Do Lenders Uniformly Capitalize Operating Leases in Debt Covenants?

• In Event: Debt and Bankruptcy
  In Paper Session: Topics in Debt and Bankruptcy

Abstract

The FASB has proposed new standards for leases that capitalize nearly all leases for financial reporting purposes. This study investigates whether lenders capitalize operating leases uniformly when defining debt covenants. The purpose is to understand whether operating lease characteristics are correlated with debt covenant choices to make inferences regarding lenders’ demand for lease accounting rules. I argue that bankruptcy treatment of leases affects lenders’ incentives to incorporate operating leases into debt covenants leading to differential treatment of operating leases as opposed to a “one-size-fits-all” contracting treatment of operating leases. Using a hand-collected sample of lending agreements from firms that use operating leases extensively, I find a positive association between the probability of lenders capitalizing operating leases into debt covenants and the duration of borrowers’ lease contracts. The results indicate that lenders discriminate among operating leases when designing debt covenants and suggest that operating leases vary in their effect on credit risk.

Author

• Bryan Graden, Illinois State University