Bringing Leased Assets onto the Balance Sheet (Digest Summary)

The Financial Accounting Standards Board (FASB) and the International Accounting Standards Board (IASB) are reforming accounting standards for lease financing. The expected result of this joint initiative is a move toward recognizing lease obligations on the balance sheet. Capitalizing leased assets alters both the cardinal measures and ordinal rankings of firms by various common metrics.

Investors, analysts, regulators, and empirical researchers may find this research useful when evaluating the impact of capitalizing leased assets and adjusting various accounting measures to compare firms over time. As a proportion of total debt, operating leases used as fixed-cost financing for US corporations increased 745% from 1980 to 2007; capital (on-balance-sheet) leases fell by half. If leased assets had been recognized on the balance sheet over the 27-year sample period covered in the authors’ research, average debt-to-capital ratios would have increased 15–29%, and average levered equity betas would have increased 18–33%. Capitalizing leased assets results in 12% of the sample firm-years being reclassified into a riskier group according to Z-scores. Return on capital (ROC) is shown to increase (decrease) off-balance-sheet (OBS) leasing for firms with positive (negative) operating income.

To demonstrate the potential implications of OBS financing at the firm level, the authors present the example of the Walgreen Company. Walgreen’s reported conventional long-term debt was $38.5 million in 2007, with $19,313 million in total assets; the firm appears to be very conservatively financed. The authors use the leasing model presented by Graham, Lemmon, and Schallheim (Journal of Finance 1998), which estimates the debt equivalent value of OBS lease liabilities as the present value of noncancellable minimum lease payments. Adjusting for commitments of longer than five years, the debt equivalent value of Walgreen’s OBS leases is estimated at approximately $15 billion. Accounting for such on the balance sheet increases the ratio of long-term debt to total assets (LTD/TA) from 0.002 to 0.439. ROC would have fallen from 10.6% to 7.5% in fiscal year 2007 if the leased assets had been capitalized.

The initial sample contains all firms in the merged CRSP/Compustat database from 1980 through 2007, including firms with only common stock and excluding regulated financial firms and utilities. The authors make adjustments for fiscal-year differences. Firms with less than $1 million in total assets, negatives sales, and no debt are not included. The authors use simulated marginal tax rates provided by John Graham of Graham et al. and the 38 industry designations from Ken French’s webpage. The final sample with complete data includes 23,962 firm-years.

The Graham et al. (1998) model is used in various tests and calculations, including a regression controlling for the underlying theoretical determinants of lease financing in a multivariate framework. The trend in US corporations’ use of operating leases as a proportion of total debt shows a significant increase and remains significant with or without adjusting for firm fixed effects. Conventional debt ratios are shown to be significantly negatively related to abnormal OBS leasing, which suggests that the perceived benefits of OBS leasing have historically been an important factor in firms’ capital structures. The authors also adjust common accounting-based measures of risk and performance to reflect the fixed-cost lease obligations and find that each understates the risk or overstates the performance of the firms relying most heavily on OBS leasing.

Practitioners may expect that capitalizing leased assets will have a profound effect on the common risk and performance metrics used in company evaluations. This research is helpful in providing a framework to begin reevaluating companies by using the information disclosed in the notes of the historical balance sheets and income statements.