Economic consequences of operating lease recognition☆
Introduction
Accounting Standards Update No. 2016–02 (ASU 2016–02) requires U.S. public firms to recognize operating lease liabilities (and corresponding right-of-use assets) on the balance sheet for annual reporting periods beginning after December 15, 2018 (FASB, 2016). Many believe that the recognition of operating leases is needed to help financial statement users more comprehensively understand the costs of property essential to a firm's operations and its debt financing risk (e.g., PwC, 2019). The new standard is also expected to discourage lease transactions primarily motivated by reporting considerations (SEC, 2005). However, many managers complained that the new accounting standard would harm lessee firms by unnecessarily affecting their balance sheets and financial ratios, leading to an increase in cost of external financing, lower profitability, and ultimately lower firm value. The dire predictions of managers of having to recognize operating leases versus the strong demand by regulators for increased transparency led to a 10-year debate resulting in ASU 2016–02. The FASB has called for research on the new lease standard to help inform its current post-implementation-review process (FASB, 2021). In this study, we examine whether the new standard affected lessee firms' use of operating leases and capital expenditures and whether these firms' response to the new standard negatively affected their performance and stakeholders.
We first examine the impact of ASU 2016–02 on firms' use of operating leases. Prior research provides mixed explanations for firms' excessive reliance on operating leases prior to ASU 2016–02. One line of research (e.g., Dechow et al., 2011; Cornaggia et al., 2013; Lim et al., 2017; Eaton et al., 2021) suggests that firms disproportionately used operating leases due to managers' reporting incentives.1 Reporting incentives for operating leases manifest in at least two ways. First, managers may have believed that keeping lease obligations off the balance sheet helped to reduce the firm's perceived risk, lower the cost of capital, and facilitate access to additional capital. Second, an agency view suggests that managers may have been attempting to extract economic rent and gain private benefits by using operating leases as a method of off-balance-sheet financing. Under either scenario, ASU 2016–02 is expected to reduce managers' reporting incentives to use operating leases.
A second line of research (e.g., Caskey and Ozel, 2019) argues that the increase in firms' use of operating leases over the 1990–2017 period is due to non-reporting incentives related to the tax and strategic operating advantages of operating leases. Operating leases facilitate borrowing for firms facing financial constraints, help minimize taxes for firms with low marginal tax rates, and allow operational flexibility for firms facing volatile business environments (Eisfeldt and Rampini, 2009; Graham et al., 1998; Gavazza, 2011). Because ASU 2016-02 has no effect on these non-reporting incentives, the conclusion from Caskey and Ozel would suggest the new lease standard should have no effect on managers' decisions on whether to use operating leases.
Using a difference-in-differences test, we find a significant decline in new operating lease commitments after issuance of the new standard (2016–2019) for treatment firms that rely more heavily on operating leases before issuance (2011–2014). This finding supports the argument that by eliminating off-balance-sheet financing, ASU 2016-02 significantly reduced managers' reporting incentives of using operating leases. The results are robust to alternative definitions of treatment firms and controlling for several firm characteristics, macro-economic factors, and firm fixed effects.
We exploit an exception in the new lease standard to further show that the change in operating leasing behavior relates to balance sheet recognition. Specifically, according to ASU 2016–02, operating lease commitments due within one year are not required to be recognized on the balance sheet. Therefore, the off-balance-sheet reporting of short-term leases remains. We find that firms shorten their lease commitments and switch from longer-term to shorter-term operating leases following ASU 2016–02. As anecdotal support of these results, International Workplace Group, a global provider of office space leases, suggested in its 2018 annual report that the short-term lease exception under ASU 2016-02 has increased demand for its short-term services (Bloomberg, 2019). Many managers expressed similar beliefs that their firms will shorten lease terms.2 In total, our findings support the conclusion that the decline in firms' use of operating leases is attributable to the reduction in reporting incentives for using operating leases.
Following the literature on lease-versus-buy decision (e.g., Beatty et al., 2010), we next hypothesize and find evidence that lessee firms increase their capital expenditures following issuance of the new standard. The increase in capital expenditures is consistent with recent survey responses by managers that the new standard would cause them to change their real investment behavior (Deloitte, 2014). To further validate whether the shift from operating leases to capital expenditures is consistent with reporting incentives, we provide several cross-sectional tests. We expect the shift from operating leases to capital expenditures to be more pronounced for firms that had greater reporting incentives to use operating leases prior to ASU 2016–02. We find evidence consistent with this expectation. The decrease (increase) in operating leases (capital expenditures) is greater for firms with higher sales growth and with a higher ratio of long-term leases to total leases. In addition, while prior research focuses on the balance sheet incentives of operating leases, we introduce income statement and cash flow reporting incentives. Firms with greater incentives to report higher EBITDA or higher operating cash flows experience a larger shift from operating leases to capital expenditures.3 In contrast, for firms that were more likely using operating leases prior to ASU 2016–02 for non-reporting incentives (e.g., financial constraints prevented them from purchasing assets), the switch from operating leases to capital expenditures is mitigated. Overall, the cross-sectional tests provide additional evidence that firms' leasing behavior is affected by reporting incentives.
We next examine whether firms' response to ASU 2016–02 affected their financial performance and stakeholders. The predicted consequences of the new standard on firm performance are mixed. While managers issued dire warnings that ASU 2016–02 would have negative effects on firm performance, standard setters and academic researchers suggested that the new standard should have no effect or perhaps even have positive effects on firm performance by constraining opportunistic uses of operating leases and encouraging more cost-efficient methods of asset acquisition. For our treatment firms that reduced their use of operating leases following the issuance of ASU 2016–02, we find no evidence of negative effects on reported firm performance. We do, however, find an increase in their net income, operating cash flows, and sales growth relative to other firms. We also find no evidence of negative consequences to other stakeholders (i.e., lessee firms' shareholders, creditors, and employees). For treatment firms that reduced their use of operating leases after issuance of 2016–02, we find neither a decrease in firm value nor an increase in risk for shareholders. In fact, we find some evidence of an increase in firm value and a decrease in systematic market risk (beta), both of which are not consistent with managers' dire predictions. We also do not observe significant effects of the reduction in operating leases on debt covenant violations or employment following ASU 2016–02. Instead, we find a relative increase in credit ratings for firms that reduce their use of operating leases, likely due to their improved financial performance. Overall, our findings do not support concerns about negative consequences of the new standard.
Our study contributes broadly to an interesting literature on understanding the impact of disclosure versus recognition of accounting information (e.g., Mittelstaedt et al., 1995; Davis-Friday et al., 1999; Guay et al., 2003; Choudhary, 2011; Bratten et al., 2013). Views expressed by managers, regulators, standard setters, and academics on the impact of mandatory accounting changes can sometimes differ dramatically. Managers commonly express negative views on recognition of certain items (e.g., employee stock options, post-retirement benefits, and leases), while they demonstrate less objection to disclosure of these items. Regulators and standard setters tend to believe recognition provides greater transparency, allows greater comparability, reduces users' information processing costs, and deters management opportunism. Academic researchers most often find that investors and creditors can incorporate disclosed versus recognized information similarly in their decisions when reliability is similar across the two sources.
Our study focuses specifically on the economic consequences of requiring recognition of operating leases by lessee firms. Imhoff et al. (1993) find that implementation of Statement of Financial Accounting Standards No. 13: Accounting for Leases (SFAS 13) had real implications on firms' leasing decisions, causing firms to shift from capital leases to operating leases. We extend the analysis to ASU 2016–02 and find a decrease in operating leases and an increase in capital expenditures. As discussed above, prior literature provides mixed arguments on whether reporting incentives contribute to firms' use of operating leases. We believe that ASU 2016–02 provides a powerful setting to address this issue. Consistent with the conclusions of reporting incentives, the decline in operating leases is stronger for firms that likely employed operating leases for their reporting benefits.
Our findings are especially relevant, given the prior debate on the potential impacts of ASU 2016–02. In a study commissioned by the Chamber of Commerce, Chang & Adams Consulting (2012) suggests that the lease accounting change could have a major negative impact on the U.S. economy and job market. However, in a response commissioned by the Financial Accounting Foundation, Lipe (2015) argues that many information users already treat operating lease commitments as a liability prior to the new standard and that the economic impacts would be minimal. We do not find any evidence that firms' reduction in operating leases after the new standard causes negative consequences to lessee firms or their stakeholders. We find no evidence of a decline in profitability, growth, firm value, credit ratings, or change in employees. We also do not find any evidence of an increase in risk or debt covenant violations. The overall evidence in our study favors regulators' and standard setters' decision to recognize operating leases, despite strong opposition by managers.
Section snippets
SFAS 13 and ASU 2016-02
The FASB issued SFAS 13 in 1976. According to SFAS 13, “A lease is defined as an agreement conveying the right to use property, plant, or equipment (land and/or depreciable assets) usually for a stated period of time” (FASB, 1976). Leases were classified into two groups: capital leases and operating leases. The former refers to a noncancelable lease that meets one of the following four criteria: (i) ownership is transferred at the end of the lease, (ii) the lease includes a bargain purchase
Sample selection
The initial sample includes all firm-year observations of U.S. firms from 2011 to 2019 (excluding 2015), a period of eight fiscal years surrounding the issuance of ASU 2016–02 in February 2016. We exclude 2015 from our sample because the issuance was close to many firms' year-end dates in that fiscal year. Our design results in four fiscal years prior to ASU 2016–02 (2011–2014) and four fiscal years after (2016–2019).12
Descriptive statistics
The descriptive statistics for the primary sample are reported in Table 1, Panel B. The mean of NewOpLease is 0.025. The amount of new operating lease commitments that a firm makes every year on average accounts for approximately 2.5 percent of firms' lagged total sales. Further, the mean of OpLease is 0.125. The amount of total operating lease commitments on average for firms in our sample is 12.5 percent of lagged total sales. In dollar values, a firm on average has $612 million operating
Robustness tests
As our first robustness test, we determine whether the decline in operating leases after the new lease standard is part of a preexisting trend. In Table 10, we replace Treatment × Post with interactions of Treatment with indicator variables for years in the pre-period (2012, 2013, and 2014). The sample period includes years before 2015. Thus, 2011 serves as the benchmark year. If the treatment firms started to decrease their use of operating leases prior to the issuance of ASU 2016–02, we would
Conclusion
In accordance with ASU 2016–02 issued in February 2016, U.S. public firms are required to recognize operating lease assets and liabilities on the balance sheet for annual reporting periods beginning after December 15, 2018. We investigate how lessee firms have responded to the new standard and how their financial performance and stakeholders have been affected by these firms' response to the new standard. We find a reduction in new operating lease commitments around issuance of ASU 2016–02 for
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We are grateful for comments received from Wayne Guay (editor), James Wahlen (reviewer), Amanda Carlson, Judson Caskey, Preeti Choudhary, Derek Christensen, Artur Hugon, Zach King, Mayer Liang, Tom Linsmeier, Eldar Maksymov, Maria Rykaczewski, David Samuel, Shyam Sunder, Dan Wangerin, Olena Watanabe, Roger White, and workshop participants at Arizona State University, the University of Arizona, Iowa State University, Oklahoma State University, Utah State University, and the University of Wisconsin.