Evidence Shows Investors Should Benefit from Lease Obligations Capitalization
In contrast to support from a majority of investors in a CFA Institute member survey, a Wall Street Journal article, “Sure-Fire Way to Harm the Economy,” reflects opposition to the proposal by the International Accounting Standards Board (IASB) and Financial Accounting Standards Board (FASB) to update their lease accounting standards.
The proposed update to the standard requires companies to recognize all lease obligations on the balance sheet (i.e., capitalization) with only a few exceptions (e.g., short-term leases), and is expected to be issued this year.
Are investor expectations of benefits justified?
Empirical evidence in an academic research working paper, Rating Analytical Adjustments to GAAP Financial Statements and Their Effects on Ratings and Bond Yields, written by Pepa Kraft of New York University, and recently published in the Accounting Review Journal, aligns with our survey results, and strengthens the case for the capitalization of lease obligations. The research finds that rating agency “hard” and “soft” adjustments to current financial statements enable better prediction of reporting companies’ default credit risk. The findings show that the leverage reported under US Generally Accepted Accounting Principles (US GAAP) understates the real economic leverage. Kraft asserts:
“To the extent that the rating agency’s adjustments capture real off-balance sheet financing, leverage ratios based on reported US GAAP numbers significantly understate default risk for a majority of the observations in my sample.”
The aforementioned paper reviews the impact of Moody’s credit rating adjustments, including those that impact on leverage (e.g., underfunded defined benefit obligations, operating leases, and securitizations), and is based on data from 2002 to 2008 for 849 US-domiciled nonfinancial issuers spread across 30 industry groups.
The paper finds an average off-balance sheet debt/total assets ratio of 14%. The rating agency analytical adjustments result in adjustments to US GAAP reported numbers:
- 70% upward adjustment to leverage (debt/total assets)
- 27% downward adjustment to interest expense coverage
- 8% downward adjustment to cash flow to debt
Naturally, the effects on leverage vary across industries due to different characteristics such as asset tangibility and the debt/equity mix employed. The estimates of off-balance sheet debt adjustments (debt adjustment/total assets) across the 30 industries range from 58.6% for retail companies to 2.8% for media companies, and across all these industries operating leases comprised the bulk of off-balance sheet debt.
Economic Relevance of Rating Adjustments
For nonfinancial companies, the proportion of debt financing (i.e., leverage) is indicative of the risk of a company facing financial distress and bankruptcy. Hence, one would expect that more accurate measures of true economic leverage should allow a better representation of default risk. In other words, to the extent that rating adjustments result in a more accurate representation of the true economic leverage, one should expect that adjusted leverage will be more closely related to capital market-based measures of default credit risk (e.g., bond yields, credit default swap (CDS), spreads) than should be the case with the leverage that is currently reported. In this vein, the study finds that rating analytical adjustments result in a closer association with two measures of credit risk, namely: a) the credit default swap spreads, and b) the steepness of the CDS yield curve (ratio of five-year over 20-year CDS spreads). All things being equal, higher CDS spreads and steeper yield curves connote higher default credit risk.
The research also shows that when rating adjustments explicitly incorporate management and corporate governance quality there is better prediction of default credit risk. Overall, the conclusions seem to strongly support the case for companies capitalizing leases rather than investors having to independently estimate the lease obligations and being subject to significant estimation error. As pointed out in a CFA Institute blog post, a 2010 study by Credit Suisse evaluated 494 S&P 500 companies that were obligated to make US$634 billion in total future minimum payments under operating leases. This study showed significant variation in the range of analysts’ estimates of the underlying lease obligations. This imperfect, but necessary, analytical adjustment by investors occurs because of currently incomplete and inconsistent disclosure of related operating lease information provided in the footnotes, and simply improving disclosures will not be enough.
Snapshot Analysis of Effects of the New Standard
As part of demonstrating benefits and analytical implications of the new standard as well as differences between the IASB and FASB models, the IASB earlier this year published a guide on the practical implications of the leasing standard. Worth a read.
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