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The Effect of Capitalizing Operating Leases on the Immediacy to Debt Covenant Violations

Sat, April 27, 10:25 to 11:40am, Hyatt Fisherman's Wharf, TBA

Abstract

Recently, the FASB and the IASB have been working on reforming lease accounting rules. At this time, it is unknown what specific lease standards will be adopted in the U.S. However, financial statement users can expect that, if the FASB decides to move toward a more principle-based approach, U.S. companies will likely be required to re-classify their operating leases into capital leases. In this study, we investigate the effect of capitalizing operating leases on firms’ immediacy (closeness or tightness) to their debt covenant violations. The results of our analysis of U.S. companies indicate that the capitalization of operating leases will cause significant changes in the various financial ratios contained within firms’ debt covenants. We find that, for some firms, capitalization deteriorates their financial ratios significantly and to the extent that firms will likely violate their debt covenants after such capitalization. However, our results also indicate that, for other firms, capitalizing operating leases results in the improvement of financial ratios and will help firms reduce their risk of debt covenant violation. This study benefits investors, creditors, management, and accounting standard setters by helping them better understand how the immediacy to debt covenant violation will be affected by changes in financial statements brought about by capitalizing operating leases.

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