Lease Accounting and the Cost of Equity Capital

Abstract

While leases are widely used to finance productive assets in the U.S, lease accounting has been sharply criticized for providing incomplete and unreliable information to investors because many leases are arranged off-balance sheet as operating leases. As such, a higher cost of equity capital may be required by investors to compensate for unrecorded liabilities and imperfect information. In this dissertation, I provide the empirical evidence as to how equity market participants perceive the off-balance sheet leases.

First, I investigate the firm characteristics that determine the choice on operating versus capital leases. By summarizing the results from prior literature, I identify the determinants from three areas: operating risks, financial constraints and tax-driven incentives. The results suggest that both economic and opportunistic reasons drive a firm's lease choice. Specifically, fast-growing, financially constrained, or low-tax firms opt for off-balance sheet operating leases.

Second, I examine the impact of off-balance sheet operating leases on the cost of equity, and whether it would be different from that of capital leases or conventional debt. The results suggest that off-balance sheet operating leases are “value relevant” as indicated by an increased cost of equity capital being associated with greater use of operating leases. However, investors also seem to suffer from the off-balance sheet position of disclosed operating leases. The leverage effect of operating leases is largely attenuated relative to capital leases and conventional debt.

Third, I explore the role of information intermediaries in compensation for the deficiency in accounting for leases. The results indicate that the cost of equity, with respect to the use of off-balance sheet leases, diminishes in greater analyst followings and the existence of credit ratings. Specifically, the diminishing effect of' financial analysts is more pronounced on off-balance sheet operating leases than that on capital leases and conventional debt. Lastly, whether a firm is audited by a big4/5/6/8 firm appears to have no effect on either off- or on-balance sheet leases.

This study contributes to the Financial Accounting Standard Board's lease accounting project and helps investors assess the risk of firms with off-balance sheet leases.