Lease Accounting Research and the G4+1 Proposal

INTRODUCTION The Group of Four Plus One, or G4+1 for short, is a cooperative effort by national accounting standard setters from Australia, Canada, New Zealand, the United Kingdom, and the United States plus the International Accounting Standards Committee. Conclusions reached by the G4+1 are not recognized as GAAP in any financial reporting jurisdiction. However, by the very nature of its membership, its conclusions influence standard setting in many jurisdictions. Thus, publication of Leases: Implementation of a New Approach (Nailor and Lennard 2000) indicates that accountants may soon be redeliberating the appropriate accounting treatment for lease transactions. Evidence from empirical academic research on lease accounting may be useful to regulators and their constituents as they redeliberate reporting standards for lease transactions. This commentary provides an overview of key results from prior research and, where appropriate, proposes possible future research topics in the leasing area. [1] LESSEE ACCOUNTING ISSUES Most empirical research on financial reporting of leases concentrates on the lessee's use of operating vs. capital lease accounting. The term operating lease accounting method means that the lessee recognizes rent expense on the income statement and does not recognize lease assets or lease liabilities in the balance sheet. Under the alternative capital lease accounting method, the lessee initially recognizes a lease asset and a lease liability in the balance sheet and subsequently records interest expense on the liability and depreciation expense on the asset. On average, lessees seem to prefer operating lease accounting, and much of the empirical research investigates the implications of unrecorded lease commitments. Statement of Financial Accounting Standards No. 13, (FASB 1976) (hereafter SFAS No. 13) provides current guidance for lessees. Noncancelable leases that meet any one of four general criteria (transfer of ownership, bargain purchase option, lease term [greater than or equal to] 75 percent useful life, present value of commitments [greater than or equal to] 90 percent of asset's fair value) must be capitalized. [2] Future payments under both capital and operating leases must be disclosed in the notes. Under the G4+1 proposal, lessees recognize the fair value of any assets and liabilities contained in a lease contract. Recognition begins when the lessor makes the property available to the lessee. Thus, lessee balance sheets are expected to reflect additional lease liabilities if this new approach is adopted. Evidence in Imhoff et al. (1993, 347) and others suggests that the additional lease liabilities could be substantial. Using the operating lease commitments disclosed under SFAS No. 13, Imhoff et al. (1993) constructively capitalize operating leases by estimating the present value of operating leases (PVOL) for a sample of 29 airlines and 51 grocery stores. The median PVOL is $195 million for airlines and $57 million for grocery stores, and these amounts are 35--40 percent as large as median total on-balance sheet liabilities. Lessee Accounting Research: An Analysis of Three Decision Contexts The members of G4+1 agree that the purpose of financial reporting is to provide information for making economic decisions. Empirical research incorporates this view by identifying and estimating linkages between accounting information and actions taken by decision makers. In my discussion of research on lessee accounting, I decompose the research into three decision contexts--financial statement analysis of equity risk, financial statement analysis of equity value, and decisions/actions by management. Research Related to the Risk of the Lessee's Equity Most empirical research on lessee accounting is based on financial statement analysis as the decision context, with particular emphasis on how unrecorded lease commitments might affect assessments of shareholder risk. …