Changes in operating lease accounting.
Veranderingen in operationele lease accounting.
Rijksuniversiteit Groningen
Faculteit Economie en Bedrijfskunde Accountancy&Controlling, Master program Supervisor: Bo Qin S2056615 Jelmer Hiemstra Heemskerkstraat 39 B 3038 VB Rotterdam 06-24984963
Abstract
The purpose of this thesis is to study the impacts of the new IASB/ FASB proposal for lease accounting on the financial statements. The impact on the financial statements will have a direct effect on the financial ratios of a company. In this thesis I calculate the impact of the new accounting rules on key financial ratios used by related parties to determine the solvency and profitability of the company. Arguments in favor or against the new proposal are looked at in order to take a position in the current debate. The current lease accounting rules favor the use of operating lease contracts to avoid recognition on the balance sheet, while the new proposal opts for one uniform way of lease accounting to improve the effectiveness of lease accounting. The findings of this thesis suggest that the new changes in lease accounting have a major impact on the financial ratios related to the balance sheet, whereby the balance sheet ratios are more affected by lease capitalization than the profitability ratios. The evidence is based on data from three countries and also in line with previous research.
Key words: Lease accounting; IASB/FASB proposal; Capitalization of operating leases; Off-balance sheet accounting
Table of Contents
Prologue ... 4
Introduction ... 6
Position and contribution to prior research ... 8
Chapter 1 Leasing ... 11
Introduction ... 11
Operating leasing ... 11
Financial leasing ... 12
Reasons for leasing ... 15
Critics on the current model ... 16
Models used for operating lease modifying ... 18
Chapter 2 Changes in lease accounting ... 199
The proposal to new lease accounting in detail ... 199
Performance obligation approach ... 20
Derecognition approach ... 20
Short term leases ... 20
Exposure draft IAS 17 ... 20
Advantages of lease capitalization ... 211
Comments and critics to the new lease accounting rules in detail ... 211
Impact on decision by capital markets and single users ... 222
Transition towards the proposed standard ... 233
Models used for operating lease modifying ... 233
Impact on decision by capital markets and single users ... 244
Chapter 3 Literature Review ... 255
Introduction ... 255
Bennett & Bradbury (2003) ... 255
Lückerath-Rovers (2007) ... 266
Fulbier et al. (2008) ... 288
Chapter 4 Empirical framework... 30
Introduction ... 30 Hypothesis development ... 30 Statistical methods ... 311 Financial ratios ... 322 Chapter 5 Research ... 344 Introduction ... 344
Data sample ... 344
Modifications ... 355
Financial statenment positions ... 355
Financial ratios ... 366
Constructive capitalization model... 377
Chapter 6 Impact analysis ... 388
Results Financial Statement Position ... 388
Results Financial Ratios ... 40
Conclusion of hypothesis 1 ... 43
Conclusion of hypothesis 2 ... 44
Implications for top management ... 465
Chapter 7 Conclusions ... 477
Results compared with other studies... 48
Future outlook, limitations and suggestions for further research ... 49
Conclusion ... Fout! Bladwijzer niet gedefinieerd. Results per country ... 499
Prologue
This thesis contributes to the discussion about the changes in reporting standards concerning financial and operational leasing. The proposal by the FASB and IASB to change the IAS 17 standard which proposes to report all operating leases on the balance sheet will have a major impact on financial statements. In this thesis I conduct an empirical research based on annual report figures of international entities and focus on the amount of operating leases and their influence on the entities financial position. Then I look at how these changes affect the users of financial statements in the way of how they measure financial data and predict future results.
This thesis investigates whether the information disclosed in the operating lease disclosure notes can be used to predict the performance of an entity. The research on lease accounting is useful for regulators and their constituents as they are the ones that deliberate new reporting standards. This thesis provides an overview of previous researches on the subject of capitalization of operating leases. Financial reporting provides information for decision making and empirical evidence shows that there is a link between accounting information and decision making, as shown in Ball & Brown (1968). Furthermore it provide a linkage between accounting information of capitalized leases and the decisions being made will be discussed as this is the most important factor in the discussion of how leases should be reported. The unrecorded leases might have an effect on the assessments made by shareholders when they use ratios to determine their risks.
According to the FASB (2007) the objective of the changes in accounting rules is to “ensure that investors and other users of financial statements are provided useful, transparent and complete information about leasing transactions in financial statements.”
lease accounting for companies is that the debt amount will increase. Other ratios will be affected as well. The changes in lease accounting will have a major impact on both lessees and lessors. In this thesis I discuss all the consequences of lease capitalization on financial statements and look at how the IAS 17 proposal influences the use of financial statements.
Introduction
Leasing has become a major source of finance as leasing is an important source for financing assets. The accounting rules (IAS 17) make a distinction between two types of leasing: Operating and financial leases. The new leasing standard proposed in the IAS 17 exposure draft is meant to make the off- balance accounting of operating leases disappear. The changes in lease accounting may have significant effects on companies and their statements. The outlook of the draft was started by the International Accounting Standard Board (IASB) and the Financial Accounting Standards Board (FASB).
I have looked at the effects of lease accounting rules on financial statements and financial ratios. Financial ratios affect the interest rates at which companies can acquire capital. The objective of this paper is to examine the effects of an on-balance sheet approach of leasing and the accounting treatment for financial statement positions on the financial ratios of international entities. It is important to examine the effects of the accounting changes in leasing on the use of financial statements because it addresses both the utility and necessity of these accounting changes.
The main research question asked is: What is the influence of on-balance sheet approach of operating leases on the use of financial statements?
From the main research question, eight sub questions deduce:
What are the current methods of how operating leases are reported?
What are the new methods of operating lease accounting under the FASB/IASB proposal?
Why is a change in lease accounting necessary?
What consequences does lease accounting have on companies/balance sheet/ ratios?
Which capitalization options are possible for the on-balance approach for leasing?
Are the current notes to the financial statements concerning operating leases sufficient for the users?
What are the effects of lease capitalization on various financial ratios?
Data are collected from the Company.info database. Due to the specific information about the operating lease liabilities I had to collect all the companies’ annual reports and the annual reports for the previous year. The data are collected for the years 2010 and 2009 in order to have a multiple year view. The dataset is used to calculate the effect of the changes of the new lease accounting rules. The companies included in this research must have a significant amount of operating leases in their annual statements. Financial institutions are excluded in this sample as they act as both lessees and lessors. I initially selected 60 companies from different countries. The countries selected are Canada, New Zealand and Australia. Previous research has always been done on a single country. With this approach I want to compare multiple countries to find out what the results are when taking a multiple country sample.
All the financial ratios are calculated before and after the capitalization of leases is applied. Based on this data collection I will look at the effects of these changes on the ratios and if these changes are significant. Empirically, I use one of the models in Lückarath-Rovers (2007) where operating leases are re-calculated and used as assets on the balance sheet. The model of Fulbier et al (2008) is also used in my research in order to calculate the effects of the accounting changes on the balance sheet and the financial ratios. The effect on financial ratios is important as it will influence the debt obligations of companies as presented in chapter 2.
The debt obligations and risks is an important factor, in empirical research, I therefore take a close look at the debt ratios per country and the changes of the debt ratio when all the operating leases are capitalized.
Position and contribution to prior research
Research about the impact of operating leases on bankruptcies has first been researched by Elam (1975). There is no link between operating leases and bankruptcy he concluded back in 1975. However since leasing as a major financing instrument has increased, there is still room for further research. Predicting bankruptcies is just one argument for the capitalization of operating leases. Furthermore there has been a significant increase in the amount of leases used compared to 1975. Altman et al. (1977) concludes in his research that non-cancelable operating and financial leases should be put on the balance sheet.
The way which operating leases and other off-balance sheet vehicles are reported are subject of discussion about their role in the current credit crisis. The capitalization of operating leases and other off-balance leasing have a major impact on the solvency and profitability ratios. The solvency and profitability will decrease significantly as was stated in the research of Imhoff, (1991), Bennet & Bradbury, (2003) and Lückerath-Rovers, (2007). These three studies will be described in chapter 3, the literature review.
Although both the research of Elam (1975) and Lawrence & Bear (1986) did not show a causality between bankruptcy and operating leases. The impact of operating leases on solvency and profitability has been confirmed and these ratios are still being used by lenders, rating agencies and banks to predict bankruptcies and to make an opinion about entities credibility.
Another important issue is that the methodology and data collection method used by both Elam (1975) and Lawrence & Bear (1986). Ohlson (1980) and Collins & Green (1982)
operating leases. The methods of statistics have improved since the research of Elam. The amount of operating leases has increased since the time Elam , Lawrence & Bear did their research. This is also a reason to conduct further research on the subject.
The discussion on the topic of operating leasing and how they should be reported is seasonable at the moment. Both the FASB and the IASB have made a proposal for lease accounting. The distinction between financial lease and operating lease would disappear. The focus of this research is on operating leases, not on financial leases as they are already being reported on the balance sheet. The operating leases need to be of a material amount so it will have a noticeable result.
This research is both relevant and is a topical subject as the discussion is still going on at the accounting standards board. The last years the proposal of new leasing reporting standards has led to a wide discussion between standard setters, accountants and companies’ boards. Both the IASB and the FASB are working on the proposal where all forms of leases will be put on the balance sheet. This new reporting standard will provide users of financial information with the capability to make better financial analyses. This proposal has been postponed due to high discussion. All big four companies have reacted with an exposure draft to give their view on this discussion. The reactions on the lease proposal will be discussed in chapter 2.
This thesis contributes to the existing literature as this study has a sample based on multiple countries. Prior research already showed that the conclusions are in line with each other, that the change in lease accounting affects key financial ratios. An extra confirmation will strengthen the basis of this conclusion. The results of this thesis and the differences per country will contribute to the discussion which is going on about which type of lease-accounting is preferred. The perspective will be the information needed by the users of financial statements also known as the information perspective. Previous research on leasing is mostly outdated because of
the leasing volumes have increased a lot over the past decades and has become a substantial form of financing, Lückerath (2007). Secondly the statistic approach has improved so that the studies should be looked at again with more recent data.
The main finding of this thesis is that the changes in operating lease accounting have a significant impact on the financial statements and financial ratios. The ratios based on the balance sheet, which calculate the solvency of the company, are affected the most. By calculating the impact on the financial positions I can answer my main question of: What is the influence of on-balance sheet approach of operating leases on the use of financial statements?
Chapter 1 will presents the current lease accounting rules, the critics towards the current accounting rules and the reasons why leasing has increased as a major source of finance. Chapter 2 presents the proposal in detail with the approaches of the IAS 17 exposure draft, the comments and critics towards the new proposal will be presented at the end of chapter two along with an impact analysis on the companies affected by the new accounting rules. Chapter 3 presents the literature review with all the discussions and previous literature on the subject of capitalized leases. The three major articles are summarized in this review. The empirical framework is laid out in Chapter 4 with the hypothesis development and an overview of the statistical methods. Chapter 5 presents the research, the results and the impact analysis. In Chapter 6, I discuss the main findings and compare my results with prior research. Chapter 7 concludes and provides limitations and suggestions for further research.
Chapter 1 Leasing
IntroductionThe volume of lease transactions had increased over the past few decades. Although leasing is an important source of financing a majority of lease obligations are not included on the balance sheet. The IASB (International Accounting Standards Board) and the American FASB (Financial Accounting Standards Board) have released a discussion paper for new accounting rules for lease accounting. These new rules mark the end of off-balance sheet leases. In this proposal all leases will be capitalized on the balance sheet. This includes operating leases which are now accounted off-balance. The outcome of these changes in lease accounting for companies is that the debt amount will increase. Other ratios will be affected as well. The changes in lease accounting will have a major impact on both lessees and lessors.
The current method of lease capitalization
The current method of leasing gives companies the choice between financial and operating leases. Leasing is based on the ‘right to use’ an asset for a set period of time according to the contract. The difference between leasing and buying is that the leased asset is not owned by the lessee and cannot be sold by the lessee.
Operating leasing
The current IAS accounting standard classifies leases as either an operating lease or a financial lease. Operating lease and financial lease are accounted in a different way. The important difference in lease accounting is that financial leases are brought up onto the balance sheet while operating leases remain ‘off-balance’. A finance lease is a lease which
transfers all the substantial risks and rewards to incidental ownership. An operating lease does not transfer all substantial risk and rewards incidental to ownership.
Situations where the ownership of the asset will transfer to the lessee and the end of the term or when the lessee has the option to buy the asset at a lower price than the fair value, the lease will be classified as a financial lease. Also when the economic life term is near the lease term an asset is considered as a financial lease. In all other cases a lease is accounted for as an operating lease and will be disclosed in the notes instead of being capitalized on the balance sheet. In determining whether a lease is a finance lease or an operating lease the form of the contract is not relevant as the substance of the transaction is leading. When the leased assets are specialized that the asset can only be used by the lessee with the consequence that the asset cannot be sold the leased asset will be classified as a finance lease. It is clear that as long as the risk does not transfer substantial risks and rewards from ownership, the lease is accounted as an operating lease.
Financial leasing
Financial leases are recognized as assets and liabilities equal to the fair value amount of the lease or, if lower, to the minimum lease payments. The IFRS 7 standards require lessees to make disclosures for finance leases. In the disclosure for operating leases the net amount must be reported at the end of the period. The present values of the operating leases must be presented in the periods less than one year, later than one year but less than five years and five years and more. In the footnotes the existence, terms of renewal, purchase options and escalation clauses and restrictions are described. The lease payments of operating leases are recognized as expenses.
Payments of operating lease are charged on the profit and loss account on a linear basis over the lease term. A finance lease is recorded on the balance sheet of the lessee as a fixed asset
value of the minimum lease payments discounted at the interest rate of the lease. Based on their economic life the asset will be depreciated.
In IAS 17 the appropriate accounting policies and disclosures for financial and operating leases are prescribed. The classification for financial or operating lease is made at inception of the lease. A lease is a financial lease when all the risks and rewards related to the
ownership are transferred. The lessee recognizes an asset for the financial lease and an obligation for the for the payments. The amount of the asset and liability is the lower of the fair value of the leased asset or the present value of the minimum lease payments. The leased asset must be depreciated. All other leases are operational leases. (IAS 17)
Important is that the classification is dependent upon the substance of the transaction rather than the form. Therefor IAS 17.10 and IAS 17.11 mention several situations whereby a lease is classified as a financial lease. According to IAS 17.20 financial leases should be recorded as an asset and a liability. Operating leases should be recognized as an expense in the income statement over the lease term. For the disclosure in the annual report both types of leases must include the a general description of the lease arrangements, how the rent is determined, the renewal terms, purchase options and the contingent rental payments. The future payments for operating leases must be disclosed in amounts of less than a year, 1 to 5 years and more than five years. The FASB has five criteria for when a lease becomes a financial lease:
1. The lease transfers ownership to the lessee;
2. The lease contains a bargain purchase option to purchase that is expected to be exercised;
3. The lease is for the major part of the economic life of the asset;
4. The present value of the minimum lease payments amounts to substantially all of the fair value of the leased asset;
5. Only the lessee can use the leased asset.
In the US the SSAP 21 determines a lease as a financial lease when the risks and rewards are transferred at the inception of the lease. Assets under finance lease will be presented by the lessors at the amount of the net investment of the lease. All the risks and rewards related to the ownership of a finance lease are transferred by the lessor.
In the disclosure notes, lessors report the gross investment and the minimum lease payments at present value for periods less than a year, between one and five years and later than five years. Unearned income, unguaranteed residual values and the accumulation for uncollectible lease payments must also be recorded in the disclosure notes.
For operating leases the lessor records a fixed asset on the balance sheet and depreciates that assets based on its economic lifetime. The amount of a finance lease is recorded as a debtor. The lease rentals and will be divided in net investment and the earnings.
For operating leases in the disclosures the future lease payments under the non-cancelable leases will be combined into the same periods of less than a year, between one and five years and later than five years. The recognized income is the total of all the rents in that period. All the lease arrangements must be described.
For lessors the proposals will mainly lead to another reckoning of existing lease contracts. The lessors determine for each lease contract whether they apply the performance obligation or the de- recognition approach. Both approaches take the present values of expected future lease payments on the balance. The future lease payments are discounted for the interest rate. The risks and rewards of the lease determine whether which approach should be conducted.
Reasons for leasing
Why do companies prefer leasing and operating leasing in general above other forms of financing? When a company buys an asset it has the ownership of the product and can sell it. This advantage is often included in lease contracts in the form of renewal options, buy options and cancellation. This risk sharing incentive makes leasing an attractive form on financing. Leasing adds flexibility in the production processes of companies when it is uncertain how long an asset is needed. It’s easier for a company to get rid of a leased asset or acquire a leased assets than to buy-or-sell the asset themselves. The risk of deterioration is carried by the lessor of the lease instead of the company. Risk sharing has an influence on the companies’ choice for operating or financial lease (Lückerath-Rovers, 2007).
Besides risk sharing reasons, another incentive to choose for leasing is for tax saving reasons. When two companies have different tax rates, they can shift tax benefits from one company to the other by operating leases. One company with the higher tax rate acts as a lessor, the lower tax paying company as lessee. It is beneficial to lease in order to shift tax advantages to the company that pays the highest tax rate.
Operating leases increase the borrowing capacity of a company because operating leases do not affect debt covenants. The amounts of operating lease are not accounted on the balance sheet as liabilities thus freeing up capital for the company. The asset is financed entirely by the lessor.
The fourth reason companies chose for leasing is that the needs for inconvenient factors as maintenance for assets, insurances, descent and the assets can be easily acquired and disposed. (Wakeman, 1985) Manager rewards based upon financial ratios also has an incentive to choose for operating lease due to the off-balance character of operating leasing.
Critics on the current model
With the proposal, FASB and IASB want to super scribe the criticism on the current lease accounting rules where most leases are accounted off-balance. With the current lease model similarly economic lease contracts are accounted in different ways. Assets and obligations are not included on the balance sheet and the estimations made at the inception of the lease are not being impaired under the current model.
The current international lease accounting standards distinguish between operating and financial leases. Operating leases have a negative image because of the off-balance character. In the period 200-2004 Lückerath-Rovers researched all the Dutch entities. She concluded that 36% of the companies did not comply with the IAS 17 standard. The users of financial statements who want the operating leases to be counted on the balance sheet have to choose between different ways of estimating the operating lease values. When there is not a uniform approach to account operating lease on the balance sheet the financial ratios are influenced by noise due to estimations of the rate of interest and the chosen capitalization method. With the new proposal of FASB and IASB all leases are capitalized on the balance sheet so there will be a uniform standard with no differences in the treatment of operating leases. Estimation errors and differences will disappear thus leading to a more transparent form of financial reporting. The current lease accounting standards provide insufficient information for the users of financial statements and are up for change. Instead of the nominal lease obligations, the present values of the lease obligations must be included.
With the current way of lease accounting it was common for companies that want to manipulate their financial statements in respect of leases. The companies’ liabilities were understated as most leases where not recorded on the balance sheet. Hereby the ‘substance over form’ concept was ignored. In most situations it was clear whether the nature of the lease was operational or financial, but this situation was not always clear and therefore this change in lease accounting rules should correct the way lease are being accounted.
The most important critic is that the two-way of lease accounting doesn’t have a ‘truthful representation’ (IASB, 2010). The new leasing standard implies a uniformed way of lease accounting. When companies choose between operating and financial leases, several reasons play a role in the decision making. They can be divided into economic and accounting reasons. Tax advantages, sharing the risk of ownership, and the offering of convenience are economic reasons. Accounting reasons apply when the company uses leases to show a better financial performance. The factor of showing a better financial performance is seen as a wrong incentive to choose for the accounting method of operating leases (IASB, 2010). For users of financial statement and third parties the difference between operating and financial leases is often not clear. The difficulty with operating leases is that it does not require a company to report assets and liabilities. The rights and obligations of operating leases are only mentioned in the disclosure notes. This is therefore not in line with the accounting framework that strives for a uniform and faithful presentation of financial statements. (IASB, 2010).
In the new IASB/ FASB proposal on 16th of May 2013 a public comment was made to outline the new changes to lease accounting. A lessee must report the leases as an asset and liability when the lease term is more than 12 months. Hans Hoogervorst, chairman of the IASB commented on the new proposal that: “The proposals outlined in this revised Exposure Draft will go a great distance towards improving the quality and comparability of financial
reporting in this area.” The main criticism on leases happened during the credit crisis when the contractual commitments were not transparent to the users of financial statements. In the new proposal companies must recognize assets and liabilities on the balance sheet that arise from leases. The asset is the right-to-use the leased asset. The liability is the obligation of the company to pay rent. Assets will be depreciated and liabilities are reduced when the rental payments are made. Important is the distinction between property (type B), unless the lease term is for a major part the remaining economic lifetime of the underlying asset. Non-property/ equipment is classified as a type A lease. Property will result in a straight-line expense over several year. Equipment will result in a front-loaded expense as interest payments and amortization expenses replace rental expenses, this means that the expenses decrease over time. Compared to the previous exposure draft only the accounting treatment for a Type B lease changes. The right-of-use is allocated on a straight-line basis and the cash flows arising from the leases would be classified under operating activities. The new proposal has an impact when a majority of the leases relate to property assets.
Models used for operating lease modifying
Although operating leases are not stated on the balance sheet itself. Users of financial statements use the information that is disclosed in the notes. Sengupta & Wang (2011) show in their research that credit rating agencies as well as debt and equity holders recalculate operating leases into their models for calculating solvency. They also show that not all the users of the financial information alter their pricing mechanism when dealing with operating leases.
When stakeholders such as banks, investors and others want to calculate the effect of the off-balance leasing on financial ratios, leverages and future earnings they need to understand the way operating lease are accounted for.
Chapter 2 Changes in lease accounting
The proposal to new lease accounting in detail
The new IASB and FASB proposal is expected to put in practice in 2013 or 2014. All lease contracts must be capitalized on the balance sheet. In this new lease accounting model estimates should be reviewed periodically.
A survey by PWC & the RSM (Rotterdam school of management) shows the impact of the operating lease proposals of 3,000 global companies on the financial ratios of these companies. The expected impact is that the debt, leverage and EBITDA (equity before interest, taxes, depreciation and amortization) will increase for most companies. Based on the survey of PWC & RSM (2009) the expected debt burden of the 3,000 companies will increase by 58%. There is a peak of a few companies with a high increase in debt, but for 24% of the companies the debt burden will rise more than 25%. There will be differences between industries. The industries that will be most affected by the changes in lease accounting is the retail sector, the transportation sector, business services, hotels and the telecom sector. Especially for the retail sector an increase in debt will be 213% which means that the ratio debt and equity increases by 64%.
Some companies have a low amount of debt on their balance sheet. The percentage impact of taking operating leases onto the balance sheet is large. There are big differences in industries when looking at the changes in operating lease accounting, but there are differences between countries as well. A particular effect of the changes in lease accounting is that the EBITDA will increase due to the fact that lease expenses will not be accounted as costs but will be accounted as interest and depreciations. The survey of PWC & RSM (2009) shows an average increase of 18% in the EBITDA amount.
Performance obligation approach
The performance obligation approach is applied when all the significant risks and rewards of the asset are retained. For lessors both the lease receivable and the underlying asset will be recorded on the balance sheet. On the balance sheet of the lessor the obligation to deliver is also recorded at the same value of the lease receivable. Depreciation and interest income will be included in the income statement.
Derecognition approach
The derecognition approach is applied when all the significant risks are transferred to the lessee. The underlying asset will not be recorded on the balance sheet of the lessor. Only the asset itself will remain on the balance sheet. The asset is will be accounted for fair value. By the transfer of use the gain or loss will be included in the income statement. The difference between both approaches is the exposure to risks and benefits associated with the asset.
Short term leases
Leases with a maximum term for less than a year are in a different category. Only the undiscounted leases are reported as asset and liability. This type of leasing falls in a different category (IASB, 2010). The payments are recognized as expenses. This is one of the major critics on the new proposal as explained in Chapter 1.
Exposure draft IAS 17
The new IAS 17 exposure draft will have only one way to account leases. The way leases are accounted is on the balance sheet. Due to the new way of operating lease accounting the capitalization leads to an increase of 6 percent in assets and an increase of 14% of liabilities (Fulbier et al., 2008)
The current IAS 17 standard makes the following distinction between operating and financial leases: A lease is classified as a finance lease if it transfers substantially all the risks and rewards incidental to ownership. A lease is classified as an operating lease if it does not transfer substantially all the risks and rewards incidental to ownership (IAS 17).
Advantages of lease capitalization
One of the sub questions was about the necessity of the new accounting rules. There are three major advantages of the new proposal (IASB, 2010). The first advantage is that a uniform approach of lease accounting leads to a more truthful representation of lease accounting. The second advantage is that the off-balance character for leasing is removed. The third advantage is that a uniform approach to lease accounting contributes to the comparability of companies. With the operating lease approach, the users of financial statements needed to adjust for operating leases. Operating leases where disclosed in the notes of financial statements, but 36 percent of the companies did not comply with the accounting rules for operating leases according to (Lückerath-Rovers, 2007)
Comments and critics to the new lease accounting rules in detail
The IASB has given individual accountants and organizations the ability to make comments and critics about the new IAS 17 proposal. The IAS 17 exposure draft has
received over three hundred letters according to the PWC review (Proposed lease accounting Research of impact on companies, research by PWC J. Tahtah & E Roelofsen, 2009). The widely received response is due to the great number of entities that are involved in leasing. The main critics are about the way lessors have to account for leasing. This thesis looks mainly at the lessees accounting which has more effect on the users of financial statements.
Both operating lease and service contracts were accounted off-balance and the asset itself was not owned by the lessee.
Where operating leases and service contracts had been accounted the same, the difference between service contracts and operating leases is difficult to determine. The possibility exists that operating leases are being accounted as service contracts to avoid the capitalization. Siemens is skeptical about the IAS 17 proposal which wants to include expected lease payments as well as term options of assets and liabilities.
Short term leases fall in a different category according to the IAS 17 proposal. In reality the short term leases (12 months maximum) will be accounted on the balance just as operating leases.
Most critics of the EFRAG (European Union) are about the fact that short term leases will be capitalized as an asset and liability as well as an expense in the profit & loss statement. Lease obligations for that have a period less than a year, don’t need to be capitalized as all the expenses are taken during the current period and therefore no capitalization is required. The last critic is the maximum rentals are not included in the lease assets and liabilities. This can lead to an understatement of the amounts on the balance sheets. The IAS 17 proposal is not clear about the recognition of what should be recognized on the balance sheet and the disclosed amount.
Impact on decision by capital markets and single users
Managers can still use earnings management to decrease the debt-equity ratio caused by the new IAS 17 proposal (Fulbier et al, 2008) With more assets and liabilities on the balance of companies the current debt covenant ratios will come under pressure. Therefore managers can react to the accounting changes for leasing by lease contract changes, earnings management and can encourage lobbying against the new accounting standards (Fulbier,
The financial services won’t be directly affected as they often act as lessor. The economic advantages will not change. The new proposal of lease accounting leads to a better comparison between IFRS and US GAAP financial reports. The problems of comparison will be removed by implementing a uniform standard. A one way to account leases is generally better for uniformity and comparison. The usurers of financial statements will be better served by this proposal and the removal of the off-balance character of operating leases will be more transparent.
Transition towards the proposed standard
In the first year the lessee will record a right to use and a lease liability on the balance sheet. On the balance sheet of the lessor a lease receivable will be recorded. For lease with the performance obligation approach the asset and the obligation to deliver are recorded on the balance sheet. With the derecognition-approach the underlying asset is recorded on the balance sheet. The new rules in lease accounting make an end to the off-balance sheet financing of sale and lease back transactions
Models used for operating lease modifying
Financial analysts and banks often use rules of thumb in their analyses of companies annual reports. A lease liability is if 6 to 8 times the reported lease expenses, (Imhoff et al. 1993) . This rule is based on the expected remaining period of the average lease. There will be a possible impact on rates of credit lending when these rules of thumb are not accurate enough so a market correction will take place. The PWC & RSM (2009) survey shows that most analysts and banks estimate the actual debt higher than it actually is. For 93% of the companies the lease liability is lower than the amount of 6-8 times the lease expenditures. The changes in lease accounting on the new models will have an effect on the rates and lending.
Impact on decision by capital markets and single users
The rules of thumb used by analysts’ estimates the amount of lease liabilities for some industries higher than the lease obligations. Only for the retail industry, transport, hotels and business services the amount of lease obligations is higher than the 6-8 times the lease expenses. For 93% the estimated amount of lease obligations is lower than seven times the lease expenses, (Tahtah & Roelofsen, PWC Proposed lease accounting Research of impact on companies, 2009) There is a possibility that the renewal options of the lease must be included in the contracts.
Bennett & Bradbury (2003) used the ‘rules of thumbs’ in their research paper and in the empirical research of Lückerath-Rovers (2007) the ‘rules of thumb’ used by analysts were used as well. The fact that the users of financial statements use these heuristics means that the current accounting standard for leases provides insufficient information for the users of financial statements. The question we have to ask is if the IAS 17 proposal will solve this problem with the new accounting standard for leasing.
These heuristics is a response to high cost of gathering information. By simply multiplying the lease obligations by 6-8 times, analysts can obtain the information without using expensive data analysis. Imhoff et al (1993) suggest that the information from these heuristics leads to a high overstatement of the lease obligations. This method is however more associated with shareholder’s risks than methods of constructive capitalization.
Chapter 3 Literature Review
Introduction
In this chapter I will review the literature and the discussion on the new lease accounting proposal. The new accounting rules for leasing have a material impact on financial statements and the financial ratios. The current accountancy standards for leasing are insufficient according to Lückerath-Rovers (2007). An increase in transparency will reduce the incentive to opt for operating leases for accounting motives. With the new accounting rules for leasing the economic incentive to opt for operating lease will remain.
Bennett & Bradbury (2003)
Bennett & Bradbury have examined the impact of the capitalization of operating leases. Bennett& Bradbury’s motivation for their research is the fact that the results will have practical implications for both accounting policy makers and financial analysts. B&B tells that lease capitalization is an important accounting standard-setting issue. In their paper B&B examine the impact of constructive capitalization on the New Zealand Stock Exchange. Before their research most studies related to large US firms. The entities on the New Zealand Stock exchange use the international accounting standard, which is the IAS 17 standard for leases. The results of this study apply also to all firms that are reporting under the IASC accounting standards. The methods used in this study can be applied to other international studies for comparison. B&B found 38 New Zealand firms with operating leases, which in all cases were leased property.
The methods used for constructive lease capitalization were the ‘rules of thumb heuristic’ and the present value procedures, Imhoff, 1991. The research of Imhoff 1993 and 1995 also presented specific operating lease capitalization procedures for firms, but these
were not used by B&B as they used the standard approach. The main results of the operating lease capitalization discussed were significant. An average increase in liabilities of 22, 9% was found. On average the debt to total assets ratio increased from 0.469 to 0.519. The current ratio fell from 2.11 to 1.81. Both the leverage and the current ratio are often used to determine the solvency of the company.
The conclusion of the Bennett & Bradbudy, 2009 research is that the operating lease capitalization will have a material impact on the reported liabilities. Furthermore the impact on the decrease of solvency ratios, liquidity ratios and profitability is confirmed. Some rules of thumb procedures for the capitalization of leases are very inaccurate, this applies to a standard used by US analysts were the rental expenses is multiplied by 8.
The results contribute to the discussion of capitalizing all non-cancelable operating leases. Bennet & Bradbury provide support to the research of Imhoff (1993) which suggests that present values of operating lease payments so the lease liability won’t be overstated by analysts. B&B also suggest that standard setters should require the disclosure of the net book amount of the leased asset.
Lückerath
-Rovers(2007)
In her 285 pages long Empirical investigation, Lückarath-Rovers as explored whether the current lease accounting standard provides useful information to the individual user of financial statements. This empirical investigation is important in determining the usefulness of the changes in lease accounting. In her investigation she examined why companies choose to opt for operating leases instead of financial leases and their motives. Two perspectives are used: Both from the external (the individual user) and the internal (the company’s management) perspective. The aim of the thesis is to help accounting standard setters with the decision of whether the lease accountant standard should be revised. It is important to
financial reporting standards. The main research question was how the current lease-accounting standard can be improved.
Lückerath points out some arguments why further research on the subject of operating leases and the predicting of bankruptcies is required. First the amount of operational leases has significantly increased as a form of financing assets both in the Netherlands and globally. Secondly the disclosure note of operating leases in the annual report has improved. According to IAS 17 companies now need to report significant non-cancelable operating lease contracts in the disclosure note. Thirdly operating leases have a significant impact on solvency ratios which have in return an influence when it comes to predicting bankruptcies or insolvencies.
The investigation analyzed the impact of the capitalization of operating leases on financial ratios. The second part investigated the economic reasons why companies choose operating leases. The majority of the leases are operating leases, but the removal of the off-balance character won’t lead to a decline for the leasing industry. The financial-distress models were not significantly improved with the new changes in lease accounting. On the other hand financially distressed companies do use more operating leases on average than healthy companies. An incentive for operating leases is the shortening of the balance, leading to better solvency ratios. The nature of operating leases is a desirable form of financing for economic reasons; however it’s a dubious form of financing when operating leases are chosen for accounting reasons. The information in the disclosure is not optimal, because the present value of the lease contract is not disclosed.
Lückerath-Rovers conclude with the remark that the user of financial statements is best served with a transparent, reliable disclosure note which states all the operating lease commitments. The transparency of the lease commitments will increase by using the present value, which shows the future lease obligations in a more transparent and reliable way. This
will lead to less abusing of the lease standard. The conclusion of Lückarath is that: “The disclosure of operating lease commitments in a transparent way lead to a more reliable view of both the financial position and the performance of a company than the capitalization of leases on the balance sheet of assets the company does not own, nor control.”
Capitalization of operating leases is not necessary for predicting bankruptcies according to Lückerath-Rovers (2007). Most entities that are making severe losses or are in a state of bankruptcy had bad solvency and profitability ratios already even before capitalization of operating leases was applied. The use of capitalization has worsened the ratios even more. Most losses came from the ICT industry which is a branch that has a higher leasing intensity anyway. So it looks like capitalization of leases is not required for predicting bankruptcies.
Fulbier et al. (2008)
The separation of operating and financial leases will give an incentive to opt for operating leasing due to the off-balance character. With operating lease contracts, companies can avoid on balance debt. Fulbier et al. researched the IASB and FASB proposal on German companies and noted a variety in financial ratios in their simulation. The impact on the assets and liability ratios was the most significant. Fulbier et al. note that these changes may lead to management incentives in order to temper the effects. The effects of operating lease capitalization shouldn’t be overstated; this statement is in line with other researches and shows that the changes in lease accounting will have a major impact on the financial statements. In their introduction Fulbier et al. expected a significant impact on the financial statements of the 90 companies in their scope. The fashion and retail groups had the largest impact from the lease accounting approach. Fulbier et al used the capitalization approach of Imhoff, Lipe & Wright (1991). The results were used in a simulation based on the
Standard&Poors Creditstats model. Fulbier et al also looked specifically on the effects on different industry groups.
Although in this thesis the difference in industry groups is not in the scope, the results show that the fashion and retail are strongly affected by the changes in operating lease accounting. The changes in financial ratios affect primarily the balance ratios, but there are also minor changes in profitability ratios. In their conclusion Fulbier et al. Assumes that the effects will give incentives to managers to act against the new changes as it will lead to higher financial risks and the risk of debt covenant violation. Due to the small impact on profitability ratios and valuation multiples the executives’ compensation won’t be affected too much. The research of Fulbier et al. is in line with prior research in other countries. In their conclusion they make a note for standard setters where they state that the effects of operating lease accounting should not be overstated. Yet there is no extensive impact on performance and market multiples. While some industries like fashion and retail are affected some industries will remain unaffected by the changes in lease accounting.
In practical terms, the markets are already sort of capitalizing leases to some extent when they use models for recalculating the impact of off-balance leases. Whether the current lease accounting standards will lead to a true and fair view of the financial statements remains a question for further research.
Chapter 4 Empirical framework
Introduction
This part of the thesis will describe the research framework and the empirical part consisting of the hypotheses formulated and the statistical methods that are used in this thesis.
Hypothesis development
The first thing that is calculated is the impact of the exposure draft IAS 17 on the income statement and the balance sheet. The expected results will be that the impact of the exposure draft IAS 17 is significant. The previous chapters already discussed the literature related to the new lease accounting proposal. Based on the literature related to leasing some expectations can be formed on the impact of the new IAS 17 proposal. First the impact on the balance and the income statement must be calculated.
Previous research of Imhoff (1997), Beatie (1998) and Bennett & Bradbury (2003) found a material effect for the capitalization of operating leases. Based on prior research and empirical testing I try to confirm the first hypothesis:
H1: The capitalization of operating leases will significantly/materially affect the income statement and the balance.
The financial statements are the basis for financial ratios. These ratios are used for decision making to users of financial statements. The financial ratios are in particular useful for predicting bankruptcy, comparison purposes and investment decision. Debt covenants with banks and other lenders are often based on specific financial ratios. A company must pay a penalty when they are violating the debt covenants. The financial ratios are used for comparison purposes and the management wants to show the firms ‘performance as best as
possible. The companies that use operating leases for meeting the debt covenant will face a significant increase in their debt-equity ratios when all the leases are capitalized.
H2: The capitalization of leased assets will significantly/materially affect financial ratios.
The users of financial statements are best served when the present value of all the leases is disclosed in the financial statement notes (Lückerath-Rovers, 2007). The companies can be better compared by the users of financial statements when all leases are disclosed in the same way. Capitalization of operating leases will contribute to the standardization and will help the users, but a disclosure based on the present value will also reflect the risks that are attached to the economic ownership. The use of operating leases purely for accounting purposes will be reduced when all the future lease payments must be presented in the disclosure notes. Lease financing distorts the transparency of financial statements and the users of financial statements do not have sufficient and accurate information. The user of financial statements will have a more consistent and reliable way of the financial position of a company and the performance (Lückerath-Rovers, 2007).
Statistical methods
The methods used for statistical research is based on the research of Fulbier, Silva & Pferdehirt (2008). For calculating the operating lease obligations I used the procedures used by Bennett & Bradbury, (2003).
The data is collected from Australian, New Zealand and Canadian companies. These companies report under de International reporting standards that are affected by the IAS 17 proposal. The financial statements data from 2010 will be used as well as 2009 data for calculating certain ratios. Because the discount rates for companies are difficult to calculate, I will use a fixed rate of 10% for all the companies as used by (Beattie, 1998). In the research of Beattie et al a discount rate of 10% was used based on the short term borrowing rates. Several studies, the one of Lückerath, (2005) included have used a fixed discount rate of
10%. There can be company specific discount rates but these will not be used due to the complex nature and the focus will be on the impact of operating lease capitalization.
The operating leases under IASf 17 are divided into three different periods: 1. Less than 1 year.
2. Between 1 and 5 years. 3. More than 5 years.
In the annual reports used in the data all companies that do not have non-cancelable operating leases will be excluded. Companies that act as both lessees and lessors will be excluded as s they acts both a lessee and lessor. The second part, consisting of leases between 1 and 5 years will be calculated per year by using the digression model used by Fulbier (2008).
Financial ratios
The most important part of the data analysis is the impact on the financial ratios. The data will be used for calculating the impact on the balance sheet and the financial ratios that affect the balance sheet. The balance ratios are used to determine the financial risks by calculating the solvency and profitability. Besides the financial performance, the valuation of the company is another important ratio used by investors and other users of financial statements.
The model used by Bennett & Bradbury (2003) for the capitalization of operating leases will be used to calculate the impact on the assets, liabilities and the equity. The minimum lease payments will be calculated by using the model of Fulbier, 2008. The remaining lifetime is hard to determine as this information cannot be obtained from the annual reports directly. I therefore used the remaining lifetime of 50% that was used in the method of Ely (1995).
The company specific discount and tax rates were not used due to complexity. Instead I used the single contract method for all the leases; this method was used by (Fulbier, 2008). Apart from the balance effects the income statement will be changed too due to the addition of depreciation of the leased assets that are now capitalized on the balance sheet.
Chapter 5 Research
Introduction
In this chapter the research design is described. The previous chapter described the hypotheses formulated. The research design is mainly based on the research approach by Fulbier (2008) with some modifications which will be explained in the second paragraph.
Data sample
The data were collected from the years 2010 and 2009. The year 2009 was used for comparison purposes. The companies were selected from New Zealand (19), Australian (7) and Canadian (20) companies. The selection was made for multiple countries as previous studies have selected only one specific country and to the best of my knowledge no research of operating leases has used a multiple country sample. Multiple country research removes the effects of regulation in a single country. As the IAS accounting standards are applied worldwide, countries can be taken together in the data sample. The results are compared with other studies in single countries, several studies are explained in the next paragraph. The countries I have selected are all part of the British commonwealth and therefore have similar regulation and all countries have are based on common law.
The data used has some limitations due to the limited amount of companies selected. Previous research has already taken place for specific countries: Nelson (1963) for U.S companies, Bennett, Bradbury (2003) for New Zealand companies, Lückerath-Rovers (2007) for Dutch companies and Imhoff, Lipe & Wright (1993:1997) U.K. companies.
The countries of New Zealand, Australia and Canada have been selected for this research and can be used for comparison as these countries have the same IFRS international accounting standards. All these countries belong to the commonwealth thus have almost the
annual reports is similar, so the information from the annual reports can be used for good comparison.
17 companies had insufficient information in their annual report and disclosure. These companies have been left out of the sample. In this research the company discount rate was used when listed in the annual report. Where the company specific discount rate was missing, a fixed discount rate of 10% was used. The 10% rate is based on the research of) Beattie et al. (1998) and Imhoff et al. (1991).Company specific tax rates will be used to calculate the tax effect.
Modifications
The future lease payments under non-cancellable operating leases must be disclosed for each of the following periods: (IASB, 2010b).
- Not later than 1 year
- Later than 1 year and not later than 5 years - Later than 5 years.
Although several researches have used company specific discount rates I have used a fixed discount rate of 10%. The fixed discount rate was also used in the research of Imhoff, Lipe & Wright (1991). The minimum lease period (MLP) is hard to calculate as the total periods are not shown in the annual reports of the companies listed in the data sample. In the calculation I used the average lease lifetime based on the research of Imhoff (1991). Imhoff et al. used an average lease period of 15 years. The average lifetime is necessary for calculating the present value of lease >5 years based on the capitalization model.
Financial statement positions
First I will calculate the effect of operating lease capitalization on 4 specific financial statement positions. I expect that the Total Liabilities will be most affected by the changes in lease accounting. This expectation is based on the research of Fulbier et al. (2008) which
reported an increase of 14% and Bennett& Bradbury (2003) which reported an increase of 12%.
Financial statement positions
1 Total Liabilities 2 Non-current assets 3 EBIT
4 Net Income
Financial ratios
The financial ratios are used to calculate the effect that the capitalization of leases will have on the annual report figures. The ratios are divided into ratios that affect the balance position, the profitability and expenditures and the valuation of the company. The financial ratios affecting the balance of the company are used to measure the financial and operating risks related to the company. The following 3 ratios are used in Beattie et al. (2000) to evaluate the financial and operating risks. These ratios will change due to the adjustment of operating lease accounting.
Ratio: Numerator: Denominator:
1 Non-current assets/ Total assets Non-current assets Total assets 2 Debt/ Equity Current+ long-term debt Equity
3 Equity/Assets Equity Total assets
The ratios with the EBIT involved are used for both the operating risk and the valuation of the company. The valuation is used for predicting the profitability in the future. (Beattie, 1991).
Ratio: Numerator: Denominator:
4 Turnover Capital employed Revenue Average capital employed
5 Profit Margin EBIT Revenue
6 ROA Return on Assets Average total assets
7 ROCE EBIT Average capital employed
8 TIE EBIT Interest expenses
Constructive capitalization model
The constructive capitalization model is used by Fulbier et al (2008) and Beattie et al. (1991). The model is used for calculating the effects of the capitalization of operating leases. For the calculation of the lease payment per year I calculated the net present value of the operating leases.
Chapter 6 Impact analysis
In this chapter I start with the changes in financial positions resulting from the operating lease capitalizations (Table 1 for changes in median and Table 2 for changes in mean). As a consequence of the changes in the financial statement positions the financial ratios will change due to the capitalization of operating leases. To calculate the significance of the differences in the adjusted and basic financial statement positions, I have calculated the
p-value at a significance level of 1%. Table 3 presents the descriptive statistics for the
Financial statement positions. Table 4 presents all the changes in the 9 selected financial ratios. Table 5 presents the descriptive statistics for the Financial statement positions. The chapter ends with the conclusion on both hypothesis 1 and 2. The supporting statistical tests are presented in table 6 for the financial positions and table 7 for the financial ratios.
Results Financial Statement Position
I calculated the operating lease liabilities and used the median to determine the changes in operating lease accounting. The Median change in liabilities is 4.1%. Compared with other research Fulbier 17.3% in median change I can conclude that most companies must report an extra liabilities when operating leases are capitalized. The method used for the constructive capitalization approach leads to a change of 19.4% for the median EBIT (earnings before interest and taxes) and 3.1% for net income. The changes in total liabilities show an increase of 6.7% on average. The EBIT shows an average increase of 4.5% after lease capitalization has been calculated. The Net income increases on average by 0.4%. The changes in net income are lower than the EBIT.
Table 1: Changes in financial positions in MEDIAN change based on the capitalization of
operating leases.
N=48
Financial statement
position Basis FSP Adjusted FSP Change (absolute)
Change (Relative)
A B B-A (B-A) /A
1 Total Liabilities 164,191 170,903 6,712 4.1% 2 Non- Current Assets 32,017 32,644 627 2.0% 3 EBIT 1,448 1,729 2,801 19.4% 4 Net Income 860 887 27 3.1%
FSP= financial statement position
Table 2: Changes in financial positions in MEAN change based on the capitalization of operating leases.
N=48
Financial statement position Basis FSP Adjusted FSP Change (absolute) Change (Relative)
A B B-A (B-A) /A
1 Total Liabilities
19,121,365 20,402,236 1,280,871 6.7% 2 Non- Current Assets
14,890,655 15,246,617 355,962 2.4% 3 EBIT (2,168,360) (2,070,959) 97,401 4.5% 4 Net Income 2,260,400 2,269,256 8,856 0.4%
FSP= financial statement position
Now we need to test the significance of our statistical tests. The statistical methods can be calculated based on the median and mean values. In order to test the significance of our test work the p-value must be calculated. I have used data before and after the capitalization of operating leases was applied. Two samples of data are there for related to each other. I will use a two-related sample test on both the median and the mean of the financial statement positions. The descriptive statistics in Table 3 show the variables for the financial statement positions.
Table 3 Descriptive statistics: Financial statement positions
N=46
Financial statement position Basis FSP
Adjusted FSP Change (absolute) Change (Relative) A B B-A (B-A) /A
1 Total Liabilities Mean 19,121,365 20,402,236 1,280,871 6.7% 1st 2,089 2,746 657 31.5% 25th 19,910 19,922 12 0.1% 50th (median) 164,191 170,903 6,712 4.1% 75th 2,611,512 2,664,902 53,390 2.0% 99th 778,771,393 792,768,948 13,997,555 1.8% 2 Non- Current Assets Mean 14,890,655 15,246,617 355,962 2.4% 1st 14 18 4 25.7% 25th 5,015 5,198 183 3.6% 50th (median) 32,017 32,644 627 2.0% 75th 1,587,800 1,892,356 304,556 19.2% 99th 616,625,712 623,859,813 7,234,101 1.2% 3 EBIT Mean (2,168,360) (2,070,959) 97,401 4.5% 1st (6,469) (2,980) 3,489 53.9% 25th 127 179 53 41.6% 50th (median) 1,448 1,729 281 19.4% 75th 24,948 25,418 470 1.9% 99th 8,313,000 8,484,672 171,672 2.1% 4 Net Income Mean 2,260,400 2,269,256 8,856 0.4%
1st (648,090) (642,751) 5,339 0.8% 25th 113 118 5 4.3% 50th (median) 860 887 27 3.1% 75th 24,561 24,561 - 0.0% 99th 104,492,942 104,800,559 307,617 0.3%
Results Financial Ratios
For the financial ratios I have calculated both the median and the average changes. The table shows the absolute and the relative change in these ratios. The first three ratios describe changes in the balance sheet. The NCA/TA and the E/A ratios change considerable both in median as in average change.
