The relation between accounting information in debt covenants and operating leases

• In Event: Financial Accounting & Reporting II - Conservatism and Debt Contracting (100 mins)

Abstract

Proposed changes by the FASB and the IASB to lease accounting standards will substantially change the accounting for operating leases by requiring the capitalization of future lease payments. We consider the impact of these changes on firms’ debt covenants by examining the choice of income statement or balance sheet based accounting ratios in debt covenants for firms in high and low off-balance-sheet (OBS) lease industries for the period 1996-2009. Our results provide evidence that firms in high OBS lease industries use balance sheet (income statement) covenants less (more) than firms in low OBS lease industries. Further the use of balance sheet (income statement) based covenants falls (rises) more quickly in high OBS lease industries than in low OBS lease industries as the use of OBS leasing increases. This evidence indicates that OBS operating leases influence the use of accounting information in covenants suggesting that firms have considered the impact of OBS leases when structuring their debt agreements. These findings also imply that the observed decline in the use of balance sheet ratios since the late 1990’s is associated with the use of OBS operating leases. Further, our results suggest that the proposed capitalization of OBS leases may not result in firms violating loan covenants but will make the balance sheet a more complete source of information for debt contracting by removing the need for constructive capitalization of OBS leases.

Authors

• Daniel Gyung H Paik, University of Richmond

• Joyce Van Der Laan Smith, University of Richmond

• Byunghwan Lee, Cal State Poly University - Pomona

• Sung Wook Yoon, Cal State University - Northridge