypotheses development 14
3 Sample and methodology 15
3.1 Estimating the lease liability 16
3.2 Estimating the lease asset 18
3.3 Estimating the income effect 20
4 Results 22
4.1 Impact on financial statement positions 22
4.2 Impact on financial ratios 24
4.3 Hypotheses – rejection or acceptation 28
5 Conclusion 30
1
Introduction
On 17 August 2010 International Accounting Standards Board (IASB) and the Financial Accounting Standards Board (FASB) published joint proposals to improve the reporting of lease contracts. The boards ensured that, if proposals adopted, they would improve the financial reporting information available to investors about the financial effects of lease contracts. The IASB and FASB received 800 comment letters on this exposure draft. Critics found that some elements of the proposal were too complex. The proposed changes would also have a significant impact on the presented result and equity of companies reporting under the International Financial Reporting Standards (IFRSs).
Based on the comment letters and other feedback the IASB and FASB have made new proposal, which was published on May 16th 2013. The revised exposure draft outlines the proposed changes for accounting for leases (EY, 2013). This proposal aims, by providing greater transparency about leverage, the assets of the organisation and the risks to which it is exposed from entering into leasing transaction, to improve the quality and comparability of financial reporting.
The proposed new standard would replace IAS 17 Leases, IFRIC 4 Determining whether an Arrangement contains a Lease, SIC-15 Operating Leases – Incentives and SIC-27 Evaluating the Substance of Transactions Involving the Legal Form of a Lease. Subsequently, there would be significant consequential changes to the IAS 40 Investment Property (KPMG, 2013). Since this release date, critics have 120 days to give feedback on the new proposal. Based on this, a definite standard that will be included in both IFRS and U.S. GAAP will be established. However, this new lease standard will not be in force for 2016.
Under the existing accounting standards, many of these leases are not reported on the balance sheet. It is now the case that lessees and lessors need to classify their leases as either finance lease or operating lease and to account for those differently. For finance leases, a lessee recognises lease assets and liabilities on the balance sheet. For operating leases, a lessee does not recognise lease assets or
failing to meet the need of users of financial information because they do not always provide a faithful representation of leasing transactions.
The key objective is to provide greater transparency around the company’s leasing transactions (KPMG, 2013). This new standard ensures that lessees recognise the assets and liabilities arising from leases. However, not every lease obligation has to be recognized on the balance sheet. An exemption is made on leases with a maximum term of 12 months or less. The research of Imhoff et al. (1991) notes that there are in certain industries no long-term operating lease commitments, but that they do appear to be an important source of financing in industries. Now, more than 20 years later most of the operational lease commitments are long-term.
Companies have to consider how this standard will affect their business practices. Implementing this new standard will be a real challenge for many organisations, as they would need to identify all their leases, make new estimates and judgements, and perform new calculations. Not only will have the new standard some implications for lessees and lessors, it will also influence the lending process for credit providers. Due to the fact that lessees and lessors will have other balance sheet and financial statement numbers, different ratios will arise. This could have an effect for the users of the financial statements for their decision making.
Due to the fact that the developments on this standards change so quickly, and there is no definitive standard yet, there is only little research done in the under Dutch listed companies. This research is a contribution to prior literature, because it identifies the latest developments of the exposure draft 2013 and the impact this has on the financial statement for Dutch listed companies. The purpose of this research is to examine the potential impact of the proposed lease accounting changes on the balance sheet numbers and financial statements from the point of view of the lessee. To test this impact, the following research question can be formulated:
What is the potential impact of the proposed lease accounting changes on financial statements?
The following sub-questions will also be answered: 1. Why do organizations choose operational leases?
2. What is the impact of the proposed standard on the balance sheet and financial statements?
3. Do these changes have a significant impact on financial ratios?
To make this research more ‘vibrant’ the new standard will be applied to a company of the sample, this will give an indication of the impact on the balance sheet and financial statements. Furthermore, these calculations are done for 106 different companies in 10 different sectors. By doing so, the research will be applicable for more different kind of companies in different sectors. This should give more insight of what the consequences are of the new leasing standard if it is actually implemented in 2016.
This research shows that capitalizing lease commitments have a significant impact on the balance sheet and financial statements. Followed by significant changes of the debt to asset, return on assets and debt to equity ratios. Companies in the consumer discretionary, financial and industrial sector will be affected the most because of companies in these sectors rely more on large operational lease commitments. Within these sectors the operational lease commitments consist mostly of vehicles and equipment rather than buildings.
The next section summarizes the prior literature and will also give some more information about leases in general. The third section describes the methodology that is used for this research and an example for the calculation of capitalizing operating leases. The fourth section presents the results of the main empirical analysis and the final section gives an overall conclusion.
2
Literature review
The following section explains the meaning of the IASB and FASB and why they converge together. Furthermore, it provides an overview of the current leasing standard and finally the demonstration of the new standard for leasing and the related discussion.
2.1 Convergence of IASB and FASB
The International Accountings Standards Board (IASB) is an independent, private sector body that develops and confirms International Financial Reporting Standards (IFRSs). In 2001 this Board was formed to replace the International Accounting Standards Committee. The second relevant party is the Financial Accounting Standards Board (FASB), which is a private, not-for-profit organisation. The FASB is responsible for setting generally accepted accounting principles (GAAP) for public companies in the United States.
The IASB and the FASB have been working together since 2002 to achieve convergence of IFRSs and US GAAP (Carmona, 2010). They tried to remove the differences between those standards embodied in a Memorandum of Understanding, also known between the boards as the Norwalk Agreement. The expectations are that the two sets of standards both improve the quality of the financial statements and becoming similar. The final projects are: revenue recognition; financial instruments; insurance; and leases. This research will only pertain to leases.
The current accounting standards for leases FASB 13 issued in 1976 and IAS 17 issued in 1982 adopt an ownership approach (Biondi et al. 2011). This is based on the extent to which the risks and rewards incident to ownership lie with the lessee of the lessor. For example, a lessee should recognize both asset and liability for a lease contract that transfers all benefits and risks to the ownership of property. In addition, a lessor should recognize such lease as a sale or financing. On the other side, when a lease does not transfer all benefits and risks to the ownership of property it is classified as an operational lease. Under this method the lessee does not recognize any elements of the lease on its balance sheet, but will
2.2 Current leasing standard
Both standards require the same reporting disclosures of the minimum lease payments arising from capital and operational leases. Beside, both standards require for capital leases the same recognition of the present value of the minimum lease payments in the balance sheet. The last accordance between the two standards is the requirement of disclosures of the minimum annual lease payments over the next five years for both capital and operational leases.
Given their similarities there are a lot of differences between the two standards. The US GAAP provides a more classic bright-line rule for determining whether a lease should be classified as capital or operating lease, which leaves little to no room for own interpretation. In contrast to the IAS 17, this is a more principle-based standard. Denton et al. (p. 2012) showed in their research the differences on how leases are classified as a capital leases between the two standards.
Table 1 Lease classification criteria: comparison IAS 17 and US GAAP
IAS 17 US GAAP
Transfer of ownership
The lease transfers ownership to the lessee by the end of the lease term
The lease transfers ownership of the property to the lessee by the end of the lease term
Bargain purchase option
The lease contains a bargain purchase option, and it is reasonably certain that the option will be exercisable
The lease contains a bargain purchase option
Lease term The lease term is for the major part of the economic life of the leased asset
The lease term is equal to 75 percent or more of the estimated economic life of the leased property
Lease payment The present value of the minimum lease payments is at least equal to substantially all of the fair value of the leased asset
The present value of the minimum lease payments to be paid by the lessor equals or exceeds 90 percent of the fair value of the leased asset
Specialized assets The leased assets are of a specialized nature such that only the lessee can use them without major modifications being made
As table 1 shows the standards are different from each other in two major ways (Denton et al. p. 705, 2012). First, the US GAAP has a bright-line quantitative threshold. It uses quantitative criteria to measure the lease terms related to the estimated life of the asset and the present value of lease payments relative to the fair value of the asset. The US GAAP requires capitalization when the lease term is equal to 75 percent or more of the estimated life of the asset. Unlike the IAS 17, which requires capitalization when the lease term is for the major part of the asset’s useful life. Based on the lease payments the US GAAP requires the present value of the minimum lease payments equals or exceeds 90 percent of the fair value of the leased asset, where the IAS 17 requires that it is at least equal to substantially all of the fair value of the leased asset. The IAS 17 leaves room for own judgement, where the US GAAP are more strict rules.
Another difference between the two standards is that IAS 17 must meet a lot of different criteria to classify as a capital lease compared to US GAAP (Denton et al. 2012). These criteria are specified in table 1. There are three other factors that suggest a lease might be a capital lease, namely, cancellation costs, residual value risk and bargain renewal option. The cancellation costs cover the costs of the lessor if the lessee terminates the lease. The residual value risk concerns the gains or losses for the lessee that is a result from the fluctuations in the fair value of the residual. The bargain renewal option gives an indication that the lessee has the ability to continue the lease for a rent that is lower than the market rent.
The US GAAP requires capitalization of a lease when at least one of the four criteria from table 1 is satisfied. If none of these criteria are met, the lease will be classified as an operational lease. This operational lease causes the fact that lease accounting has been criticized over the past years. The major criticism on the current standard is that through operational lease not all of the lease obligations are recognised in the balance sheet. This leads to a less accurate picture of reality.
The researchers Imhoff et al. (1991) find that capitalizations of operating leases have a significant effect on risk and return measures. They used a sample of only 14 firms and found that averages decrease of 34 percent in return on assets and an average increase of 191 percent in debt-to-equity ratios. The very similar research by Beattie et al. (1998) came to the same conclusion as Imhoff et al.
(1991) but with a sample that was much larger, namely 232 firms. This research indicates that operating leases represent an average of 39 percent of total debt and 6 percent of total assets. They re-calculated different ratios like profit margin, return on assets, return on equity and assets turnover, which were significantly affected by capitalizing operating leases.
A more recent research of PricewaterhouseCoopers (2009) shows that by using a sample of 3,000 companies, reported interest-bearing debt in 2008 would increase by 58 percent after adjusting for operational leases.
Some other numbers from the SEC Report in 2005, the undiscounted total non-cancellable future payments required under operational lease financing for U.S. companies would be around €1.25 trillion.
In the article of Biondi et al. (2011) they stated that according to the World Leasing Yearbook 2010, leasing activity in 2008 amounted to €640 billion, while the assets and liabilities arising from those contracts are not shown in the balance sheet.
As the research of Franzen et al. (2009) demonstrates, off-balance sheet lease financing as a percentage of the total debt increased with 745 percent. This research was conducted from 1980-2007. Franzen et al. (2009) shows that if these leased assets were brought onto the balance sheet over this time period, the average debt-to-capital ratios would increase by 50-75 percent.
The overall advantage of operational leases depends on the firm’s circumstances. According to Goodarce (2003) operational lease is most beneficial for companies when the equipment will not be used for long-term; this is also the case for equipment that becomes very quickly outdated. For example, technological advances that makes equipment obsolete every year. Another reason for choosing operational lease is when the company’s cash flow is tight or if the company want to protect their balance sheet, because it increases the debt and reduces the available cash. Final, one of the most popular advantages of operational leases are the potential tax benefits. An operational lease is treated as an operating expense during the period. However, if the company purchases equipment, it has to deduct the interest and cost of depreciation.
2.3 Current effects on the financial statements
Capital leases have a bigger impact on the balance sheet, income statement and cash flow statement instead of the operational leases. At the start of a capital lease, the lessee will recognize on the balance sheet the equipment as an asset, and a liability, for an amount that is equal to the present value of the minimum lease payments. The leased asset will be depreciated consistent with the lessee’s usual policy for deprecating assets. For the operational lease no assets or liabilities are recorded.
The income statement for a capital lease payment includes two elements: the interest expense and the principal payment (Imhoff et al. (1993). In the first years the interest component will be higher consistent with an amortized loan. The payment of operating leases will be treated as an operating expense.
The cash flow statement remains the same under and capital and operating leases (Imhoff et al. 1993). The cash flow from operations will be overstated as it contains only the interest component of the capital-lease expense. When at the same time the cash flow from financing activities will be understated as the principal payment will be included as a cash outflow.
The off-balance sheet treatment results in improved liquidity and solvency ratios. By reducing the denominator in the return on assets (ROA), which is total assets, it enhances the measure of profitability. Given the fact that there are significant benefits of classifying leases as operating leases, lessees and lessors might structure their leases as operating leases on purpose. However, accounting for operating leases understates the assets and liabilities of lessees, which lead to a false impression of the assets and liabilities in the financial statements. Many users have to adjust the financial statements of lessees for the effect of operating leases (Denton et al. 2012). These adjustments are usually based on own estimates and can, therefore, be incomplete or inaccurate. Over the years, companies have tended to structure most leases as operating leases (Bryan, Lilien and Martin (2010).
2.4 New leasing standard
In the third quarter of 2010, the IASB and FASB came with their first exposure draft of a new standard on lease accounting. The exposure draft proposed a fundamental change in accounting for lease contracts providing a new accounting model for both lessees and lessors. The Boards introduced a “right-of-use” accounting model, which implies that both lessees and lessors recognize assets and liabilities from lease contracts (Biondi et al. (2011). To recognize the leased assets, the leased item will be measured initially at cost, which equals the present value of the lease payments and to recognise a liability the leased item will be measured initially at the present value of the lease payments (Shough, 2010). In this way the new standard would eliminate operating leases, except from the lease contracts that will have duration of less than twelve months.
The proposals define a lease as, “A contract that conveys the right to use an asset (the underlying asset) for a period of time in exchange for consideration” (IFRS, May 2013). There is a wide diversity of lease transactions, which all can be accounting differently. The new exposure draft proposed a dual approach to recognition, measurement and presentation of the cash flows arising from a lease. It makes a distinction between the nature of the underlying asset in the lease, if the underlying asset is property or not. The first proposed type of lease is Type A, which applies for most leases of assets other than property. This could be for example equipment or vehicles. For leases of property, a lessee should classify the lease as Type B. The difference between the calculation of Type A and Type B leases is the measurement of the right-of-use asset after initial recognition and the effect in the income statement (IFRS, May 2013). Between the two types it will give a different balance sheet amount throughout the years, but on total level it will be the same. This also applies to the lease expenses.
In this research there is no distinction made between Type A and Type B, because on total level there is no difference between the two types of leases.
In the article of Knubley (2010), there are some reasons given for the proposed change. First, the author explains that leasing is an important source of finance to business. “It is therefore important that lease accounting provides users of financial statements with a complete and understandable picture of an entity’s leasing activities” (Knubley, 2010, p. 322). The author also mentioned that because of the way leases are currently treated in the financial statements, many leases remain off-balance sheet. This causes that analysts have to make their own assessments about the assets and liabilities arising from lease contracts. However, the most significant change will be that lessees will be required to recognise assets and liabilities under operational lease on the balance sheet (Knubley, 2010).
Besides the positive feedback, there are still a lot of companies that are not so pleased with this new standard. The objective in the exposure draft states that the proposed standard is “to report relevant and representationally faithful information to users of financial statement about the amounts, timing, and uncertainty of the cash flows arising from leases” (FASB, 2010), doing so by recognizing assets and liabilities on the balance sheet. In addition, the exposure draft requires straight-line amortization except when “the pattern in which the economic benefits of the intangible asset are consumed” can be “reliably determined” by the reporting entity (FASB, 2010). Compared to the current method, straight-line amortization would accelerate the expense recognition, which results in lower net income in the first years of the assets life and cumulatively over the asset’s life (Jennings, 2013). Unsurprisingly, there were some negative comments on this outcome. In the research of Jennings (2013) a company argues “Recognizing higher occupancy costs in the early part of the lease compared to the latter part is out of step with the underlying economics and would misrepresent net income. It would not enhance a user’s ability to make comparisons among companies, and would significantly complicate the ability to understand trends or forecast future results” (p. 54). Another company from the food industry complains that “The proposal significantly changes the pattern of income/expense recognition from both the lessee and lessor perspective with the front-loading of income/expense. We believe that the proposed approach will provide less relevant information to users of our financial statements and does not reflect the economics of the transaction” (p. 54).
These respondents argue that this way of amortization will provide less relevant information that does not faithfully represent the leasing contracts, and will reduce comparability across firms. Also the changes of income and expense recognition will have a major impact on the financial statements.
2.5 Hypotheses development
The new approach will have a major impact on the lessee’s financial statements. As a result from this, financial ratios will change significantly. Previous studies already suggest that capitalizing operational leases will have a major effect on financial ratios. According to Fülbier et al. (2008) the debt to equity decreases by 22 percent and Imhoff et al. (1993) show an excessive decrease for debt to equity ratio of 191 percent. The purpose of the exposure draft is to provide for users of financial statements a more faithful representation of lease commitments. The current standard gives the lessee the option to manipulate the financial statement.
It is expected that the leverage ratio debt to asset will decrease, because of the increase in the present value of the operational lease liabilities. Also the ratio debt to equity will fall because the debt position will increase with the lease liabilities, but equity remains the same. Therefore the first hypothesis is formulated as follows: H1: The financial ratios between pre-calculation and post-calculation will differ significantly from each other.
Furthermore, the impact of the exposure draft will be felt in different sectors, in some more than other. For instance, companies that lease high value assets like transport companies, will have large increases in their liabilities. The second hypothesis can be formulated as follows:
H2: The new leasing standard will have a higher impact on financial ratios of sectors with more operational lease commitments.
3
Sample and methodology
This research focuses on companies from three major Dutch indexes the AEX, AMX, and ASCX. According to Compustat, the three indexes, which include the largest Dutch listed companies, comprise a total of 75 companies. Given the size of the sample there are also some Dutch listed companies added to the research that fall under “other indexes”. The total sample consists of 127 companies.
For this research there are 5 companies eliminated due to lack of Compustat data and 16 more companies that do not provide sufficient information on operating leases in their annual reports. After eliminating these 21 companies due to data deficiencies, there are 106 companies left for the final sample. The information for operational leases is manually extracted from the annual reports of the organizations. For this research the financial year-end closing dates of 2012 were used.
The method used in this research for constructively capitalizing the noncancelable commitments is based on the research of Imhoff et al. (1991). After capitalizing the noncancelable commitments the effects on the reported assets, liabilities, and net income are examined separately. For capitalization of operational leases it requires estimations of the amount of debt and assets that would be reported on the balance sheet if the operating leases had been treated as capital leases. This can be calculated by using the schedule of minimum future cash flows required to be disclosed by IAS 17.56.
The IAS 17.56 describes that all companies must disclose in their annual report the future minimum operating lease payments for the following year, for the years two to five, and the years after the fifth. 87 companies of the final sample satisfy this requirement and 19 companies disclose each year explicitly, providing more detailed information.
In line with the research of Imhoff et al. (1991) the future cash flows which are used in the constructive capitalization method represent the same minimum lease payments which would have been used to measure the liability. Based on an estimation of the firm’s incremental secured borrowing rate and an estimation of the remaining life of the asset the minimum future cash flows can be discounted.
This results in an estimation of the off-balance sheet debt represented by the present value of the remaining noncancelable obligations under operating leases. As soon as the present value of the debt is measured, an estimation of the related unamortized off-balance sheet assets can be made. This is done by examining the relation between the assets and debt. In the paper of Imhoff et al. (1991) the researchers stated that they assumed that the leased assets are 100 percent financed with debt. This is a reasonable assumption because of the rules stated in the IAS 17. It is necessary that the depreciation or amortization of the leased assets end when the lease payments end, to avoid capitalization.
3.1 Estimating the lease liability
The calculation of the present value of operating lease commitments is based on the research of Imhoff et al. (1991). To estimate the present value of the lease obligation, two assumptions has to be made. The first assumption is the appropriate interest rate for discounting the minimum cash flows. The second assumption is the duration of the cash flows after 5 years, since they are reported in most cases as a lump sum.
According to Imhoff et al. (1991) this interest rate should be the average of the historical marginal secured borrowing rates of the organizations at the inception of the operating leases. In most prior studies the researchers choose a fixed discount rate of 10 percent for the complete sample (Imhoff et al. (1991; 1993), Beattie et al. (1998), Bennet and Bradbury (2003), and Fülbier et al. (2008)). Although this interest rate is higher than most of the average historical interest rates it still be used in this research to produce a conservative measure which avoids overstate the lease liability.
The calculation for the duration of the future cash flows is also based on the research of Imhoff et al. (1991). How many years the payments would continue at the level of the fifth year’s payment is based on the following calculation; the fifth future year’s minimum cash payment divided by the “beyond five years” out total. One company of the sample has been taken to illustrate this calculation. However, this calculation is applied to the entire sample.
Table 2 Duration future cash flows
Panel A
Lease commitments (x €1,000)
12/31/2012
Capital Leases Operating Leases
2013 5,396 16,309 2014 5,304 11,389 2015 5,290 9,834 2016 3,998 5,879 2017 1,429 3,234 Thereafter 1,429 7,909 22,846 54,554
Less: amount interest -7,161
15,685
Panel B
“After 2017” = 7,909 “After 2017” = 7,909
2017 payment 3,234 7 years 3
= 2.5 years beyond 2017 = 2.636 per year
Table 2 is an example of calculation the duration of the future cash flows. The numbers are derived from the financial report of a company that provides technologies for pharmaceutical research per 12/31/2012. Panel A shows the footnote “Lease commitments” where the minimum future cash flows from operating leases are stated. Furthermore, all payments are assumed to occur at the end of each year.
Panel B demonstrates the calculation of how many years the payments would continue at the level of the fifth year’s payment is in the case 2.5 years, This outcome is then rounded up to the next whole year. The estimated cash flows after 2017 will be €2.6 million per year. Including the years 2013 until 2017, there will be a total of 8 future years.
When calculating all of the total lease years of the whole sample, it became obvious that the lease periods are much shorter than in prior research. For instance, Imhoff et al. (1991; 1993) and Beattie et al. (1998) report a lease terms ranging from 15 to 20 years. Ely (1995) even use a lease term of 25 years in her research. However, in this research the median lease term of the sample is 7.2
after 2017 has been established, the calculation of the present value of the lease obligation can be made. With the following equation based on the research of Bennett and Bradbury (2003) this can be calculated:
= ,
where is the present value of the lease obligation at balance date ( ), , is the annuity factor for interest rate ( ) and period to end lease term ( ), and
is the lease rental for the following periods.
Table 3 Present value of operating leases
(x €1,000) Scheduled Cash Flows x 10% Present Value Factor = Present Value of Cash Flows 2013 16,309 x 0,909 14,826 2014 11,389 x 0,826 9,412 2015 9,834 x 0,751 7,388 2016 5,879 x 0,683 4,015 2017 3,234 x 0,621 2,008 2018 to 2020 2,636 x 1,544 4,070 41,721
Table 3 demonstrates the present value of operating leases during the future 8 years. The factor for the years 2018 until 2020 is calculated based on a present value of an 8 years annuity at 10 percent less the present value of a 5 years annuity at 10 percent. In total the estimated unrecorded debt is €41.7 million.
3.2 Estimating the lease asset
The previous section illustrates a technique for estimating the firm’s off-balance sheet debt from noncancelable operating leases. To measure the total balance sheet effects of constructive capitalization, there should also be an estimation of the associated unrecorded asset. In line with the method used estimating the lease liability, the unrecorded asset measurement depends also on the scheduled cash
(1991) used in addition the weighted average total life of the leased asset and assumed a deprecation method. In most cases the total life of the leased asset is unknown, so estimation has to be made. In addition, straight-line deprecation is assumed as this is used for most long-term assets. When determining the unrecorded asset, the error of a wrong estimation becomes bigger because of the many assumptions that have to be made. However, these estimations will be within the tolerable limits of this research.
Table 4 Ratio of asset balance to liability balance
Percentage of Original Lease Life Expired Total
Lease Life MarginalInterest Rate 20% 30% 40% 50% 60% 70% 80% 10 0.08 93 90 87 84 81 78 75 15 0.08 91 86 82 78 74 70 66 20 0.08 89 83 78 73 68 64 59 25 0.08 87 81 75 69 64 58 53 30 0.08 86 79 72 66 60 54 49 10 0.10 92 88 85 81 78 74 71 15 0.10 89 84 79 74 70 65 61 20 0.10 87 81 75 69 64 59 54 25 0.10 85 78 72 65 59 53 48 30 0.10 84 76 69 62 55 49 43 10 0.12 91 87 82 78 74 71 67 15 0.12 88 82 77 71 66 61 57 20 0.12 86 79 72 66 60 55 49 25 0.12 84 76 69 62 56 49 44 30 0.12 83 75 67 59 52 45 39
Table 4 is derived from the article by Imhoff et al. (1991), which gives an overview of the relation between unrecorded liability and unrecorded asset over time. The percentages in this table show the unamortized unrecorded operating lease asset as a part of the remaining unrecorded operating lease liability. The lease liability is included in this table based on the various stages of the assets’ remaining useful life. In order to make use of this table, another assumption over the total useful life of the asset has to be made. Imhoff et al. (1991) stated that most of the lease assets have a useful life of 30 years or less and that the lease has an average total remaining life of 15 years. The section of ‘estimating the lease liability’ states that
the average total remaining life of the asset is 7 years, which is approximately half of the average total remaining life of 15 years based on the research of Imhoff et al. (1991). Therefore, this research takes also half the useful life of 30 years for the calculation of the unrecorded lease asset.
For a total lease life of 15 years and an average total remaining life of 7 years, the asset is between the 40 and 50 percent expired. Looking at table 4 with a marginal interest rate of 10 percent, the asset to liability ratio lies between the 79 and 74 percent. The mean of the percentages leads to an unrecorded asset value of 76.5 percent that is used for this research.
Relating to the research of Bennett and Bradbury (2003) an additional procedure is integrated in this research to estimate the asset value:
= ,
where is the present value of the lease asset at balance date ( ), , is the annuity factor for interest rate ( ) and total life of the asset ( ), is the lease rental for the following periods, and is the portion of the unamortized lease asset ( / ). The total life of the asset ( ) can be calculated as follows: number of lease periods to expiry( ) plus the number of lease periods expired ( ).
Based on the previous example the leased assets will increase with €31.9 million (76,5 percent of 41.7) if the operating leases are capitalized. Compared to the capital leases in table 2, the unrecorded operating leases have doubled.
3.3 Estimating the income effect
The income statement effect on capitalizing operating leases is not always that significant as the effect on the balance sheet. After the research of Imhoff et al. (1991) that was more focused on the effect on the balance sheet, they conducted in 1993 a new research that was only focused on the income statement effects. This last research concludes that adjusting only the balance sheet and not the income statement effects, it will distort the comparative analysis. However, when measuring the effect on the off-balance commitments demands a lot of predicting
reliable. Table 5 illustrates the impact of constructive capitalization of operating leases on the balance sheet based on the previous example.
Table 5 Balance sheet after capitalization
(x €1,000)
December 31, 2012
Assets: Liabilities:
Lease Assets 31,878 Lease Liabilities 41,670
Tax -2,448
39,222
Equity:
Retained Earnings -7,344
31,878 31,878
For estimating the income effect an appropriate combined tax rate for Dutch companies has to be set. According to KPMG the tax rate for 2012 can be set at 25 percent.
The calculation of the unrecorded lease asset and lease liabilities is discussed in the previous sections. The calculation of the cumulative effect on retained earnings of tax consequences is the difference between the unrecorded lease liability and lease assets times 1 minus the tax rate of 25 percent. The tax liability is the difference between the unrecorded lease liability and lease assets times the tax rate.
Over the total life of the asset, the lease rental expenses are equal to the sum of the depreciation and interest expenses. Based on the estimated life of the asset, the depreciation expenses will be in most cases calculated on a straight-line basis (Bennett and Bradbury, 2003).
4
Results
Table 6 breaks down the 106 Dutch listed companies in the initial sample by industry segment. The consumer discretionary, industrials and information technology sectors, cover approximately 50 percent of the total sample. These are typically industries that require long-term use of assets or real estate, which carry larger operating lease portfolios. In contrast with the materials sector, which covers only 8 percent of the total sample, require more short-term access to specialized equipment. Table 6 Sample Sector Frequency Consumer Discretionary 18 Consumer Staples 11 Energy 6 Financials 12 Healthcare 5 Industrials 24 Information Technology 19 Materials 8 Telecommunications 2 Utilities 1 Total 106
4.1 Impact on financial statement positions
The following tables will present the financial statement impact of the procedures described in section 3. To make this research comparable with previous studies the focus lies on the effect of the balance sheet rather than the income statement.
To start off, table 7 gives an overview of the impact of capitalizing lease commitments on the financial statement positions. By sector, there is a distinction between the additional assets and liabilities due to capitalization of lease commitments and the total assets and liabilities before the capitalization. Furthermore, in the fourth and seventh column the change is calculated between the total assets and liabilities before capitalization of operational leases and after
capitalization per sector. This allows seeing which sectors will be most affected by the capitalization.
Table 7 Additional asset and liabilities due to capitalization
(x €1,000) Sector Additional assets due to capitalization Total assets before capitalization % Additional liabilities due to capitalization Total liabilities before capitalization % Consumer Discretionary 682,668 14,700,465 2.9 892,376 13,001,371 6,9 Consumer Staples 4,649,118 151,196,142 2.8 6,077,278 98,922,091 6.0 Energy 2,335,015 18,732,894 8.0 3,052,307 11,632,368 15.8 Financials 4,311,615 129,009,501 16.1 5,636,098 109,094,115 25.5 Healthcare 49,462 6,233,979 2.8 64,656 2,667,973 4.6 Industrials 2,530,397 117,175,589 4.7 3,307,709 79,148,420 11.3 Information Technology 247,976 13,694,186 5.5 324,151 5,555,507 13.2 Materials 1,632,833 32,043,525 1.4 2,134,422 17,837,535 3.3 Telecommunications 1,321,898 27,596,946 3.2 1,727,972 23,757,042 4.9 Utilities 26,855 11,073,100 0.2 35,105 6,216,600 0.6 Total 17,787,837 521,456,327 23,252,074 367,833,022
Table 7 shows that in total companies must report extra assets of €17.788 million spread over 10 different sectors due to the capitalization. An additional liability of €23.252 million will be recognized on the credit side of the balance sheet.
The recognition of additional assets due to capitalization causes for energy (8 percent) and financial (16.1 percent) sectors for most of the significant changes. The financial sector can be divided into: bank, diversified financials, insurance, and real estate. Most of their operational lease assets are buildings. In addition, the sectors industrial (11.3 percent) and information technology (13.2 percent) significantly increase the liabilities of the companies due to capitalization of operating leases. Industry groups within the industrial sector are capital goods, commercial and professional services, and transportation. For these industries a lot of their operational lease liabilities are equipment and vehicles.
The utility sector will suffer less from the capitalization, neither on assets side of the balance sheet (0.2 percent) nor liability (0.6 percent) side. However, the sample only contains one company that covers this sector, so no reliable statements can be made here.
Consequently, the adjustment of the financial statements numbers will cause a change in financial ratios, which will be described in the following table.
4.2 Impact on financial ratios
Users of financial statements, like investors or loan officers, use financial ratios as a decision tool. To see what the impact of capitalizing operating leases, the change in financial ratios are calculated.
Panel A in table 8 presents the descriptive statistics of the estimated amounts for capitalized operating lease assets (PVLA) and lease liabilities (PVOL). In panel B the impact on the financial statements are shown and in panel C the differences of financial ratios between pre-calculation and post-calculation.
The mean lease liability is €219 million, of which €9 million is related to short-term lease liabilities and €225 million. The total lease liability is €167 million, which represents 5.4 percent (median 2.26 percent). Furthermore, the capitalization of the operational leases causes an increase in liabilities of 11.2 percent (median 5.29 percent). Equity shows a relatively large decrease of 11 percent (median 1.68 percent).
For the calculation of the total increase or decrease in the financial statements some of the companies are excluded. For the increase in total assets, increase in total liabilities, and decrease in equity, respectively 5, 4 and 7 companies are excluded because of extreme positive values.
Panel C presents the financial ratios debt to assets and return on assets before and pre-calculation and post-calculation. The debt to asset ratio is a ratio that defines the total amount of debt divided by total assets (Bennett and Bradbury, 2003). Across different companies a comparison of leverage can be made, so the higher the ratio, the higher the leverage, which lead to greater financial risk. This research shows that, on average, the debt to asset ratio increases after capitalization from 0.573 to 0.596. For the pre-calculation 8 companies were eliminated from the sample and for the post-calculation 11 companies due to extreme positive values.
The return on assets ratio can be calculated as follows; net income divided by total assets. This percentage is an indicator how profitable a company’s assets are in generating revenues (Bennett and Bradbury, 2003). It depends on the industry
intensive. Table 8 shows that the return on assets ratio decreases from 0.411 to 0.366, because of the lease capitalization. For both pre-calculation and post-calculation 2 companies are excluded from the sample due to extreme positive values and 1 company with a negative value.
Table 8 Impact on financial statements
(x €1,000) N Mean Median Minimum Maximum Panel A PVOL Short-term 106 5,892 126 5 17,545 PVOL Long-term 106 225,577 34,087 2 3,528,853 PVOL Total 106 219,359 28,153 2 3,528,853 PVLA 106 167,810 22,302 1 2,699,572 Panel B
% Increase in Total Assets 101 5.4% 2,26% 0.01% 74.73% % Increase in Total Liabilities 102 11.2% 5.39% 0.01% 81.44% % Decrease in Equity 99 11.0% 1.68% 51.13 0.01% Panel C Debt to assets: Pre-calculation 98 0.573 0.548 0.242 0.890 Post-calculation 95 0.596 0.573 0.226 0.885 Return on assets: Pre-calculations 103 0.411 0.439 0.010 0.758 Post-calculations 103 0.366 0.437 0.006 0.734 Debt to equity: Pre-calculation 100 1.794 1.208 0.320 8.107 Post-calculation 95 2.159 1.341 0.362 14.001
The final ratio used is the debt to equity ratio. This is also a measure to calculate the company’s financial leverage by dividing total liabilities by stockholder’s equity. The outcome gives an indication of the proportion of debt and equity that the company is using to finance its assets. Companies that finance its growth with debt will have a higher debt to equity ratio. The industry in which the company operates also influences the ratio. More capital-intensive industries tend to have a debt to equity ratio above 2, where companies in the technology sector will have a debt to equity ratio under 0.5. In table 8 the ratio increases from 1.794 to 2.159 due to lease capitalization. By ignoring 6 companies for pre-calculation and 11 companies for post-calculation extreme values are excluded from the sample. To test the significance level of capitalizing operating leases a paired t-test has been
conducted. The results are summarized in table 9. The same extreme values of table 8 are excluded from this calculation to reduce the impact of outlier observations.
Table 9 Impact on financial ratios
Sector Mean pre-capitalization Mean post-capitalization Difference t-value* Consumer Discretionary Debt to asset 0.549 0.571 0.022 (-4.541)*** ROA 0.410 0.362 -0.048 1.696* Debt to equity 1.368 1.509 0.141 (-2.741)*** Consumer Staples Debt to asset 0.625 0.643 0.018 (-1.912)** ROA 0.375 0.357 -0.018 1.912** Debt to equity 2.046 2.204 0.158 (-1.999)** Energy Debt to asset 0.585 0.628 0.043 (-2.587)** ROA 0.415 0.372 0.043 2.587** Debt to equity 1.641 2.488 0.847 (-1.264) Financials Debt to asset 0.571 0.612 0.041 (-2.678)** ROA 0.312 0.269 -0.043 2.978*** Debt to equity 1.770 2.034 0.264 0.5628 Healthcare Debt to asset 0.509 0.520 0.011 (-2.142)* ROA 0.486 0.480 -0.006 2.852** Debt to equity 1.189 1.237 0.048 (-1.959)* Industrials Debt to asset 0.636 0.666 0.030 (-5.019)*** ROA 0.364 0.334 -0.030 5.017*** Debt to equity 2.411 2.797 0.386 (-3.774)*** Information Technology Debt to asset 0.465 0.499 0.034 (-3.883)*** ROA 0.535 0.501 -0.034 4.057*** Debt to equity 0.916 1.102 0.186 (-2.490)** Materials Debt to asset 0.525 0.534 0.009 (-3.350)** ROA 0.486 0.315 -0.171 1.608* Debt to equity 1.355 1.428 0.073 (-2.121)** Telecommunications Debt to asset 0.812 0.826 0.014 (-1.467) ROA 0.188 0.174 -0.014 1.467 Debt to equity 5.433 5.643 0.210 (-1.054) Notes: 1. Two-tailed test.
The impact of capitalizing operating lease commitments is calculated using the mean pre-calculation and post-calculation of the three ratios for each sector. The results across the different sectors must be compared with caution since the amount of companies varies per sector. This is the case with the telecommunication sector, whereas the utilities sector has been removed from this table, since there was only one company representative for this sector. As a result, the impact on the financial ratios could not be calculated.
For almost all sectors a significant difference is observed within the three ratios, only for the telecommunications sector is no significant alteration. First, the differences in debt to asset, return on asset, and debt to equity ratio before and after capitalizing operating leases are significantly different from zero at the 1 percent level for the industry sector. Second, note that the mean difference of debt to asset equity would increase with 85 percent for the energy sector, almost 40 percent for the industrial sector, and 26 percent for the financial sector. One possible explanation is that within these sectors a large amount of lease debt is currently off-balance sheet.
Capitalizing operating leases will only have a small effect on the debt to equity ratio (4.8 percent) for the healthcare sector. This is also the case for the materials sector (7.3 percent). The return on assets is only significant for a 1 percent level for the sectors: financials, industrials, and information technology.
It is noticeable that, based on the results, capitalizing operating lease commitments impacts the industrial sector the most. Thereafter, the information technology sector has the highest significance impact on the three ratios.
According to the Dutch Association of Leasing Companies (Nederlandse Vereniging van Leasemaatschappijen) the total turnover on the leasing market was €3.9 billion in 2012. Approximately one-third is regarding to transport and another third to equipment. Regarding the report of the Dutch Association of Leasing Companies, the total turnover on the Dutch leasing market comprises most of the consumer discretionary, financial, and the industrial sector. This is consistent with the results of this research.
Table 10 Pearson rank correlation
Sector Debt to asset ROA Debt to equity
Consumer Discretionary 0.984 0.859 0.978 Consumer Staples 0.969 0.969 0.983 Energy 0.983 0.983 0.921 Financials 0.951 0.968 0.521 Healthcare 0.997 0.999 0.998 Industrials 0.985 0.985 0.982 Information Technology 0.979 0.985 0.965 Materials 0.999 0.274 0.999 Telecommunications 1,000 1,000 1,000
The Pearson rank correlation coefficients between the pre-capitalization and post-capitalization ratios are presented in table 10 per sector for each financial indicator. The lowest correlation is 0.274 for the return on assets in the materials sector. This indicates that there is a change of 27.4 percent that companies’ return on asset ranking will remain the same after capitalizing operating leases. Subsequently, the correlation of 0.521 for debt to equity in the financial sector is the lowest.
For the other sectors the correlations are much higher, some may even reach the top of 1.00. This indicates that the company’s ranking would remain identical, whether or not capitalizing operating leases.
4.3 Hypotheses – rejection or acceptation
All results have been discussed, so in the following section the two hypotheses can be rejected or accepted. The first hypothesis predicted that the financial ratios between pre-calculation and post-calculation will differ significantly from each other. Consistent with prior literature, the outcome of this research shows that capitalizing operational leases will have a large impact on the debt to asset, return on asset, and debt to equity ratios. The results support this prediction. As shown in table 9 all leverage ratios are significant from zero except the debt to equity ratio for the energy, financial, and telecommunications sector.
the yearly report of the Dutch Association of Leasing Companies the sectors which are most affected by the change are consumer discretionary, financial and the industrial sector. In this research the information technology sector is also highly significant from zero at a level of 1 percent for debt to asset and return on asset ratio and 5 percent for the debt to equity ratio.
Table 9 shows that capitalizing operating lease commitment has no significant impact on the telecommunication sector. This could mean that within this sector there are fewer companies that have operational lease commitments.
5
Conclusion
The IASB and FASB published a revised exposure draft outlining proposed changes for the accounting for leases. The boards ensure that when the new standards are adopted, it will improve the financial reporting by providing greater transparency about leverage, the assets of the organisation and the risk to which it is exposed. However, companies argue that the capitalizing lease commitments will dramatically change the amount of debt and assets on the balance sheet and the amount of expenses that are recognized in the income statement. Moreover, the proposed changes are expected to significantly affect various ratios like leverage, debt to equity ratio, and return on assets. These ratios are used to compare company’s financial performance.
Before calculating the impact of capitalizing operating leases on the financial ratios, an estimation of the new lease liability and asset have to be made. These calculations are based on the research of Imhoff et al. (1991). For determination of the lease liabilities the duration of the cash flows is based on an assumption since these amounts are reported, in most cases, as a lump sum in the financial reports. Furthermore, when the duration of the cash flows are estimated, the present value of the lease liability can be calculated. Inconsistent with the research of Imhoff et al. (1991) the sample mean of the total lease terms is only 7.2 years, instead of 25 to 30 years according to Imhoff et al. (1991). After estimating the lease liability, the lease asset can be calculated on the basis of table 4 in section 3.2, which presents the ratio asset to liability.
If operating lease commitments will be capitalized, Dutch listed companies will report important additional assets and liabilities on the balance sheet. This will strengthen the financial indicators. For instance, the debt to assets and debt to equity ratio would increase, in line with the decrease of return on assets. The outcome of the research shows that capitalizing operational lease commitments will have a large impact the ratios debt to asset, return on assets and debt to equity. The ratios debt to asset and return on assets are significant from zero for all sectors except for the telecommunications ratio. This gives an indication that
Furthermore, the industrials sector shows a significant impact on the level 1 percent for all three ratios, which indicates that companies that belongs in this sector will have large operational lease commitments.
Taking into account that this research is based on different underlying assumptions, samples, ratios, the results are in line with prior studies. However, prior studies showed that the effects of capitalizing operating leases are slightly stronger for the balance sheet, income statement and financial ratios. The relatively small sample seems to be the major driver. Furthermore, other studies could have a sample with companies that rely more on operating leases than the companies in this sample.
Another limitation was the availability of the information required for this research. A few companies were excluded from the research due to missing data, which causes a relatively small sample to work with. This resulted in less extreme values when measuring the impact of changes in financial ratios as the researches of Fülbier et al. (2008) and Imhoff et al. (1993). Also, for calculating the capitalization of operating leases assumptions had to be made, which could affect the reliability of the research. However, this research can be seen as reliable as it is in line with previous studies.
6
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