1. ABSTRACT
Although lease accounting regulations under United States General Accepted Accounting Principles (hereafter US GAAP) and International Financial Reporting Standards (IFRS) have been in place for decades, some of the fundamental principles underlying these lease accounting models have been the subject of much debate by standard setters and practitioners. In particular, the conceptual soundness of Lessees not capitalising operating lease commitments (under IAS 17 and FAS 13, the most recent standards), have been a key area of consideration despite attempts by accounting and financial regulators to streamline disclosure.
Financial disclosure of obligations such as off-balance sheet leases (OBS) has generally extended to a one-line item in the balance sheet with the notes to the accounts. This is the main area where relevant additional detail of these obligations might be addressed in a form and/or substance which is open to the discretion of the preparer but likewise open to misinterpretation and/or estimation of its summary effects by the user.
The mission of the International Accounting Standards Board (IASB) is to develop high quality, understandable, and enforceable global accounting standards and to work with national standard setters, such as the Financial Accounting Standards Board (FASB) to achieve worldwide convergence or harmony (Fletcher 2002, cited by Edman, 2011:13).
This paper considers whether the release of the new accounting standards [IFRS16 and ASC 842, Leases] in 2016 by IASB and FASB (hereafter ‘the Boards’) has supported the IASB to achieve its mission or further complicate the process. The paper uses three large UK companies from the UK FTSE 100, as industry-relevant lessee case studies, to assess the economic and practical consequences of compliance to the new lease accounting standard – IFRS16.
The magnitude of reporting of off-balance sheet assets and liabilities and the impact of enforced lease capitalisation under IFRS16 on these entities (and by inference, the wider corporate environment) is also assessed by examining effects on key accounting ratios that are normally used in financial decision-making. Imhoff’s (1991) ‘constructive capitalisation’ methodology is employed to estimate the unrecorded lease liabilities and assets. IFRS 16 is the focus of this paper, but comparison to and contrast with ASC-842, Leases (the US GAAP equivalent) is included where relevant.
2. BACKGROUND
Leasing is an important activity for many corporate and public sector entities as a means of gaining access to assets, raising financing and reducing an organisation’s exposure to the risks of obsolescence or asset ownership. Many organisations lease assets such as real estate, airplanes, trucks, ships, construction, manufacturing, office and information technology equipment. The use of lease arrangements varies widely, but a broad distinction can be made between short-term leases such as car rentals, medium-term leases such as equipment and long-term leases of buildings and land.
In 1996, the G4+1 Group representing accounting standards Boards of Australia, Canada, New Zealand, the UK and the US published a report titled Accounting for Leases: a New Approach (IASB & FASB, 2007:21) declaring that
“the distinction between operating leases and finance leases by existing accounting standards is arbitrary and unsatisfactory because lessee’s balance sheets omit material assets and liabilities arising from operating leases” (IASB & FASB, 2007: 21).
In 2005, the US Securities and Exchange Commission (SEC) released a report which estimated that US public companies had approximately US$1.25 trillion of off balance sheet leases” (OBS). The focus of the report was to: discourage transactions and transaction structures motivated primarily and largely by accounting and reporting considerations, rather than economics; expand the use of objectives-oriented standards; improve the consistency and relevance of disclosures; and focus financial reporting on communication with investors, rather than just compliance with rules.
In 2009, the FASB and IASB established a joint project to reconsider lease accounting standards. The stated objectives of the project were twofold:
First, to ‘improve the quality and comparability of financial reporting by providing greater transparency about leverage, the assets an entity uses in its operations and to ‘the risks to which it is exposed from entering into lease transactions; and
Second, to ‘develop a new approach to lease accounting that would ensure that assets and liabilities arising under leases are recognized in the statement of financial position’.
Underpinning these significant changes to lease accounting was the central conclusion of both the Boards that confining financial information about a company’s undiscounted commitments for off-balance sheet leases to the Notes to the Financial Statements was not enough, because the information:
(a) is insufficient for some investors and analysts who often estimate a company’s assets and lease liabilities based on the limited information available by using techniques that produce estimates that can vary widely and may not be accurate; and
(b) is not apparent to other investors and analysts who rely on a company’s balance sheet, income statement and cash flow statement to provide information about financial leverage and the asset base of a company without considering information reported in the notes.
The first proposals for amending the leasing accounting standards were published as an Exposure Draft (ED) in August 2010, and heavily criticized. A second ED in May 2013 was generally considered to be an improvement, but many respondents, while supporting the concept of bringing lessees’ accounting for operating leases on balance sheet, felt that the proposed changes to the lessor accounting model were not cost-justified. Developing a consistent accounting approach that required all leases to be recorded on-balance sheet proved to be challenging for the two regulatory Boards. During this process, the Boards also sought to determine:
• whether the arrangement is a lease or a service contract
• what amounts should be initially recorded on the lessee’s balance sheet for the arrangement
• how to reflect the effects of leases in the income statement of a lessee (a point on which the Boards were ultimately unable to converge) and
• how to apply the resulting accounting in a cost-effective manner.
The following three years saw significant revamping of these proposals with the IASB and FASB finally issuing separate standards on January 13, 2016 and February 25, 2016 respectively, with a common effective date for compliance by public listed firms being January 1, 2019. These standards represent a wholesale change to lease accounting, and as a result, firms will face significant implementation challenges during transition to full compliance from 2019 and beyond.
The Boards were also required to confront the following challenges as they reviewed the introduction of new standards including:
1. Applying judgment regarding disclosure of and making estimates of operating lease obligations.
2. Managing the complexities of data collection, storage, and maintenance.
3. Enhancing information technology systems to ensure their ability to perform the calculations necessary for compliance with reporting requirements.
4. Refining internal controls and other business processes related to leases.
5. Determining whether debt covenants are likely to be affected and, if so, working with lenders to avoid violations.
6. Addressing any income tax implications.
The final release of IFRS16 was not a moment too soon for the IASB in 2016 with global listed companies now having circa $3.3 Trillion of leasing commitments – over 85 percent of which do not appear on their balance sheet. These figures suggest that off balance sheet financing has ballooned since the origination of the project in 2009 to become an entrenched corporate financing methodology.
In response to this worrying trend, the Chairman of the IASB stated,
“the development of an improved standard for leasing is vital. At present, investors must take an educated guess to determine the hidden leverage from leasing by using basic disclosures in financial statements and applying arbitrary multiples. It is clearly not in the best interests of investors to expect analysts and others to guess the liabilities associated with leases.”
3. OBJECTIVES OF THIS PAPER
This paper critiques the Boards’ success in achieving their mission to develop high quality, understandable and enforceable global accounting standards.
The paper examines this in the context of whether the accounting quality of financial statements with respect to relevancy, reliability and comparability has been improved by the release of new standards. The paper also considers the effects of the Boards desire for ‘convergence’ on lessee accounting and the Boards’ expectations of enhanced disclosure and resulting transparency of financial statements of lessees under IFRS16 and ASC-842 in comparison to the existing standards IAS17 and FAS13.
Empirically, the paper seeks to identify significant effects of enforced capitalisation of assets and liabilities which were not previously required to be ‘on-balance sheet’ and further considers some of the real-world implications of complying with these new standards from a systems and operational perspective
Keywords: accounting quality; relevancy; reliability; transparency; convergence; capitalisation
4. MOTIVATION FOR STUDY
The vast majority of research was published before the final enactment of the standards in Q1, 2016. In Q3, 2016, corporate entities will be in the first stages of compliance planning; therefore now is the perfect time to be reviewing the challenges and opportunities of this important accounting change.
Personal Motivation:
During my 15-year career in lease management it has often been my role to educate corporate clients on the real and potential impact of lease regulation. Balancing the intellectual challenge of explaining the new standards and their impact to my clients and implementing them to create “greater transparency” for their decision-making has remained paramount as I have tackled this paper.
5. LITERATURE REVIEW
The literature review examines relevant scholarship in separate sub-sections: 1/ how lease accounting information is perceived and used (or could be used) in practice,
2/ the degree to which users and preparers have different perceptions about leases in particular, and
3/ how lease accounting information affects users of that information in lending, credit, and security analysis, with reference to leasing and capital structure and debt and equity.
4/Significant research has also reviewed the ex ante effects of the prior iterations of lease accounting standards with prior studies by Imhoff et al. (1991, 1993 and 1997) documenting the significance of lease capitalisation on lessees’ financial statements. Imhoff’s “constructive capitalization” methodology is adopted for this paper with support from studies in Australia, Canada, Germany, New Zealand, South Africa, the UK, Hong Kong and the US.
1. 5.1 ACCOUNTING QUALITY
The objective for the new IASB lease accounting standard is to “establish principles that lessees shall apply to report relevant and representationally faithful information to users of financial statements about the amounts, timing and uncertainty of cash flows arising from leases” (IASB, 2010, p. 17).
According to the IASB, Relevance and reliability are two key characteristics to determine the usefulness of an accounting number. An accounting amount is relevant (to have predictive value and/ or confirmatory value and be material) if it is capable of influencing the economic decision of a statement user. Reliability is achieved when an accounting amount represents faithfully that which it either purports to represent, or could reasonably be expected to represent (IASB;2001, 2007, 2014). These objectives put simply, aim to ‘improve the accounting quality of financial statements’.
In previous research (Barth, et al., 2008; Soderstorm et al., 2007 and Hribar et al., 2014), accounting quality is either defined by qualitative characteristics of financial information (according to IFRS or US GAAP requirements) or as quality of financial statements (financial reporting); however, there does not appear to be a commonly used definition of accounting quality. The association between relevance, reliability and accounting quality is highlighted by Soderstrom and Sun (2007) in his statement,
“the quality of accounting is determined by the quality of the accounting standards chosen. If the IASB continues to improve the quality of IFRS, we would expect financial reporting under IFRS to become increasingly value relevant and reliable” (Soderstrom & Sun, 2007: 688).
Morais and Curto (2008) and Hribar, et al. (2014) agree that it is difficult to measure accounting quality due to its complexity but find that accounting quality is linked with better earnings management, more timely loss recognition, higher value relevance of accounting amounts, and a lower cost of capital (c.f, Christensen, et al., 2008; Leuz, et al., 2003). Isidro and Raonic (2012) looked at firm-specific factors influencing accounting quality to assess how institutional factors impact changes in accounting quality. In general, users perceive a product (in this case, financial information presented in financial statements of an entity) as having a high level of quality if it conforms with their expectations and satisfies their need for information.
For Tsoncheva (2014) “high quality accounting information” is of key importance for a large number of users, as it influences the quality of the financial and managerial decisions made. Usefulness (or ‘value relevant’ per Soderstrom & Sun, 2007) is determined by the quality of that accounting information. Measuring and assessing the quality and usefulness of accounting information are of particular importance, as these activities will not only enhance the quality of economic decision-making for the users, but the overall market efficiency of the business as well.
The above research illustrates that accounting quality is hard to define and hard to measure. This suggests that it is therefore difficult to conclusively confirm that users and preparers of this information can be certain that the new standards are an improvement on previous iterations of lease regulation. Further, this research provides a body of evidence that the definition of “high” quality as described in the IASB mission is open to interpretation. It must follow then that there is sufficient uncertainty as to whether the disclosure of financial information, with respect to leases in particular, can ever represent a true and fair view of an entity’s financial results and position and enhance users assessment of an entity’s value and help predict a firm’s future performance. This is explored below in Section 5.2.
2. 5.2 PERCEPTIONS OF LEASE ACCOUNTING INFORMATION
Studies have examined how ‘users’ and ‘preparers’ perceive lease accounting information in financial reports. Most studies find that individual users appear to be influenced by whether the information is recognised in the financial statements or merely disclosed in the footnotes to the accounts (Wilkins & Zimmer 1983b; Bretton & Taffler 1995, Gopalakrishnan & Parkash, 1996 and Munter, 2003) which support the Boards position on capitalisation of leases, but some studies do not (Wilkins & Zimmer 1983b, Wilkins, 1984).
A study by Dresdner Kleinwort Benson (1998) found that investment analysts and credit-rating agencies recast financial statements by calculating all assets and liabilities implicit in off-balance sheet operating leases. The importance of this is that while the disclosure of these “hidden” elements was not mandatory as it has become under the new lease accounting standards, this information was already inducted into user perception of the firm’s financial status, albeit that these could be described as more sophisticated investors and analysts.
Company managers (preparers) do not believe that users, individually or in aggregate (i.e. the stock market), process financial information efficiently (Abdel-Khalik, 1981; Beattie et al., 2000). Evidence suggests that users in aggregate are not misled by such presentational issues. There is evidence for both the UK (Beattie et al. 2000b) and the US (Ely, 1995; Imhoff et al, 1993) that the stock market already incorporates operating lease disclosures in its assessment of firm risk. Beattie et al. (2006) surveyed 415 finance directors of UK firms that were included in the UK-quoted industrials (preparers), 400 financial analysts from a London-based associate members list and 72 fund managers listed in CA Magazine (users). Respondents were asked to indicate the extent to which they agreed with a number of statements regarding lease information.
The key findings of this study were as follows:
In concert with the Boards’ aim for the standards, both users and preparers in this study supported a single lease model (i.e. all assets and liabilities on balance sheet) and agreed that the existing standards were inconsistent, lacking uniformity, clarity and did not portray the substance of financial transactions with users more positive than preparers that capitalisation would improve the ability to compare firms.
However it is also important to note that the investors and analysts that Beattie et al. consulted for their study habitually used financial information (whether in the body of the financial statements or in the notes) to estimate assets and liabilities arising from off balance sheet leases. Some tried to estimate the present value of future lease payments. However, because of the limited information that was generally available, many others used techniques such as multiplying the annual lease expense by 8 in order to estimate, for example, financial leverage and the capital employed in operations.
Many investors, however, are not in a position to make these kind of adjustments, relying instead on data aggregators when screening potential investments or making investment decisions, which may not efficiently or clearly, interpret these off-balance sheet assets and liabilities.
3. 5.3 LEASING AND DEBT
In common with Beattie’s study referred to in Section 5.2, the results of IASB’s 2013 ED Outreach process indicated that most sophisticated users of financial statements (including credit rating agencies and lenders) already estimate the effect of off-balance sheet leases on leverage, particularly when an entity has a significant amount of off-balance sheet leases. Lim et al.(2003) supports this, noting that “ratings agencies and finance textbooks agree that long-term lease obligations represent debt, regardless of the accounting treatment”
A number of previous studies have examined the similarities between operating leases and debt in order to understand the debt-like qualities of lease arrangements. This is now particularly important as IASB has determined for IFRS 16 (unlike FASB) that all leases will be treated as debt.
Myers et al. (1976) and Franks and Hodges (1978) both saw leasing and long-term debt as fixed, contractual obligations with leases (operating leases in particular) appearing to be partial substitutes for debt financing, with leases partially consuming debt capacity.
Wilkins and Zimmer (1983) wanted to understand how lease usage affected loan approval decisions, asking Singapore bank loan officers from 35 international banks to review 4 loan applications in a realistic and detailed setting. Participants were told that the applicants’ existing financing came either from a term loan, recognised capital leases, or footnoted leases (assumed to be operating leases). The results indicated no differentiated effect for type of financing product nor risk category – suggesting that the lending officers perceived all the financing structures to be similar when making lending decisions.
Ang and Peterson (1984), with a sample of 600 firms, estimated the relationship between the likelihood and the extent of leasing activity showing a positive and statistically significant relationship between leasing activity and debt ratios. Marston and Harris (1988) analysed coincidental changes in leasing and changes in debt financing across a sample of firms – finding these two variables to be inversely related. Their conclusions seem to confirm therefore that lease and debt are substitutes but also that corporates that employ lease financing typically use higher levels of debt compared to corporates that do not.
All of these studies serve to demonstrate that in the perception of users of financial statements, leasing – whether finance or operating leases – tend to be associated with debt. This summation supports IASB’s position that leasing is another form of financing and to that end, capitalisation of off balance sheet leases makes logical and presentational sense, as does front loading of expenses as if these were traditional borrowing.
4. 5.4 LEASING AND EQUITY
Finance theory also proposes that the level of debt is positively associated with equity risk which is relevant to this paper as investors and analysts use financial and accounting information to assess the equity value of firms. A material variation in perceived firm financial performance due to a significant accounting change to a firm’s capital structure with off balance sheet leases being capitalized under IFRS 16/ASC-842 could distress the stock price of a firm. If the information presented is not clearly described to the market this could influence market perception of the relative performance of the firm to competitors, industry and general indices.
Beaver et al. (1970) discovered that as earnings available to equity holders become more uncertain, the variation in stock price (i.e., equity risk) also increases-suggesting that the level of debt is positively associated with equity risk. Given this relationship, researchers have questioned whether the amount of leases may also be associated with equity risk.
Many critics of FASB Statement 13 (the predecessor to the ACS-842) argued that the general market’s assessment of a firm’s risk would increase if unrecognised finance leases were capitalised. Martin et al. (1979) examined this issue by comparing stock return variance (a measure of equity risk) before and after adoption of FAS13 for 17 U.S. firms that had significant new capitalisations of leases under FAS13. The hypothesis of equal variances before and after FAS13 could not be rejected, suggesting that equity risk did not change when previously unrecognised leases were capitalised. The degree to which the firms’ stock returns covaried with the market return (i.e., Beta) also did not change after adoption of FAS1. These results suggest that any new standard requiring the capitalisation of operating leases would not likely have an effect on the market’s perception of a firm’s equity risk.
Finnerty et al. (1980) and Murray (1982) support the findings of Martin et al, with similar results for samples in the U.S. for which the capitalised present value of lease commitments under FAS13 was a significant portion of total debt. The authors found that the degree to which a firm’s stock returns covaried with the market return (i.e., Beta) did not change significantly after the adoption of FAS13. Bowman (1980) found, using a sample of 92 US firms, that entities with high levels of outstanding debt also engaged in leasing activity. Further, Bowman found that equity risk was positively associated with the present value of capital leases, suggesting that capital leases behave a similar effect to debt on equity risk.
Imhoff et al. (1993) examined whether operating leases might also be associated with equity risk using a sample of 29 airline and 51 grocery firms listed in the US. The authors first confirmed that the reported level of debt was associated with equity risk (measured as the standard deviation in stock returns). The authors then added a variable for the present value of operating leases and found that it enhanced the variation in equity risk. They noted that the measured effects on equity risk were similar for both debt and operating leases.
Yai (2013) examined two large fast-food restaurant chains through constructive capitalisation, indicating that both the return-on-assets and debt-to-equity ratios of the two companies, under various discount rate assumptions, suffered serious deterioration when their operating leases were capitalised.
5. 5.5 IMPACT OF CAPITALISATION OF OPERATING LEASES
Research has also examined the extent to which capitalisation of off-balance sheet leases would impact lessee financial statements. Prior studies have evidenced the impact of lease capitalisation on financial statements and financial ratios. (Nelson, 1963 and Myers et al. (1976) and Ashton (1985) examined finance leases to advance understanding around the effect of leases on capital structure. More recent studies have focused on the impact operating leases would have, if capitalized. Imhoff et al. (1991, 1993 and 1997), Beattie et al. (1998, 2004, and 2006), Kilpatrick and Wilburn (2006) and Duke et al. (2009) are notable studies.
Imhoff et al. (1991) chose seven U.S. firms where the ratio of operating lease cash flows to total assets was relatively high and seven additional firms (size and industry were matched) where this ratio was correspondingly low. Assuming (a) a constant borrowing rate, (b) a constant useful life, and (c) leased assets equal to 70 percent of the capitalised operating lease amount, the authors found that constructive capitalization of operating leases decreased return on assets by 34 percent for high-lease firms, but only 10 percent for low-lease firms. In addition, debt-to equity increased by 191 percent for high-lease firms, but only 47 percent for low-lease firms.
Imhoff et al. (1993, 1997) extended this earlier work to cover industry segmentation with a sample of 29 airlines and 51 grocers over a 6-year term, to find that total debt would increase by a median $195 million for each airline and $57 million for each grocer if operating leases were capitalised. These amounts equaled approximately 40 percent of the median recognised liabilities at the time for both industries supporting the theory that capitalisation of operating leases would have significant effect on the balance sheets of firms, and potentially entire industry sectors.
Using simplified assumptions, Gritta, Lippman, and Chow (1994) calculated the effect of capitalising operating leases on the debt burden of U.S. airlines. Applying a uniform 10% interest rate to discount future lease payments they computed that the debt-to-capital ratio vastly increased from 21.8% to 60.7% for six of the ten firms in fiscal 1991 suggesting that airline leases should be a significant contributor to debt obligations on-balance sheet.
Beattie et al. (1998) reviewed 232 UK firms across multiple industries, allowing for firm-specific measures of borrowing rates and asset-useful lives. The authors examined nine different performance and balance sheet ratios and found that six of the nine ratios (profit margin, return on assets, asset turnover, and three measures of gearing) were materially affected by capitalisation of operating leases, computing that the estimated present value of operating leases amounted to 39% of total debt, on average. In a similar study of 126 U.S. companies in nine industry segments reporting in fiscal 1998, Gosman and Hanson (2000) found, after capitalising operating leases, the leverage ratios of 30 sample firms exceeded 50%, with ten firms reporting over 75%.
Alan Goodacre’s research (2003) into UK retail firms (wherein 98% of the leases related to land and building usage in contrast to the US lease market) also documented a significant impact on multiple performance metrics as well as gearing ratios. Fulbher et al (2006) sampled German firms to corroborate these results, describing an 8% increase in debt-to-equity ratios but only a 4% percent increase in total assets when operating leases were capitalised, suggesting that the German market at the time was dominated by financing structures that were not operating lease-led. The effects were most pronounced for industries such as retail and fashion firms wherein debt-to-equity ratios increased by 58% and noncurrent assets to total assets increased by 32% .
Imhoff’s constructive capitalisation methodology gained a following with Aboody (1996), Altamuro (2006), Lukerath-Rovers (2007), Altamuro, et al. (2008,. 2014), Ahmed, at al. (2009), Cornaggia, et al. (2012) and Demper (2012) all considering potential gains to Off Balance Sheet lease accounting treatment in greater detail. Such was the global popularity of constructive capitalization-as an example, Bennett & Bradbury (2003), sought to validate Imhoff’s studies, with research on firms on the New Zealand Stock Exchange; where a 23% increase in total liabilities and a 9% increase in total assets and 11% average increase in leverage ratio resulted from constructive capitalisation of operating leases. The authors used a 9.4% discount rate and assumed a total lease life of 10 years. Durocher (2008) developed a refined approach for assessing the impact of operating lease capitalisation that incorporates company-specific assumptions to restate reported figures. The results revealed that the mean debt-to-asset ratio increased from 66.2% to 68.9%. However, the author found that return-on-assets, return-on-equity, and earnings-per-share ratios were found to be insignificantly different.
FIGURE 1. ‘The Research Onion’
With reference to Saunders et al (2008: 169) “The Research Onion” (Figure 1), I have adopted a pragmatic philosophy in hopes of balancing competing theories of finance and accounting for leases with expected real world effects for lessees and lessors in complying with the new standards. My research strategy was deductive, predominantly based on a quantitative content analysis, and designed to obtain ex ante evidence of the financial impact from the implementation of new standards.
A large dataset was examined by IASB research (2016) with 13,000 corporate entities from the US and UK, from which certain UK FTSE 100 listed corporate entities were selected as individual case studies for this study. The focus is to assess the potential impact of off-balance sheet capitalization, changes to operating income and profitability, together with corporate capital structure by reference to key financial indicators and ratios, with reference to the ‘constructive capitalization’ method proposed by Imhoff et al. (1991). An industry analysis of the FTSE 100 was compared and contrasted to the IASB sample set to understand the extent to which the findings of IASB research could be supported.
Additionally, qualitative analysis by case study, interview and secondary research from relevant experts was undertaken in support of the objectives of the paper. When first examining the topic of perceptions of financial information, one avenue could have been to provide a survey based to a wider sample of people for their impressions of one set of financial statements under the existing lease accounting standards and one with IFRS16, but it became apparent from initial interviews with experts contacted as part of the research process that the average person would be unable to adequately describe the changes to the financial statements. So a more empirical approach to discovery was taken which led to the Case Study approach found in this study.
The Case Study approach required review of the 2015 financial statements of the three chosen firms to ascertain their balance sheet, income statement and cash-flow for the 2015 year end. This was then interpreted for accounting treatment under IAS17 the existing accounting standards to be compared to the requirements of the new Standards of IFRS16. A re-casting of all the elements comprising the financial statements was then attemoted with assumptions made when information was either not clearly disclosed in the audited accounts of the firm or where there was uncertainty as to the computation required- for example in remainng asset life. Where possible previous scholarship has been referred to support the assumptions made. A Step-by Step metholodogy for the calculations is included in the Case Study section for further clarity of the logic followed.