Operating Leases and Credit Assessments

Abstract

Operating leases have grown significantly as a source of corporate financing over the last 30 years. Their offbalance sheet treatment, which may in part explain their popularity, raises concern that financial risk may be misjudged and capital misallocated. Prior research evidence on the above issue is mixed. To improve reporting transparency, regulators propose a new accounting concept, right of use, which will add the present value of most leases to the balance sheet. We examine the effect of operating leases on loan pricing by banks, a sophisticated financial statement user. Since leases are a potential debt substitute, we expect them to be important in our setting. With loan spreads as the dependent variable, we test the differential explanatory power and model fit of as-reported financial ratios versus financial ratios adjusted for the capitalization of operating leases. We find that lease-adjusted financial ratios better explain loan spreads, especially for larger lenders. Our results also suggest that retailer leases that are closer in substance to rental agreements than financed asset purchases are less relevant for credit risk assessments. Thus we conclude that banks not only price operating leases, on average, but also make distinctions about which leases should be priced. Second, we explore the role of credit rating agencies and confirm that credit ratings also reflect capitalized operating leases, and find support for an informational role for others' credit assessments. However, unlike banks, rating agencies appear to capitalize all operating leases mechanically. Overall, our results suggest that banks and rating agencies adjust for the off-balance sheet presentation of operating leases and, at least in the case of banks, attempt to do so to reflect the underlying economics of the leases. This evidence lessens concern over the potential negative consequences of existing operating lease accounting and raises concern over proposed accounting that capitalizes all leases regardless of their economic characteristics. Electronic copy available at: http://ssrn.com/abstract=1115924 1 AbstractOperating leases have grown significantly as a source of corporate financing over the last 30 years. Their off-balance sheet treatment, which may in part explain their popularity, raises concern that financial risk may be misjudged and capital misallocated. Prior research evidence on the above issue is mixed. To improve reporting transparency, regulators propose a new accounting concept, right of use, which will add the present value of most leases to the balance sheet. We examine the effect of operating leases on loan pricing by banks, a sophisticated financial statement user. Since leases are a potential debt substitute, we expect them to be important in our setting. With loan spreads as the dependent variable, we test the differential explanatory power and model fit of as-reported financial ratios versus financial ratios adjusted for the capitalization of operating leases. We find that lease-adjusted financial...

The Approaching Lease Accounting Regulations and Its Impact on Cost of Capital, "A Practical Case Study"

“…Also, Shareholders have limited information about lease contracts provisions and their content while debt holders may enforce access to hidden information in contracts' provision text. In contrast, Altamuro, Johnston, Pandit, and Zhang (2012) claim that the effect on credit risk is more than the equity risk, given that leases represent a future cash flow commitment and can impact creditor's claims in liquidation. However, liquidation is the odd case.…”

Does recognition versus disclosure affect risk relevance? Evidence from finance leases in Japan

“…Capital market participants assess firms' risk using accounting information, including recognized amounts in financial statements and disclosed financial information in the notes. In fact, prior studies show that capital market participants amend firms' leverage using off-balance leases and assess firms' equity and credit risk (e.g., Altamuro et al, 2014;Beattie et al, 2000;Bowman, 1980;Ely, 1995;Imhoff et al, 1993;Kraft, 2015;Kusano, 2017a;Lim et al, 2017).…”

“…For an in-depth study of recognition versus disclosure of lease arrangements, the first objective of this study is to examine whether disclosed finance leases are associated with firms' equity risk and whether the risk relevance of finance leases differs between recognition in financial statements and disclosure in the notes. Capital market participants consider off-balance leases when assessing firms' risk (e.g., Altamuro et al, 2014;Beattie et al, 2000;Ely, 1995;Imhoff et al, 1993;Kraft, 2015;Kusano, 2017a;Lim et al, 2017). Even though capital market participants incorporate disclosed leases into their decision making, it is uncertain whether they process disclosed and recognized leases similarly.…”

Recognition versus disclosure of finance leases: Evidence from Japan

“…Moreover, firms can use off-balance sheet leases as an important source of debt financing to expand their borrowing capacity (e.g., Eisfeldt & Rampini, 2009;Lim, Mann, & Mihov, 2017;Sharpe & Nguyen, 1995). Many prior studies investigate whether credit market participants consider disclosed operating leases when assessing firms' credit risk (e.g., Altamuro et al, 2014;Andrade, Henry, & Nanda, 2014;Chu, Levesque, Mathieu, & Zhang, 2008;Kraft, 2015;Kusano, 2018). These studies find that disclosed operating leases are associated with credit risk.…”

“…The first objective of this study is to examine whether disclosed finance leases are associated with firms' credit risk. Capital market participants consider off-balance sheet leases when assessing firms' risk (e.g., Altamuro, Johnston, Pandit, & Zhang, 2014;Bowman, 1980;Ely, 1995;Imhoff, Lipe, & Wright, 1993;Kraft, 2015). However, previous studies, using a sample of Japanese firms, do not find an association between disclosed finance leases and firms' risk (Arata, 2012;Shimizu & Yoshida, 2016).…”