Literature review on the upcoming IFRS on recognition of operational lease in the financial statements.

Transcription

1 Literature review on the upcoming IFRS on recognition of operational lease in the financial statements. Minko van Donselaar, student number , University of Amsterdam, BSc Accountancy and Control. Final version 1 July Supervisor Mario Schabus. One of my great ambitions before I die is to fly in an aircraft that is on an airline s balance sheet. Sir David Tweedie, former chairman of the IASB when addressing the Empire club in Canada. 25 april Abstract. In this literature review the IASB s and FASB s proposal on future accounting for leases will be evaluated on the basis of three criteria, distilled from the IASB framework for accounting information. Current legislation (IAS 17 and SFAS 13) only makes the recognition of financial lease contracts obligatory. Operational lease contracts are to be disclosed in the notes to the financial statements. Therefore there is often not enough information for analysts to draw conclusions on the lease obligations an enterprise is committed to. Many lessees restructure their capital leases into operational leases to avoid liability recognition. In the following chapters, the usefulness of financial statements, with respect to lease accounting, is evaluated on the basis of reliability, relevance and comparability of information in these financial statements. Because of the potentially big impact of the new recognition rules on the balance sheets of many companies, an evaluation on the usability improvement of information in future financial statements, claimed by the standard setters, could provide an important contribution. There are estimates that suggest that the implementation of these 1

2 recognition rules would add $2 trillion dollars of lease obligations onto corporate balance sheets (Chasan, 2012). Recognition of operating leases could improve the reliability of information because auditors apply bigger materiality thresholds on balance sheet figures. The relevance and comparability however, will not improve. Recognition could actually result in a loss of information. The IASB s right to use approach causes for a gap between the accounting for lease figures and the true economics of the underlying lease transaction. This influences the relevance of the lease accounting information in a negative way. Because the possibilities of options in lease contracts are endless, and due to the fact that in the IASB s proposal, these options are not to be recognized on the balance sheet, comparability of financial statements is also influenced negatively. The IASB s proposal leaves enough room for manipulation of the balance sheet figures. By extending short lease contract for example, the recognised balance sheet figures are easily manipulated. Also the choice between two possible discount rates could create manipulation of the reported liability figure. Comparing the financial statements of several companies is therefore virtually impossible. Therefore the usefulness of financial statements is not enhanced if the IASB s proposal is actually implemented in the future. Samenvatting. In dit literatuuronderzoek wordt het voorstel van de IASB en FASB over de toekomstige accountingregels met betrekking tot leaseaccounting geëvalueerd op basis van drie criteria welke gedestilleerd zijn uit het framework voor accounting informatie van de IASB zelf. De huidige regelgeving (IAS 17 en SAFS 13) verplicht alleen de balansopname van financial leasecontracten. Informatie over operational leasecontracten moeten vermeld worden in de notities bij het jaarverslag. Daarom is de informatie over de leaseverplichtingen van een organisatie waar analisten hun conclusies op moeten baseren vaak onvoldoende. Veel lessees buigen hun financial leasecontracten om naar operational leasecontracten om zo de erkenning van betalingsverplichtingen van de balans te krijgen. In de volgende hoofdstukken wordt de bruikbaarheid van jaarverslagen met betrekking tot de leaseaccounting geëvalueerd, op basis van de criteria betrouwbaarheid, relevantie en vergelijkbaarheid van informatie in het jaarverslag. De bruikbaarheid van jaarverslagen zal volgens de IASB na implementatie van het voorstel immers verbeteren. Omdat de nieuwe 2

3 regels voor balansopname waarschijnlijk een grote invloed hebben op de balansen van veel organisaties kan een evaluatie van deze verbetering in bruikbaarheid een belangrijke bijdrage leveren. Er zijn schattingen dat de implementatie van een dergelijke regel $2 triljoen dollar aan lease verplichtingen op de balansen van bedrijven zal toevoegen (Chasan, 2012). De balansopname van operational leasecontracten zou de betrouwbaarheid van informatie kunnen verbeteren omdat auditors een grotere materialiteit hanteren bij bedragen die op de balans staan in vergelijking tot bedragen vermeld in de notities. Echter, de relevantie en vergelijkbaarheid zullen niet verbeteren. De balansopname van alle leasecontracten zou zelfs tot een verlies van informatie kunnen leiden. De gebruikersrecht benadering" van de IASB zorgt voor een kloof tussen de bedragen in de leaseaccounting en de daadwerkelijke economische inhoud van de leasetransactie. Dit beïnvloedt de relevantie van de leaseaccounting informatie op een negatieve manier. Omdat de mogelijke opties in lease contracten eindeloos zijn en omdat deze opties in het voorstel van de IASB niet op de balans worden opgenomen, heeft dat een negatieve invloed op de vergelijkbaarheid van jaarverslagen. In het voorstel van de IASB is genoeg ruimte voor de manipulatie van de bedragen op de balans. Door bijvoorbeeld een kort lease contract telkens te verlengen kan een opgenomen bedrag op de balans gemakkelijk gemanipuleerd worden. Maar ook het feit dat de lessee een keuze heeft tussen twee interest percentages bij het bepalen van de contante waarde van de lease verplichting zou manipulatie in de hand kunnen werken. Het vergelijken van de jaarverslagen van verschillende bedrijven is daarom vrijwel onmogelijk. Daarom zal de bruikbaarheid van de jaarverslagen niet verbeteren als het voorstel van de IASB in de toekomst geïmplementeerd wordt. 3

4 Chapter outline. 1. Introduction P Background P Current legislation. P Leasing instead of buying. P Financial ratio s and the problems for stakeholders. P The proposal for future lease accounting. P The quality of information and the usefulness of financial statements. P Evaluating the proposal. P The reliability of financial reported information. P Reliability and relevance, trade-off or compliments? P Relevance. P Comparability. P Conclusions P references. P.24 4

5 1 Introduction. On may 16, 2013 the International Accounting Standards Board (IASB) and the United States Financial Accounting Standards Board (FASB) published an exposure draft for public comment, containing a proposal for new standards for the accounting for leases. Current legislation (SFAS 13 in the United States and IAS 17 globally) states that only financial lease is to be recognised as an asset and liability on the balance sheet. Operational leases are only to be disclosed in the notes to the financial statements (ISAB, 2012a). The IASB, together with the FASB (US GAAP) proposes to, in the future, recognise all leases with longer duration than twelve months (including operational leases) on the balance sheet. Since 1976 the implementation of SFAS 13 and the later implementation of IAS 17 in 1982, caused a shift in many financial statements. Many lessees restructured their capital leases into operational leases to avoid liability recognition (Imhoff and Thomas, 1988). According to Johnson (1992) there where concerns that disclosure overload was occurring. Because of the sheer volume of disclosures, investors are having increasing difficulty analysing financial statements. The information about a companies lease obligations available in the notes to the financial statements is often not enough to draw conclusions on the value of these leased assets in the lessees operation (IASB, 2012b). According to the IASB, reporting all leases of more than twelve months on the balance sheet should increase the usefulness of the financial statements. Hans Hoogervorst, chairman of the IASB, claims that the proposals outlined in the exposure draft will go a great distance towards improving the quality and comparability of financial reporting of lease obligations. The IASB states that transparency on the true leverage of a company would increase. Greater accuracy and comparability should lower the costs and the effort investors make analysing the financial statements (IASB, 2013). Operational lease contracts, however, are often not as straight forward compared to financial lease contracts. There usually are many options to consider when valuating operational lease contracts (Trigeorgis, 1996). Options for contract extension or ending the contract prematurely for example. The IASB proposes to value operational leases by simply discounting and aggregating all future cash flows from the lessee to the lessor. This will amount in one asset figure on the balance sheet, and one liability figure (IASB, 2012a). Will this really improve the transparency of these often complicated contracts? 5

6 Because the implementation of the new accounting standard is imminent the most important question to be answered in this literature review is: to what extend does the implementation of the IASB s proposal on lease accounting improve the usefulness of the lessees financial statements? Because of the potentially big impact of the new recognition rules on the balance sheets of many companies, an evaluation on a quality improvement of information in future financial statements could provide an important contribution. Estimates are suggesting that the implementation of the upcoming recognition rules would add $2 trillion dollars of lease obligations onto corporate balance sheets (Chasan, 2012). This research attempts to answer the question above by testing criteria on the quality of information in financial statements, set up by the IASB itself. In the proposal for future lease accounting, also the accounting for leases by the lessor is discussed. Because the difficulties for analysts on the treatment of leases in the lessees financial statements is cause for the biggest concern, only that part of the proposal is evaluated in this review. Chapter two describes the background on leases, incentives for accounting choices, the information problems for analysts and the current legislation. Chapter three outlines the criteria of the quality and usefulness of accounting information. In chapter four the new accounting proposal will be evaluated against these criteria. In chapter five a conclusion will be drawn on the findings of this review and a recommendation for future research will be discussed. 6

7 2 Background. This chapter starts with a description of the current legislation in lease accounting. In sector two several reasons for leasing instead of buying an asset will be covered. The third sector describes the impact of recognition on financial ratio s and the problems of processing information for analysts. Finally, sector four explains the proposal for the new legislation on accounting for leases with a simple case calculation. 2.1 Current legislation. In the current lease accounting standards there is a distinction between two kinds of leases, financial leases, called capital leases under United States GAAP, and operational leases. A contract is classified as a financial lease if ownership (all the risk and rewards associated with the leased asset) is transferred from lessor (selling party of the lease) to the lessee (the using party of the leased asset) at the end of the lease period. All other leases are classified as operational (IASB, 2012a). Operational leases are to acquire the use of an asset, not to acquire the legal title. (Graham and King, 2011). When information or an accounting figure is disclosed, it is presented in the notes to the financial statements. When a certain asset or liability is recognised, it is presented on the balance sheet. The current risk and rewards approach (SFAS 13 and IAS 17) states that all financial leases are to be recognised as an asset and a liability, equal to the fair value of the asset or, if lower, at the present value of the lease payments. The discount rate to be used when computing this present value is the interest rate on the lease contract itself (the contract specific rate) or, if that rate is unknown, the average rate for incremental borrowing of the company (the company specific rate). Information about all operational leases is to be disclosed in the notes to the financial statements. The operational lease or rental payments must be recorded as costs in a straight line basis in the income statement (IASB, 2012a). Future operating lease rentals are individually disclosed for the first and second years following the balance sheet date, combined for the third through fifth years, and aggregated for over five years past the balance sheet date. A reason for disclosing certain amounts in the notes to the financial statements instead of recognising them on the balance sheet, could be that this information is less reliable due to uncertainties in the measurement of the amount. (Johnson and Storey, 1982). 7

8 2.2 Leasing instead of buying. When we presume that the goal of an enterprise is to maximise shareholder value, the wealth of the companies owners, the choice of leasing an asset compared to buying it has to be based on a calculation of the net present value of the cash flows of both alternatives (Ofer, 1976). There are however, multiple reasons for leasing instead of buying an asset or using other debt financing. That is, risk sharing reasons, borrowing related reasons, tax reasons and other financial reasons (Lűckerath-Rovers, 2007). The risk-sharing reason has to do with the vast innovations and changes of modern technology. Equipment that is of the highest sophistication when bought today could be out dated and thereby less valuable in a very short period of time. With an operational lease the risk of high depreciation of an asset is thereby transferred from lessee to lessor (Flath, 1980; and Smith and Wakeman, 1985). The lessee therefore has more flexibility to keep its technology up to date (Thomson, 2003; Lűckerath-Rovers, 2007). Other risks are for example, having revenue generating equipment sit idle in low producing periods and owning an entire office building when only needing one floor (Monson, 2001). If a lessor owns the entire building and offers it for leasing, the exploitation could be more cost-effective. The lessor might have bigger bargaining power because of buying large quantities and thus buy the asset at lower costs (Thomson, 2003). The fact that, with an operational lease, the lessor bears the depreciation on the asset, the valuable tax benefits of depreciation are also used by the lessor. Sometimes the lessor can use these benefits more effectively, which lowers the lease cost for the lessee (Oum et. Al., 2000). There are several borrowing related reasons one can think of. First of all, when an organisation has used up its debt-capacity it might want to extend this by leasing instead of financing the asset in another manner. Debt capacity is the ability to borrow. It refers to the amount of funding that an organization can borrow, up to the point where its corporate value no longer increases. It could be that investors and borrowers ignore the operational lease obligations because of their off-balance character. Oum et. Al. (2000) however, argue that the effect of off-balance sheet financing is merely cosmetic. Bank loan officers would not be fooled and reduce their willingness to loan funds when there are lease obligations involved. Second, often in lease agreements no collateral is needed, which lowers risk for the lessee which could enhance its debt capacity (Lűckerath-Rovers, 2007). Third, there could be financial contracting motivations. Outside investors (such as banks and suppliers) are usually 8

9 less informed about a firms operations compared to inside investors (shareholders). This could be a reason to spend a lot of resources on creating restrictive covenants to mitigate conflicts of interest between the investing parties. Because leasing is sometimes seen as a less risky investment, such difficulties could be avoided (Smith and Wakeman, 1985). There are however, also conflicts of interest between lessor and lessee. These conflicts cause agency costs which also express themselves in the costs of creating restrictive covenants. In particular with organization-specific assets this could become an issue. Organization-specific assets are assets that are more valuable within the firm that makes use of them, compared to their best alternative use outside the firm. Klein, Crawford, and Alchian (1978) argue that additional negotiation, administration and contract enforcement costs due to the conflicts between lessor and lessee in the division of the value in excess of the alternative-use value of the asset, are reduced when such assets are bought instead of leased. When deciding how to finance their assets, enterprises take multiple alternatives into consideration. Long- or short-term finances, fixed or variable interest are examples of such variables. Because the general level of interest changes in response to fluctuations in the demand and supply for money, risks or possible gains are created for both the lessor and lessee. This could also be an argument for leasing instead of buying an asset (Monson, 2001). For speculation motives or to avoid such fluctuations and create more certainty on future obligations. Off course, leasing could simply be cheaper for a company than borrowing. When a lessee or borrower file for bankruptcy, it is much easier for a lessor to repossess the leased asset than it is for an investor to reclaim the invested funds. Because this risk is lower, a lower risk premium is necessary to incorporate in the lease price, which lowers the interest on the lease contracts (Rauh and Sufi, 2012; Sharpe and Nguyen, 1995; Eisfeldt and Rampini, 2009). Combining different services in one contract might be cheaper and/or easier for the lessee. With car leasing for example, the use of the vehicle, insurance and road taxes are often included in the contract. This saves time and recourses on the part of the lessee, which creates more time to focus on its core business. 9

10 2.3 Financial ratio s and the problems for stakeholders. Disclosing lease obligations instead of recognizing them on the balance sheet has a positive effect on certain financial ratio s. Ceteris paribus, lower assets result in higher return on assets (net income divided by total assets) and lower liabilities results in a lower debt to equity ratio (total liabilities divided by shareholders equity). Lenders use debt to equity ratios to asses creditworthiness of customers. Equity investors use return on assets and revenue per dollar of fixed assets when analysing a company (Monson, 2001). Often, management compensation is based on these financial ratio s. This gives incentives for managers to convert financial leases into operational leases because of their off-balance character (Lűckerath-Rovers, 2007). Since 1976 the implementation of SFAS 13 (US GAAP) caused a shift in many financial statements. One reason for giving information in the notes to the financial statements instead of recognising it could be because certain information is considered less reliable and / or uncertain (Johnson and Storey, 1982). Many lessees however, restructured their capital leases into operational leases to avoid liability recognition (Imhoff and Thomas, 1988). In 2004 for example, 85 percent of leasing obligations took place under leases that avoided the lease capitalization criteria of SFAF 13, (Lindsey, 2006). According to Johnson (1992) there where concerns that disclosure overload was occurring. A good example of this overload phenomenon is visible in the airline industry. According to estimates from the 1990 s, approximately one-half of the world aircraft fleet was operating under a lease contract, with an increasing trend towards short term operating leases (Oum et. Al., 2000). In the United States, aircraft leasing rose from 19 percent in 1969 to 54 percent in Operational leasing rose from 13 percent in 1969 to 82 percent in 1991 (Gritta et. Al., 1994). At the end of 2004, total operational lease obligations recorded by U.S. firms exceeded $1 trillion (Lindsey, 2006). Many analysts view non cancellable leases (for the lessee) as financing transactions, but only a small portion of these transactions are actually reported on the balance sheet. In informational efficient markets, information is easily available to everyone and there are no costs involved in getting this information. In such a market the issue of disclosure versus recognition would not be an issue at all. In the real world however, information is not freely available. There are the cost of processing information (Barth et. Al., 2003) and systematic biases in how this information is processed (Hirshleifer and Teoh, 2003). Many annalists go trough the effort of making adjustments to the reported amounts to incorporate the future 10

11 lease obligations on the balance sheet. (IASB, 2012b). A rule-of-thumb procedure to estimate the total lease liability is often used by security analysts. The total annual rent is multiplied by a factor of eight and then added to the balance sheet debt. Calculating the present value of minimum lease payments reported in the notes to the financial statements however, is also often used by security analysts (Cottle et. Al, 1988). The problems with disclosure arise because information available in the notes is often insufficient to make reliable estimates (IASB, 2012b). Which leaves the valuation of an enterprise and the comparison of multiple enterprises open for subjectivity. 2.4 The proposal for future lease accounting. According to the IASB, the objective of the new proposal is to develop a standard that establishes the principles that lessees and lessors must apply, to report useful information to users of financial statements about the amount, timing and uncertainty of cash flows arising from a lease. The exposure draft, published on 16 may 2013 explains the proposal for future lease accounting. Recognition of lease obligations will only be compulsory with leases longer than twelve months. Within operational leases there will be a distinction between leases for real estate called a type B lease and other leases called type A leases. This is what is called the dual approach. The distinction is made on the amount of consumption of the underlying asset during the lease contract period. It will better reflect the difference in economics between a lease obligation that uses up the underlying asset (for example vehicles and equipment), that have a significant lower residual value at the end of the lease period and thus depreciate, called a type A lease, and lease obligations were merely the use of the underlying asset will be paid for (buildings, land) called a type B lease. Leased assets would be presented on the balance sheet within property, plant and equipment. Table 1 on page 12 illustrates a simple example of two, three year lease contracts. The annual payments for both contract is 231 and in both contracts the discount rate is 7.5 per cent. Again in practice there are two possible discount rates, the company specific rate and the contract specific rate. On the left a vehicle or equipment is leased, a type A lease. On the right real estate is leased, a type B lease. For most real estate leases, a lessee would report a straight-line lease expense in its income statement. Only the lease payments are recorded as 11

12 an expense in the income statement as well as in the cash flow statement. Probably the same amount annually through the duration of the contract. The balance sheet figure shows the aggregated present value of the lease payments, the right of use, in the future. Note that the asset and liability figure are the same. For the type A lease the lessee would report amortization of the asset separately from interest on the lease liability. The annual amortization in this case is 200. The liability side however, shows the aggregated present value of the annual payments of 231. In the income statement the type A lease amortization and interest expense is recorded separately. This causes for different figures in assets and liabilities. Accounting for a type A lease is therefore more complex than for a type B lease. In the cash flow statement, the cash paid for the principle is recorded in financing activities and the cash paid for interest is recorded separately, also in financing activities or in operating activities. Type A lease Type B lease cash flow Year cash flow BS year Asset Liability IS Expense year Operating expence Interest Total Lease Liability Year Accounting Begin balance interest Payment End balance Liability calculation Year Interest ( ) 231- ( ) 231-(215-0) calculation Interest expense Year = (231 / 1,075) + (231/ 1,075²) + (231/1,075³) 414 = (231/1,075) + (231/1,075²) 215 = (231/1,075) Table 1. IASB (2013). Type A and type B leases. Three year contracts, 7.5% discount rate. 12

13 The IASB and the FASB are also proposing disclosures that should enable investors and other users of financial statements to better understand the amount, timing, and uncertainty of cash flows arising from leases (IASB, 2012b). 13

14 3. The quality of information and the usefulness of financial statements. This chapter describes the IASB s own perspective on the quality of financial information and the usability of financial statements. Three criteria are set up to evaluate the proposal for future lease accounting. According to the IASB, qualitative characteristics of information determine its usefulness to (potential) investors, lenders and other stakeholders of the reporting entity. The usefulness of financial information determines the ability of all stakeholders to make decisions about their stake in the reporting entity. There are various ways to explain what quality and / or usefulness of financial information entails. Singhvi and Desai (1971) state that quality of financial disclosure addresses completeness, accuracy and reliability. Francis and Schipper (1999) interpret usefulness as value relevance by dividing it into the content of financial information, what is reported, and the timeliness of information, when is it reported. The IASB conceptual framework for financial reporting (2011) states that if financial information is to be useful, it has to be relevant and reliable. Information is relevant if it has predictive value and confirmatory value. Monson (2001) highlights that also the timeliness of information determines its relevance. Useful information is to be faithfully representing what it purports to represent. It must be complete, neutral and free from error (IASB framework, 2011). Monson (2001) summarizes this as reliability. Usefulness is enhanced if financial reports are comparable. The relevance of financial statements depends on the extend that accounting information can be used to make comparisons either from period to period or from one entity to another (Monson, 2001). Investors need information to assess the nature and magnitude of the risk an enterprise is exposed to in order to distinguish between multiple investment projects. A new accounting policy that enhances the reliability, relevance and comparability of the information about the position of the enterprise on this risk is preferred (Monson, 2001). So, to make an evaluation on the proposal for future lease accounting and its usefulness, we have to determine if reliability, relevance and comparability of financial statements in respect of an enterprises lease obligations is likely to be enhanced after its implementation. These will be the three criteria on which the evaluation is based in the following chapter. 14

15 4. Evaluating the proposal. The following chapter evaluates the IASB s lease accounting proposal on the criteria set up in chapter three. The reliability and relevance is discussed and later linked together as complimentary criteria. Comparability is evaluated with and without recognition of several options that are possible in lease contracts. 4.1 The reliability of financial reported information. Information is material if its omission or misstatement could influence the economic decisions of users taken on the basis of financial statements. Materiality therefore relates to the significance of transactions, balance sheet amounts and possible errors in the financial statements. When a misstatement is found by the auditor, a consideration will be made by the auditor on how significant or influential the misstatement is. Materiality is relative to the size of the particular company, but also to the particular account on the balance sheet. An estimate error of $ dollar on a two million dollar asset for example, is usually not material. On the other hand, a $ dollar error in a $ dollar cash position is very material. According to research of Libby, Nelson and Hunton (2006), auditors view misstatements in recognised amounts to be more material compared to amounts that are disclosed. Auditors are willing to use a higher materiality threshold when they find an error in disclosed amounts compared to recognised amounts. So, they demand much greater corrections when they find misstatements in amounts on the balance sheet, compared to the same amounts disclosed in the notes. This could be an indication that disclosing information in the notes to the financial statements reduces information reliability. The higher tolerance for misstatements in the disclosed notes, compared to on the balance sheet could reduce the quality of financial statements overall. Libby et. al.(2006) describe the possibility of a self fulfilling prophecy. Because the standard setters decide that information that is less reliable is to be reported in the notes, auditors already view this information to be less reliable and thus apply a different materiality, which actually causes this information to be less reliable. If auditors apply a bigger threshold for materiality in figures recognised on the balance sheet, with recognition of leases, reliability could be enhanced, which could suggest that the new IASB proposal on leasing is preferable. 15

16 4.2 Reliability and relevance, trade-off or compliments? According to Givoly and Hayn (2000), earnings recognition has become more conservative over the last decennia. The cause is that expenses and anticipation of future losses in income are earlier recognised in the financial statements. Gains however, are recognised not before they are realized. This prudence in accounting has become of bigger importance, promoted by the standard setters (Givoly and Hayn, 2000). The recognition of current earnings is more precise and are therefore more able to predict future cash flows. These future cash flows, discounted in present value, determine the share price of the enterprise. So the conservatism in modern accounting enhances the relevance of accounting information. The estimation of future losses however, might increase the chances of an error in measurement and bias into accounting accruals because there is a lot of uncertainty involved in these estimates. Future earnings are therefore harder to predict. Hence, the reliability of accounting information decreases. In accounting research this phenomenon is called the trade-off between relevance and reliability (Bandyopadhyay et. al., 2010). Kirschenheiter (1997) states that reliability is determined by the precision of an estimate. According to Dye and Sridhar (2004) making the trade off between reliability and relevance is one of the biggest problems in financial accounting. Examples of decisions effected by the trade-off are, using cost versus market value in asset valuation, decisions on the timeliness of information and deciding what information to recognise on the balance sheet, and what to disclose in the notes. This trade-off seems to be unavoidable because financial statements often contain aggregated figures and summaries. If there were no limits in the length of financial statements the trade-off would not be an issue at all because all information would be disclosed and left for the users of the financial statements to asses for themselves (dye and Sridhar, 2004). This reliability and relevance trade-off however, is not likely to be an issue in the assessment of lease obligations. The trade-off issue arises because of biases or errors that are made when estimating future cash flows. With leasing these cash flows are contractually binding so, estimating them is hardly necessary. Furthermore, if the interest rate on the contract itself is used to discount these cash flows, no wrong assumptions could possibly be made. So the concern that reliability decreases if relevance is enhanced and vice versa should not be a part of this evaluation of the new lease accounting proposals. In the contrary to the trade-off phenomenon described above, amongst others, Barth et. al. (2001; 2003) and Lindsey (2006) share the opinion that relevance and reliability are 16

17 complementary to each other. Reliability is very important when equity investors valuate accounting amounts. Because in the current disclosure of leases, the lease obligations are aggregated in a one to five year figure and a figure for beyond five years, the reliability is uncertain (Lindsey, 2006). In their research on recognition versus disclosure in 2003, Barth et. al. find that recognising a highly unreliable accounting figure, can result in a better price informativeness for users of financial statements. An important result however, is that when disclosed figures are aggregated and recognised, it does not always result in a better price informativeness for users of financial statements. This could indicate that disclosure of operating leases alone is sufficient enough. Lindsey (2006) provides evidence that the (often limited) disclosures of operational leases as current legislation prescribes, provide sufficient reliable and relevant information to estimate firm values. Lindsey also proves that equity investors price operating and capital leases differently. Which suggests that aggregation of all leases into one balance sheet figure could in fact result in a loss of information. Barth et. al. (2003) find that relevance is an significant factor to reliability. So, reliability should be viewed in combination with the relevance of information. When relevance is enhanced, reliability is as well. 4.3 Relevance. How do we operationalize the rather vague concept of relevance? According to Barth et al. (2001) value relevance studies determine whether accounting amounts are informative for investors when valuating a firm s equity. Value relevance is an empirical operationalization of the concept of relevance because an accounting amount will be value relevant, i.e., contributes to the prediction of future cash flows to determine share prices, only if the amount reflects information that is relevant to investors in valuing the firm and is measured reliably enough to be reflected in share prices. Only if an accounting amount is relevant to a financial statement user, can it be capable of making a difference to that user s decisions (Barth et al, 2001). In the last decades there has been an ongoing debate about the value relevance of recognised versus disclosed amounts. But there does not seem to be a consensus on the matter. Some empirical results from different researches state that recognition versus disclosure does improve relevance of amounts in financial statements. Davis-Friday, Folami, Liu, Mittelsteadt (1999) for example, on retirement liabilities, other than pensions. And Ge 17

18 (2006) and Ely (1995) on operating leases. Other empirical studies state that relevance is not improved by recognition. Al Jifri and Citron (2009) on accounting for goodwill and Gallary and Imhoff (1998) on operational leases in Australia. Because of the contradictory results in these value relevance studies its hard to make an evaluation based on empirical evidence. The IASB in there conceptual framework also link relevance to reliability. The more relevant the information is, the more reliable it becomes. Furthermore, the more relevant and reliable information is, the more suitable for making comparisons (Monson, 2001). Reliable information faithfully represents what is purports to represent. In other words, the information presented in the financial statements have to be a good reflection of the physical economics that underlie the transaction of the asset. Monson (2001) discusses the lease of an airplane and notes that the intangible asset created by the discounted cash flows of the use of an airplane do not reflect the reality that exists in the real world. It is not the contractual obligations that make a contribution to the earnings of the firm. The underlying asset (the airplane) itself facilitates these earnings. It could therefore be that this contribution to the earnings of an enterprise, the relevance, of the operating leased asset derived from contractual obligations is understated (Graham and King, 2011). Graham and King (2011) examine the capitalization of operating leases in two approaches. The capitalization of the lessees right to use the leased asset (the present value of future minimum lease payments) and the capitalization of the underlying value of the leased asset itself. The relation between capitalized operating leases and return on assets is strongest when the value on the balance sheet corresponds to the value of the asset itself that is being leased (Graham and King 2011). This could be an indication that the capitalization of the right to use the asset, as the IASB proposes, is not the best way to enhance the relevance of information. Consequences of capitalization of operating leases for the liability side of the balance sheet however, were not investigated. 4.4 Comparability. In financial analysis the comparability of financial statements across firms is highly important for several reasons. When investors are able to compare the profitability and risks of multiple investment projects, efficient allocation of capital is facilitated and investors are more confident when investing in such projects. The FASB (1980) states that investing and lending 18

19 decisions, the evaluation of alternate opportunities, can not be made rationally if financial information is not comparable enough. The comparability across financial statements is very important for judging a firm s performance using financial ratios (De Franco, Kotha and Verdi, 2011). Multiple academic accounting research find that both capital and operational leases are treated like debt for risk assessment and valuation purposes. For example Ely (1995) and Imhoff et al. (1993, 1995) find that estimated operating lease liabilities based on SFAS no 13 disclosures are positively associated with measures of equity risk. Lidsey (2006) however, investigates the value relevance of operational leases. By experimenting with as-if capitalized operational leases, compared to financial leases (capitalized), he finds that operating and capital leases are priced differently. This could imply that recognition of all leases into one amount would not improve the comparability of the capitalized lease amounts between several firms and in fact could result in a loss of information. Monson (2001) makes certain comparisons on leases with different durations. Comparing the recognised leases of, for example, two airline companies. One has a three year lease obligation and one has an eighteen year lease obligation on the same type of aircraft. Obviously the balance sheet figures are quite different because the discounted cash flows of the eighteen year contract results in a much higher recognised amount. The underlying asset however, the airplane, is exactly the same. In this example, there could be argued that the big differences on the two airline companies balance sheets is actually very logical. The three year lease is a much smaller obligation and, compared to the eighteen year lease, the right to use the airplane is much shorter. But what if the three year contract is extended after three years? In fact, what if it is extended after three years, for five times in a row? In that scenario both companies have the same rights and obligations, both for eighteen years and both on the same airplane. The balance sheet figures however, still differ enormously. In this case, similar economic events are treaded quite differently. In 2007, Hyatt and Reed and in 2008, Kieso et al. find evidence which suggests that companies frequently use renewal options to keep lease obligations off the balance sheet. This indicates that meaningful comparisons of financial statements of these two airline companies is very difficult and maybe virtually impossible (Monson, 2001). Off course the example above is quite a simple one. In reality however, the possible options in lease contracts are endless. Many lease contracts give the lessee certain flexibilities. 19

20 To cancel the lease early for example, leaving the risk of obsolescence with the lessor. Or to buy the asset at a certain price, or to extend the life of the lease (Trigeorgis, 1996). In the IASB proposal, these options are not recognised. If the lease contains a forward option (extention option), it is not recognised unless it is classified as a deritive (Barth, 2006). In that case the forward contract should be recognised at fair value. The IASB investor spotlight on their lease proposal states that a lessee would not include rentals that are contingent on future sales or usage and rentals payable in option extension periods, in the measurement of the assets and liabilities (investor spotlight IASB). But what if we did recognize these options? Trigeorgis (1996) acknowledges the fact that lease contracts that contain operating options are likely to be miss valued if the value of these options are not recognised. The valuation of these options however, is very difficult, if not impossible. Especially when there are multiple options that are present simultaneously (Trigeorgis, 1996). Furthermore, options in lease contracts involve possible cash flows, not contractually binding, actually cash flows. Some of these cash flows are related and others are not. Deciding which cash flows to recon with jointly can have a significant impact on their valuation (Hales and Venkataraman and Wilks, 2007). Monson (2001) states that in most situations there is no observable market to validate the lessee s estimates of the fair values of options recognition. Lease agreements appear to be custom made so the number of variables that determine their value is infinite. Another matter on the standard setters proposal concerns the available choice on the discount rate used in determining the present value of the lease obligation. In the future, just as current legislation prescribes, a lessee can either use the company specific rate or the contract specific rate. The fact that there is a choice, opens the possibility for manipulation. When the choice is up to the lessee, the wise thing to do is discount its lease liabilities using the highest rate of the two, lowering its liabilities as much as possible. Furthermore, riskier lessees will report a lower liability compared to less riskier lessees because there incremental borrowing rate is higher. This double standard not only seems to create a contradiction in the reporting for liabilities (a liability with more risk should be stated as such on the balance sheet), it also reduces comparability because different firms could report different liabilities on the same lease contracts (Biondi et. al., 2011). The IASB s proposal does not seem to enhance comparability, with or without recognition of the options in lease contracts. 20

21 5 Conclusions. In this chapter, after a short summery, the research question will be answered and a recommendation will be discussed for further research on the cost-benefit trade-off of information. In may 2013 the IASB and the FASB published an exposure draft for public comment, containing a proposal for new standards for the accounting for leases. Current legislation states that only financial lease is to be recognised as an asset and liability on the balance sheet and operational leases are only to be disclosed in the notes to the financial statements. The IASB, together with the FASB proposes to, in the future, recognise all lease contracts (including operational lease contracts), longer than twelve months on the balance sheet. Since 1976 the implementation of SFAS 13 and the later implementation of IAS 17 in 1982, caused a shift in many financial statements. Many lessees restructured their capital leases into operational leases to avoid liability recognition. There where concerns that disclosure overload was occurring. Because of the sheer volume of disclosures, investors are having difficulty analysing financial statements. The information about a companies lease obligations available in the notes to the financial statements is often not enough to draw conclusions on the value of these leased assets in the lessees operation. According to the IASB, reporting all leases on the balance sheet should increase the quality of information and the usefulness of the financial statements. Because of the potentially big impact of the new recognition rules on the balance sheets of many companies, an evaluation on a quality improvement of information in future financial statements could provide an important contribution. The question that is at the heart of this review is to what extend does the implementation of the IASB s proposal on lease accounting improve the usefulness of the lessees financial statements? The IASB itself describes usefulness as a combination of reliability, relevance and comparability. To answer the question stated above, these three criteria were evaluated. Because standard setters prescribe that information that is less reliable is to be reported in the notes, auditors already view disclosed information to be less reliable and thus apply a different materiality, which actually causes this information to be less reliable. The reliability of disclosed information in this way works as a self for filling prophesy. If auditors apply a bigger threshold for materiality in figures recognised on the balance sheet, with recognition of 21

22 lease obligations, reliability could increase, which could suggest that the new IASB proposal on leasing is preferable. In accounting research a phenomenon is often discussed called the trade-off between relevance and reliability. According to Dye and Sridhar (2004) making the trade off between reliability and relevance is one of the biggest problems in financial accounting. The reliability and relevance trade-off however, is not likely to be an issue in the assessment of lease obligations. The trade-off issue arises because of biases or errors that are made when estimating future cash flows. With leasing these cash flows are contractually binding so Estimating them is hardly necessary. Furthermore, if the interest rate on the contract itself is used to discount these cash flows, no wrong assumptions could possibly be made. Therefore the concern that reliability decreases if relevance is enhanced and vice versa should not be a part of the evaluation of the new lease proposals. In the contrary to the trade-off phenomenon there are signs that relevance and reliability are complementary to each other. Barth et. al. (2003) find that relevance is an significant factor to reliability. So, reliability should be viewed in combination with the relevance of information. When relevance is enhanced, reliability is as well. When disclosed figures are aggregated and recognised, it does not always result in a better price informativeness for users of financial statements. This could indicate that disclosure of operating leases alone is sufficient enough. Reliable information faithfully represents what is purports to represent. This means that the information presented in the financial statements has to be a good reflection of the physical economics that underlie the transaction of the asset. The intangible asset created by the discounted cash flows of the right to use a leased asset does not reflect a reality that exists in the real world. This could be an indication that the recognition in the right to use approach is not the best way to enhance the relevance of information. In research on value relevance by experimenting with as-if capitalized operational leases Lindsey (2006) found that operating and capital leases are priced differently. This could imply that recognition of all leases into one amount would not improve comparability and in fact could result in a loss of information. In a comparison of two fictitious airline companies, Monson (2001) explains that similar economic events could be treaded differently in different financial reports. If short 22

23 period lease contracts are extended, the balance sheet figures of assets and liabilities concerning these contracts could differ dramatically, compared to long term leases of the same assets, with the same total lease period. This indicates that meaningful comparisons of financial statements after the recognition of leases is difficult and maybe virtually impossible. In reality the possible options in lease contracts are endless. Many lease contracts give the lessee certain flexibilities. In the IASB proposal, these options are not recognised. Valuation of these options however, is difficult. Lease agreements appear to be custom made so in most situations there is no observable market to validate the lessee s estimates of the fair values of options recognition. The fact that lessees can choose between two discount rates in the valuation of their lease liabilities creates a contradiction in the reporting for liabilities and reduces comparability because different firms could report different liabilities on the same lease contracts. The IASB s proposal does not seem to enhance comparability, with or without recognition of options in lease contracts. In conclusion there could be argued that on the basis of the evaluation on the three earlier mentioned criteria, usefulness of financial statements would not improve if the IASB s proposal is actually implemented. If the problems of current legislation arise from a lack of information, it could be better to focus on the informativeness of the lease disclosures. A recognition on the balance sheet of lease obligations does seem to improve reliability because of interpretations of auditors about the materiality thresholds they apply in misstatement situations. Materiality thresholds however, are easy to adjust and agreed upon. Perhaps recognition is a rather drastic method to reach these reliability improvements. The Raad voor de Jaarverslaggeving (Dutch GAAP) (2010) argued that adoption of the new IFRS on leases would rise the costs of preparing the financial statements for companies. The users of the financial statements however, also incur costs when analysing them. If needed, expert information is costly (Barth, 2003). So, there seems to be a trade-off between the costs of preparing the financial statements and the costs of users to assess the figures in them. Balancing between user demands against preparer costs of information involves difficult decisions for standard setters. A cost-benefit analysis could therefore be an interesting topic for further research. 23