Beruflich Dokumente
Kultur Dokumente
North-Holland
Samir EL-GAZZAR
Rutgers Unioersr<y, Newark, NJ 07102, USA
This study examines factors that affected managements choices in accounting for leases prior to
the implementation of SFAS No. 13. Empirical evidence indicates that tinancial contracting and
management bonus incentive variables help explain the choice. Empirical results do not support
the political cost hypothesis; rather, tax return considerations also seem to influence manage-
ments lease accounting choice.
1. Introduction
*The authors acknowledge the useful comments of Paul Healy, Martin Benis. Eric Noreen,
Joshua Ronen, Ross Watts, and Jerry Zimmerman.
Samir El-Gazzar is also associated with Tanta University in Egypt.
The literature of Positioe Accounting Theor?, is reviewed extensively in Watts and Zimmerman
(1986). An incomplete list of studies on motivations for firms accounting choices includes:
Bowen, Noreen and Lacey (1981), Collins, Dent and Dhaliwal (1981), Hagerman and Zmijewski
(1979). Holthausen (1981), Holthausen and Leftwich (1983). Lilien and Pastena (1982). Leftwich
(1981), Zmijewski and Hagerman (1981) and Watts and Zimmerman (1978).
The 600 firms included in the 1977 Accounting Trends & Techniques (ATT)
constitute the sample for this study. Of these firms. 37 are identified as having
capitalized all leases. An additional four firms included in the 1976 ATT
sample, but deleted from the 1977 ATT sample, are identified as having only
capitalized leases and are included in the current study. These 41 firms were
already capitalizing all their leases prior to the adoption of SFAS No. 13 in
November 1976 and consequently are classified as capitalizers by managerial
choice. The capitalizers were not required to make any retroactive restate-
ments to comply with the statement.
ATT for 1977 classified 300 firms as having only operating leases in 1976. A
search of the annual reports of these 300 firms for the years 1977 through 1979
revealed that 113 of these firms subsequently restated their financial state-
ments to comply with the provisions of SFAS No. 13. We classify these 113
lessees as non-capitalizers by managerial choice because the nature of their
leasing arrangements was such that they were forced to capitalize their leases
retroactively when their discretion was narrowed by SFAS No. 13. The 113
non-capitalizers by managerial choice plus the 41 all capitalizers constitute our
reporting sample of 154 firms.
Table 1
Effects of lease capitalization on lessees debt-to-equity ratios (D/E) and retained earnings
Capitalizersa Non-capitalizersa
Number Number
Increase of firms Percent of firms Percent
1% to 9.9% 34 R3 46 41
10% to 19.9% 7 17 32 2x
20% to 49.9% 0 0 15 13
50% to 99.9% 0 0 13 12
over 100% 0 0 7 6
-
Total 41 100 113 100
Mean and (median) percentages for capitalizers 4.6% (3.7%)
Mean and (median) percentages for non-capitalizers 31.2% (23.5%)
Less than 3% 73 65
3% to 10% 15 13
10.1% to 19.9% 2 2
20% or more 8 7
Not disclosed 15 13
-
Total 113 100
Mean percentage for 113 non-capitalizers 6.0%
Median percentage for 113 non-capitalizers 2.3%
The capitalizers are the 41 lessees that AT&T for 1975 or 1976 identified as capitalizing all of
their leases. The non-capitalizers are the 113 lessees that AT&T for 1976 identified as not
capitalizing any leases. Subsequently, these 113 non-capitalizers had to capitalize their leases to
comply with SFAS No. 13. The increases in the D/E ratio for non-capitalizers reflect the ASR
No. 147 disclosures on lessees 1976 Form 10.KS.
Note that non-capitalizers adopted SFAS No. 13 and capitalized the appropriate leases in
either 1977, 197X. or 1979. The potential negative effects of lease capitalization on RE are
understated in this table because some lessees renegotiated leases prior to their adoption of SFAS
No. 13.
ratio (D/E) for the non-capitalizing lessees is 31.2%. For these non-capital-
izers, the effect of lease capitalization was substantial and may have had
potential for causing violation of lending covenants and other contracts.
Panel A of table 1 also indicates that on average the leasing choice prior to
SFAS No. 13 had an effect on the debt-to-equity ratio of the 41 capitalizers by
choice. The average D/E of capitalizers increased by 4.6% as a result of lease
capitalization. This increase in the capitalizers D/E is obtained by dividing
capitalized lease debt for 1976 by equity for 1976. While this debt-to-equity
S. El-Guzzur et al., Lease accoumng 221
effect is low for the capitalizer group as compared to the non-capitalizer group,
even a 4.6% increase in debt has potential for affecting covenants and financial
contracts. In fact, leasing debt constituted almost half of the total liabilities of
capitalizers.
Panal B of table 1 shows the actual retroactive adjustment to retained
earnings when non-capitalizing lessees adopted SFAS No. 13. The effect on
retained earnings was generally negative and typically less than 10%. The
average decrease in retained earnings was 6%. These results may be under-
stated because management had an extended opportunity to restructure leases
to circumvent the SFAS No. 13 guidelines before SFAS No. 13 was finally
adopted.
Smith and Warner (1979) point out that debt agreements contain covenants
that restrict dividend payments, issuance of additional debt, reacquisition of
common stock, production and investment activities, and payout options.
Often, these covenant restrictions use accounting numbers that are defined in
terms of generally accepted accounting principles (GAAP).
While managers ability to control the calculation of accounting-based
covenant restrictions is constrained by GAAP, the availability of alternatives
in selecting and applying accounting methods within GAAP provides managers
with an opportunity to mitigate the constraints imposed by these covenants. A
series of studies, summarized in Watts and Zimmerman (1986) report results
consistent with the hypothesis that managers utilize their discretion under
GAAP to mitigate financial covenant constraints.
As previously reported in table 1, prior to the promulgation of SFAS No.
13, managers lease accounting choice had an effect on reported debt and
retained earnings. If externally reported debt and equity numbers are gener-
ally used for covenant purposes, capitalization may move many operating
lessees closer to covenant default. In fact, Nakayama, Lilien and Benis (1981)
indicate that expected covenant violations resulting from the capitalization of
lease debt was a major managerial motivation for lobbying against SFAS No.
13. However, Leftwich (1983) reports that most private financial covenants
already required the capitalization of leases for covenant purposes so, by
implication, the method of lease accounting used in external reports would not
affect the calculation of debt for covenant purposes.
Given this apparent conflict in prior literature, we sought further evidence
as to whether the lease accounting choice available under GAAP allowed firms
JAE (
to mitigate covenant constraints. We obtained a sample of 11 private cove-
nants of those firms whose debt was heavily affected by SFAS No. 13. The
lenders to these intensive lessees should be cognizant of the impact of leasing
reporting methods on GAAP financial statements; so, the covenants of inten-
sive lessees are more likely to contain special non-GAAP lease accounting
rules.
Our analysis indicates that in all 11 cases managers lease accounting
choices under GAAP influenced the computation of covenant financial restric-
tions. Only one of the 11 covenants, that of Frontier Airlines. requires the
inclusion of the imputed present value of lease payments in the calculation of
debt. Yet even in the case of Frontier, the covenant based debt-to-equity ratio
uses an unmodified GAAP definition of equity.
Frontier could improve its covenant-based D/E ratio by choosing the
operating method to increase income. Specifically, in switching from the
operating method to the capitalization method to comply with SFAS No. 13.
Frontier Airlines had to reduce equity by 13%. This indicates that prior to
SFAS No. 13, Frontier was able to loosen covenant constraints by using the
operating method for financial reporting.
Our analysis of lessees covenants does not confirm the Leftwich (19X3)
statement that most lease agreements insure that lease liabilities are counted
as debt. The divergent conclusions may be due to sample differences. Our
sample uses eleven agreements between bank lenders and intensive lessees.
Leftwich (1983) focuses on lending agreements that were drafted by insurance
companies. While the intensive lessees in the current sample may not be
representative of all U.S. firms, the debt covenants of intensive lessees are
most likely to be customized regarding leases.
Prior research indicates that firms with financial ratios closer to the limits
specified in covenants should be motivated to loosen the covenant constraints.
Kalay (1982) argues firms with higher D/E ratios are more likely to be closer
to covenant constraints, and so, are more likely to have incentives to adopt
accounting methods that ease those financial constraints. Violation of the
constraints imposes costs because it restricts investment and financing policy
and in some cases leads to technical default and triggering debt renegotiation
costs.
Given the evidence from our covenant analysis that managers can mitigate
the effects of covenant constraints by using the operating method for external
reporting, high D/E lessees should be the most motivated to keep lease
liabilities off the books by using the operating method. As in much of the
previous research, we do not test the actual financial constraints within
covenants. Rather, we assume that the D/E ratio is an adequate proxy for
financial covenant constraints.
The effect of capitalization on debt constraints is affected by both the
magnitude of the capitalization effect and the level of D/E subsequent to
capitalization; thus, we employ several variables to measure the effects of
S. El-Gaz:ar et al., Lease uccountmg 223
When a firms covenants limit its D/E ratio. the creation of additional debt
through lease capitalization will move the firm toward the maximum ratio.
Hence, the effects of lease capitalization on the D/E ratio can proxy for the
extent to which covenants are more likely to limit managements actions.
The Change in Leverage Hypothesis. Those firms who would increase their
D/E ratio the most by lease capitalization ure the most likely to use the operating
method. This implies a positive correlation between the increase in D/E and the
operuting method.
Using Kalay (1982). we infer that firms with high D/E ratios are closer to
their debt covenant constraints. These firms are more likely to adopt proce-
dures that increase equity by shifting income from future periods to the
current period. Firms with high D/E ratios can loosen the effects of account-
ing based constraints by choosing the operating method which increases equity
and avoids additional balance sheet debt.
The Leveruge Hypothesis. Those jirms with the highest D/E ratios after
capitulization are the most likely to use the operating method for lease accounting.
This implies a positive correlation between the D/E rutio and the operuting
method.
The use of D/E as a surrogate for the extent to which covenants are
binding assumes that the D/E level specified in debt covenants does not vary
across industries. However, both Schwartz and Aronson (1967) and Scott and
Martin (1975) find that firms within an industry have similar financial struc-
tures and the D/E ratio of a firm is associated with industry membership.
Hence, it is likely that the D/E level in a firms debt covenants is a function
of its industry. To allow for that possibility, a firms D/E ratio relative to the
industry average D/E ratio is also used as a surrogate for the extent to which
debt covenants are binding.
The Industry Adjusted Leverage Hypothesis. Firms with the highest industry-
adjusted D/E ratios after capitalization are the most likely to reduce debt by
using the operating method. This implies u positive correlation between the
industry-adjusted D/E and the operating method.
3.2. Incentive plan hypothesis
The Incentive Plan H_vpothesis. Those jirms with incentive plans based on
income after interest expense are more like!r? to use the operuting approach for
lease accounting. Those firms without income-based incentive plans or incentire
plans based on income before interest expense ure more like!v to capitalize leases.
This implies a positive correlation between the operating method and income-bused
compensation plans.
This paper uses two measures of political costs: (1) size, which is the
measure used in prior research, and (2) the effective tax rate, which is an
alternate measure of political costs, adopted from Zimmerman (1983). The
paper also tests an alternative hypothesis that views the effective tax as a
surrogate for the tax incentives of capitalizers and reporting incentives of
operating lessees.
S. El-Gazzur et ul., Lease uccounring 225
The Size Hypothesis. Large lessees are more like& to report lower earnings by
capitalizing leases; thus, sales are negative@ correlated with the operating
method.
The Tax-Based Political Hypothesis. Firms with high efSective tax rates are
more likely to reduce their political costs by using lease capitalization to reduce
income. Thus, the effective tax rate will be negatively correlated with the
operating approach.
credit (ITC) and depreciation entitlements. 2 Ideally, these tax entitlements will
be shifted from users unable to take full advantage of the credit and deprecia-
tion deduction to the party who can most benefit from these items. Parties to
contracts will write those contracts to maximize the present value of cash flows
to the contracting parties, ceteris paribus. Arranging contracts so that the
highest-tax-rate firm has maximum tax deductions early in the life of the
contract is a means of maximizing the combined net present value of the tax
benefits available to the lessor and lessee.
The tax and reporting incentives of low-tax lessees. In addition to the financ-
ing benefits, leasing rather than purchasing allows a low-tax-rate lessee to
obtain benefits from tax entitlements that would be underutilized otherwise. If
the lease contract passes tax benefits to the lessor, the low-tax-rate lessee can
share the cash savings from tax benefits by obtaining lower lease rentals. The
ability to share otherwise lost tax benefits is a strong motivator for low-tax-rate
Clearly, the ability to transfer the ITC to the high-tax-rate firm is valuable if one party to the
lease contract is in a tax-loss-carryforward position, In fact, 19 sample lessees disclosed tax-carry
forward positions in their financial statements during the 1970s. It is probable that other sample
lessees were close to a loss-carryforward position, so they would not have fully utilized the ITC.
Also, Schall and Sundem (1982) demonstrate that (under the most likely conditions) even if both
parties to the lease contract can reduce taxes by using the ITC, total tax benetits to both firms are
maximized when the high-tax-rate firm uses the ITC. In fact, Schall and Sundem (1982) argue that
this ability to transfer the ITC to the high-tax-rate firm provides a greater tax subsidy at the
margin to asset leasing than to asset sales to users.
S. El-Gazzur et cd., Leme uccounting 221
firms to lease so we expect that low-tax firms will be more intensive lessees as
compared to high-tax-rate firms.
Comparatively, low-tax lessees do not have tax incentives to obtain tax
entitlements, so they do not need to demonstrate material equity in the leased
property. Accordingly, there are no tax incentives for low-tax-rate lessees to
capitalize leases on their financial statements. On the other hand, low-tax
lessees are likely to be the most intensive lessees so they experience the highest
increases in debt and decreases in income if forced to capitalize. This reporting
scenario leads to a positive correlation between the operating method and
leasing intensity and also implies a negative correlation between the operating
method and the lessees tax rate.
All four models use the existence of an incentive plan based on after interest
income as an independent variable. A dummy variable takes the value one if
an incentive plan existed and incentive income was defined on an after interest
basis. If an income-based bonus plan does not exist, or incentive income is
calculated using income before interest expense, the dummy variable takes the
value zero.
The compensation information source is lessees Form 10-K and its exhibits.
The exhibits often, but not always, contain copies of compensation plans
and/or proxy statements that contain the plans. If the existence of a manage-
ment incentive plan is not mentioned in the Form 10-K or its footnotes or
exhibits, it is assumed that no compensation plan existed.
Column 1 of table 2 shows that 21 non-capitalizers did not have income-
based incentive plans and nine non-capitalizers had incentive plans based on
22x S. El-Guzzur et ul.. Lear uccounrrng
Table 2
Basis for coding of managerial incentive variable using proxy statement and Form 10-K
information,
Non-capitalizers Capitalizers
before interest income. These 30 non-capitalizers take the dummy value zero.
Sixty-two non-capitalizers have short-term bonus plans based on after-interest
income and take the dummy value one. In four other cases, the short-term
bonus plan is based on before-interest income but the long-term bonus plan is
based on after-interest income. These four firms also take the dummy value
one because their long-term plans provide incentives for managers to report
higher income. In total, 66 non-capitalizers are assigned dummy values of one.
Column 2 of table 2 indicates that only 10 capitalizers have incentive plans
based on after-interest income; thus, these ten lessees are assigned a managerial
incentive dummy of one. Twenty-eight capitalizers without incentive plans
take the dummy value zero.
In the case of 20 lessees, the existence of compensation plans is indicated by
the footnotes in Form 10-K; however, detailed information about the income
definitions used in the plan is not included in the exhibits. These 17 non-
capitalizers and three capitalizers are excluded from the empirical testing.
Thus, each of the four models is tested on the basis of the empirical sample of
S. El-Garrar et al., Lease accounting 229
Sign = + + _
Model 3: Z=a+b,LEV~+b,MC+b,TAX,
where
The four models are tested using both N-chotomous probit analysis (NPA)
and multiple discriminant analysis (MDA). NPA was developed by McKelvey
and Zavoina (1975) and used for empirical tests by Kaplan and Urwitz (1979)
Zmijewski and Hagerman (1981), Bowen, Noreen and Lacey (1981) and Lilien
and Pastena (1982). The NPA technique gives significance tests on individual
variables as well as significance tests on overall classifications. The MDA tests
use the holdout approach developed by Lachenbruch and Mickey (1968) to
avoid biasing results by testing the model on the same data used to develop
the model.
230 S. El-Gazrar et al., Lease accounting
Table 3
Probit results in which the dependent variable is the lease reporting choice (capitalizers take the
dependent value zero and non-capitalizers one).
Independent
variables Model 1 Model 2 Model 3 Model 4
5. Empirical results
Probit results for all four of the managerial incentive models are presented
in table 3. The chi-squared statistics indicate that all four models are signifi-
cant at the 0.001 level with the R2 ranging from 0.878 in model 4 to 0.966 in
model 2. The percent correctly predicted ranged from 79.8% in model 1 to
85.8% in model 3. Even the 79.8% correctly predicted generated in model 1
significantly exceeds at the 0.1 level of 71.6% correct achievable under the
most successful naive model.
As explained in Pincus (1980), the most successful naive model classifies all
observations as members of the larger group, non-capitalizers in the current
S. El-Gazzar et al., Lease accouniing 231
The probit results for models 1 through 4 as reported in table 3 indicate that
all three variations of the covenant constraint variable, the change in D/E due
to capitalization in models 1 and 2, the D/E ratio in model 3, and the
industry-adjusted D/E ratio in model 4, assume the predicted positive
correlation with the operating method. (0.001 significance level). The signifi-
cant positive correlation between the change in the D/E and the operating
method in models 1 and 2 supports the Change in Leverage Hypothesis and
implies that lessees whose D/E ratios are most affected by capitalization are
unlikely to capitalize.
The high explanatory ability of the industry-adjusted leverage variable in
model 4 implies that the D/E ratio of operating lessees is high compared to
the industry average; thus, the level of the lessees D/E ratio is not merely
surrogating for industry membership.
The Change in Leverage Hypothesis, the Leverage Hypothesis, and the
Industry-Adjusted Leverage Hypothesis are not mutually exclusive. In fact, the
results are consistent with all three of these hypotheses. Also, given the success
of the leverage-based surrogates for closeness to covenant constraints, we did
not further improve our model as suggested by Lys (1984) by including the
variability of firms cash flows as an additional explanatory variable. This
omission works against our achieving adequate prediction of managements
choices.
those of earlier research, where the coding of the incentive variable was based
only on the existence of plans.
The negative correlation between the tax rate and the operating method in
the probit tests is consistent with both the Tax-Based Political Cost and the
Tax Savings/Reporting Incentives Hypotheses, so more evidence is required
to indicate which of the two hypotheses is more plausible. Lessees reporting
choices outside of leasing may provide additional insight. Table 5 contains a
comparative analysis of lessees reporting choices for depreciation, the ITC,
and the past service cost amortization period.3 Reporting. choices in these
areas do not have tax return implications so the Tax Savings/Reporting
Incentives Hypothesis does not imply particular reporting choices.
On the other hand, if the lease capitalization choice reflects the desire of
high-tax firms to reduce income, these high-tax-rate firms should be motivated
to reduce reported income with their reporting choices outside of leasing.
Thus, under the Tax Based Political Hypothesis, the reporting choices of the
capitalizers and non-capitalizers should be different because the capitalizers
will choose income reducing methods. Accelerated depreciation, the deferred
method for the ITC, and short pension amortization periods reduce reported
income.
Although not reported in table 5, we did compare the inventory choices of capitalizers and
non-capitalizers. Both the Tax-Based Political Hypothesis and the Tax Savings/Reporting Incen-
tives Hypothesis predict that thC two groups of lessees would have different inventory choices with
the high-tax capitalizers using predominantly LIFO. Consistent with both the Tax-Based Political
Hypothesis and the Tax Savings/Reporting Incentives Hypothesis, almost 75% of capitalizers use
LIFO, while only 40% of the non-capitalizers use LIFO. A cm-square test for differences between
the capitalizer and non-capitalizer groups produces a &-square statistics of 8.23 (significant at the
0.01 level).
Another result not reported in the tables is that growth is positively correlated with the
operating choice (0.05 level of statistical significance). As argued by Ernst & Ernst (1977), lessees
with growing leasing activities will report substantially lower income under capitalization. Thus.
growing lessees have greater motivation to choose the operating method. This empirical finding of
a positive correlation between growth and the operating choice provides additional support for the
Tax Savings/Reporting Incentives Hypothesis.
234 S. El-Gazrur et ul., Lease accounting
Table 4
A comparison of the leasing choice (LC), leasing intensity (LI), and effective tax rates (TAX)
in 1976.
Table 5
Comparative analysis of alternate accounting choices in 1976.
Capitalizers 4 30
Non-capitalizers 6 73
Capitalizers 5 26
Non-capitalizers 16 64
Capitalizers 11 13
Non-capitalizers 20 43
a Only those lessees who indicated a predominant accounting choice in a given area are included
in these tables.
bThe &i-square statistic of 0.128 is not significant at the 0.1 level.
The &i-square statistic of 0.039 is not significant at the 0.1 level.
dThe &i-square statistic of 0.960 is not significant at the 0.1 level.
S. El-Gazzar et al.. Lease uccouniing 235
Probit results show that only the inventory and leasing choices are correlated with the elfective
tax rate at a statistically significant level. The results follow:
Probit analysis with accounting choices as the dependent variable and the effective tax rate as the
independent variable
Type of accounting choice Slope C&square statistic
and the operating method for leasing. Interestingly, this negative correlation
between the tax rate and income-maximizing accounting choices was signifi-
cant at the 0.1 level for inventory accounting but significant at the 0.01 level
for the leasing choice.
In so far as political cost considerations do not determine the reporting
choices of capitalizers outside of the tax-related areas of leasing and inventory,
it is doubtful that the desire to minimize political cost by reporting lower
income is a prime motivator for capitalizers. As reported in prior research, the
inventory reporting choice of many firms seems to be tax motivated. Similarly,
the current results are consistent with the Tax Savings/Reporting Incentives
Hypothesis because tax factors affect the lease accounting choice.
6. Conclusions
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