IFRS 16 and Corporate Financial Performance in Italy: An Empirical Post-Implementation Analysis (Contributions to Finance and Accounting) 3030716325, 9783030716325

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Contributions to Finance and Accounting

Elisa Raoli

IFRS 16 and Corporate Financial Performance in Italy An Empirical Post-Implementation Analysis

Contributions to Finance and Accounting

The book series ‘Contributions to Finance and Accounting’ features the latest research from research areas like financial management, investment, capital markets, financial institutions, FinTech and financial innovation, accounting methods and standards, reporting, and corporate governance, among others. Books published in this series are primarily monographs and edited volumes that present new research results, both theoretical and empirical, on a clearly defined topic. All books are published in print and digital formats and disseminated globally.

More information about this series at http://www.springer.com/series/16616

Elisa Raoli

IFRS 16 and Corporate Financial Performance in Italy An Empirical Post-Implementation Analysis

Elisa Raoli Catholic University of the Sacred Heart Milan, Italy

ISSN 2730-6038 ISSN 2730-6046 (electronic) Contributions to Finance and Accounting ISBN 978-3-030-71632-5 ISBN 978-3-030-71633-2 (eBook) https://doi.org/10.1007/978-3-030-71633-2 © The Editor(s) (if applicable) and The Author(s), under exclusive license to Springer Nature Switzerland AG 2021 This work is subject to copyright. All rights are solely and exclusively licensed by the Publisher, whether the whole or part of the material is concerned, specifically the rights of translation, reprinting, reuse of illustrations, recitation, broadcasting, reproduction on microfilms or in any other physical way, and transmission or information storage and retrieval, electronic adaptation, computer software, or by similar or dissimilar methodology now known or hereafter developed. The use of general descriptive names, registered names, trademarks, service marks, etc. in this publication does not imply, even in the absence of a specific statement, that such names are exempt from the relevant protective laws and regulations and therefore free for general use. The publisher, the authors, and the editors are safe to assume that the advice and information in this book are believed to be true and accurate at the date of publication. Neither the publisher nor the authors or the editors give a warranty, expressed or implied, with respect to the material contained herein or for any errors or omissions that may have been made. The publisher remains neutral with regard to jurisdictional claims in published maps and institutional affiliations. This Springer imprint is published by the registered company Springer Nature Switzerland AG. The registered company address is: Gewerbestrasse 11, 6330 Cham, Switzerland

Contents

1

Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . References . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

2

Lease Accounting Framework and the Development of International Accounting Standards . . . . . . . . . . . . . . . . . . . . . . 2.1 Lease Accounting Regulation Throughout the History . . . . . . . . 2.2 The Statement of Financial Accounting No. 13: Accounting for Leases (SFAS 13) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2.3 The International Accounting Standard 17: Leasing (IAS 17) . . . 2.4 Lease Accounting for the Lessee Under the IAS 17 . . . . . . . . . . 2.4.1 Finance Lease . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2.4.2 Operating Lease . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2.5 Lease Accounting for the Lessor Under IAS 17 . . . . . . . . . . . . 2.5.1 Finance Lease . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2.5.2 Operating Lease . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2.6 Main Criticisms of IAS 17 and the Transition to the New Accounting Standard . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2.7 The New International Financial Reporting Standard: IFRS 16 . . 2.7.1 Identifying a Lease . . . . . . . . . . . . . . . . . . . . . . . . . . . 2.8 Lease Accounting for the Lessee Under IFRS 16 . . . . . . . . . . . 2.9 Lease Accounting for the Lessor Under IFRS 16 . . . . . . . . . . . . 2.9.1 Finance Lease . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2.9.2 Operating Lease . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2.10 The Relevant Changes Introduced by IFRS 16 . . . . . . . . . . . . . 2.10.1 Lease Definition . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2.10.2 Lease Classification . . . . . . . . . . . . . . . . . . . . . . . . . . 2.10.3 The Initial Recognition and the Subsequent Measurement . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2.10.4 The Determination of the Right-of-Use Liability and the Right-of-Use Asset . . . . . . . . . . . . . . . . . . . . .

1 6

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7 7

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10 12 14 14 15 17 17 21

. . . . . . . . . .

22 24 25 27 30 30 31 32 32 32

.

33

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34 v

vi

Contents

2.10.5 2.10.6 2.10.7 References . . 3

4

The Assessment of the Lease Term . . . . . . . . . . . . . . . The Discount Rate . . . . . . . . . . . . . . . . . . . . . . . . . . . Sub-leasing Accounting . . . . . . . . . . . . . . . . . . . . . . . ..........................................

Lease Accounting Literature Review and Hypotheses Development . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3.1 The Determinants (Explanatory Variables) of Off-Balance Sheet Leases . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3.1.1 Leverage and Financial Constraints . . . . . . . . . . . . . . . 3.1.2 Ownership Structure . . . . . . . . . . . . . . . . . . . . . . . . . . 3.1.3 The Nature of Underlying Asset . . . . . . . . . . . . . . . . . 3.1.4 Growth Opportunities . . . . . . . . . . . . . . . . . . . . . . . . . 3.1.5 Taxes . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3.1.6 Size . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3.2 The Relationship Between Capitalization of Off-Balance Sheet Leases and the Economic and Financial Performance . . . . . . . . 3.3 Reactions of Market Operators and Financial Statements Users . References . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

. . . .

34 35 36 36

.

39

. . . . . . .

41 41 43 44 44 45 47

. . .

49 55 59

Post-Implementation Analysis of IFRS 16 on Companies’ Financial Structure, Economic and Financial Performance . . . . . . . . . . . . . . . 4.1 Sample Selection . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4.2 The Empirical Analysis on Determinants (Explanatory Variables) of Off-Balance Sheet Leases . . . . . . . . . . . . . . . . . . . . . . . . . . . 4.2.1 Variables Description and Research Design . . . . . . . . . . 4.2.2 Results and Discussion . . . . . . . . . . . . . . . . . . . . . . . . . 4.3 Post-Implementation Analysis of IFRS 16 on Companies’ Financial Structure and Economic and Financial Performance . . . 4.3.1 Variables Description and Research Design . . . . . . . . . . 4.3.2 Results and Discussion . . . . . . . . . . . . . . . . . . . . . . . . . 4.3.3 Industry Analysis . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4.4 Reaction of Market Operators and Financial Statement Users . . . . 4.4.1 Variables Description and Research Design . . . . . . . . . . 4.4.2 Results and Discussion . . . . . . . . . . . . . . . . . . . . . . . . . 4.5 Conclusions and Limitations . . . . . . . . . . . . . . . . . . . . . . . . . . . References . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

65 65 66 66 71 77 77 85 95 106 106 108 110 113

Appendix . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 117

Chapter 1

Introduction

Financial communication provided by companies disclosing relevant information about their financial situation is considered one of the most relevant factors in reducing the cost of capital and it plays an important role in informing investors about its financial conditions (Wang 2013). With the aim of providing clearer and transparent information and in order to ensure financial statements comparability, companies adopt same accounting rules. In this regard, Meeks and Meeks (2001) introduced the concept of “accounting regulation” referring to financial accounting standards and auditing/assurance principles. The rules for financial communication and disclosure for European companies are determined by the European Union which—through the Regulation (EC) no. 1606/ 2002 of the European Parliament—required all listed companies to adopt the International Accounting Standard (IAS/IFRS), with the aim to ensure and improve financial statements comparability. On January 2016, the IASB (International Accounting Standard Board) issued a new regulation for lease contracts (IFRS 16—Leases) which entered into force on January 1, 2019. The introduction of the new lease accounting regulation requires, for all companies adopting IAS/IFRS, relevant changes in the lease accounting systems compared to the one envisaged by the previous IAS 17, generating material impacts on their financial statements. IFRS 16 was the result of a long and welldefined process implemented to satisfy the need of investors to have reliable and comparable financial statements as a source of their investing decision-making processes. In fact, under IAS 17 many companies using operating leases were able to enter in multiyear lease contracts without disclosing any information on their balance sheet and rather were only required to record operating expenses related to leases in the income statement. As a consequence, for companies having a material amount of off-balance sheet leases, obligations recorded in the liabilities could not be considered true and reliable. As a consequence, taking into consideration the previous lease accounting model (IAS 17), investors started developing several theoretical models to “guess” the real level of indebtedness, creating market distortions, competitive disadvantages, and/or other market inefficiencies. Hence, the © The Author(s), under exclusive license to Springer Nature Switzerland AG 2021 E. Raoli, IFRS 16 and Corporate Financial Performance in Italy, Contributions to Finance and Accounting, https://doi.org/10.1007/978-3-030-71633-2_1

1

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1 Introduction

standard setters (IASB and FASB) addressed this issue by developing a new lease accounting standard (IFRS 16), allowing investors and creditors to consider companies’ financial statements as a trustable source of information and useful document to support the decision-making process. Specifically, IFRS 16 requires the recognition of a lease liability for future payments to be paid to the lessor, regardless of whether the lease is classified as operating or financial, thus, producing relevant changes on companies’ financial position and performance. Indeed, the aim of the new lease accounting model is to overcome the lack of transparency of the accounting system under IAS 17, to avoid or reduce structured operating lease contracts with the purpose of achieving certain accounting effects within financial statements, and to improve accounting disclosure and financial statements comparability. At this point, it seems to be interesting to provide a perspective about the magnitude of the content of this research. In 2005, the US Securities and Exchange Commission (SEC) estimated that the amount of operating leases not recognized in US financial statements was approximately $1.25 trillion, showing how companies having financial troubles can hide them using lease contracts as a source of financing. Similarly, in 2015, a survey conducted by IASB on the potential impact of the new lease accounting regulation on financial statements of listed companies, showed that unrecognized operating leases were approximately $2.86 trillion. More update updated source of information highlights the same situation. Figure 1.1 illustrates the market value of lease contracts over the period 2016–2018, highlighting that the value of lease contracts continues to grow year by year in almost all European Union regions (https://www.leaseurope.org/resources/statisticsresearch). In this context, the European Financial Reporting Advisory Group (EFRAG) through the “Ex-ante impact assessment of IFRS 16”—taking into consideration the lease information provided in 2015 financial statements—demonstrated an increase in liabilities of European listed companies (excluding banking sector) by approximately 576 billion Euro. Thus, in 2017, EFRAG issued a favorable opinion on the adoption of IFRS 16, concluding that “IFRS 16 meets the qualitative characteristics of relevance, reliability, comparability and understandability required to support economic decisions and the assessment of stewardship, leads to prudent accounting, and that is not contrary to the true and fair value view principle.” The analysis conducted in this study can be included within the theoretical framework related to off-balance sheet financing, with a particular focus on the role of lease contracts in this practice. Previous research mainly focused on the potential impacts on companies’ financial statement deriving from the capitalization of operating lease contracts and, in this regard, Morais (2011) conducted a comprehensive literature review including more than 80 papers and categorized them in the following five fields of research: economic consequences of accounting standards, determinants of leases, value relevance, leases’ valuation and the impact of leases on accounting ratios (see also Barone et al. 2014). The main contribution of this study is related to the last of the previous lines of research identified by Morais (2011), since it is one of the first empirical analysis conducted on the real impacts of the post-implementation of IFRS 16 on companies’

Fig. 1.1 Leases volumes in Europe. Source: Leaseurope, Statista 2020

1 Introduction 3

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1 Introduction

financial statements and performance, thorough which the classification of the lease contracts between financial and operating has been eliminated. In fact, under IFRS 16, all contracts that meet the requirements for lease definition, have to be recorded in the financial statements, generating changes on assets, liabilities, income statements, and performance ratios. The common expectation was that the new standard affects performance ratios and accounting metrics such as assets, liabilities, EBITDA, EBIT, operating profit, ROE, current ratio, asset turnover. As a consequence, these changes might have an impact on loan covenants, credit rating, borrowing costs, and companies’ value, compelling many organizations to reassess certain “lease versus buy” decisions. Moreover, companies leasing “big asset”— including real estate, manufacturing equipment, aircraft, trains, ship, and technology—was expected to be greater affected, and even within industries, some companies use off-balance sheet leases more extensively than others being more affected by the introduction of IFRS 16. The aim of this study is to analyze and to measure the real impact on companies’ financial statements and performance of the lease capitalization due to the adoption of the new lease accounting model and to determine how different industries have been affected. As later will be discussed in more detail in the next chapters, the first part of the empirical analysis belongs to the stream of literature related to the determinants (explanatory variables) of off-balance sheet leases (Ang and Peterson 1984; Sharpe and Nguyen 1995; Lasfer and Levis 1998; Deloof and Veruschueren 1999; Graham et al. 1998; Duke et al. 2009), while the second part belongs to the literature focusing on the relationship between operating leases capitalization and companies’ performance. In this regard, most scholars conducted their analysis based on the constructive capitalization model introduced by Imhoff et al. (1991, 1997), which consists in discounting future minimum lease payments disclosed in the notes to the financial statement. Other authors such as Durocher (2008), Goodacre (2003), Grossmann and Grossmann (2010), and Giner et al. (2019) demonstrated the different ways in which leverage, profitability, and other ratios were affected by the capitalization of operating leases, with distinctions due to the different sample used. However, results provided by previous studies are only based on hypothetical impacts reconstructing the potential effect of the capitalization of off-balance sheet leases, often providing controversial results. This study aims to analyze the post-implementation impacts of IFRS 16 measuring the real value of changes in companies’ financial statements and key performance ratios, through the following research questions: Do the determinants (explanatory variables) of off-balance sheet leases present a relationship with the level of lease liabilities recorded due to the implementation of IFRS 16? Does the new lease accounting model (IFRS 16) has had an impact on the overall companies’ performance? And, if so, to what extent? Therefore, in order to provide insights about the above-mentioned post-implementation impacts an empirical analysis on 167 Italian listed companies has been conducted. First of all, a stepwise regression model has been used with the aim of verifying the role assumed by companies’ characteristics defined in the previous

1 Introduction

5

literature as determinants (explanatory variables) related to the decision to enter into an off-balance sheet lease contract. The results demonstrate that the nature of the underlying assets and the ownership structure of the company are significantly correlated to the level of lease liabilities recorded in companies’ financial statements due to the implementation of IFRS 16. Furthermore, the results also demonstrate that this relationship is statistically significant in some industries, such as manufacturing, telecommunications, and IT, while no significant results have been highlighted for all other sectors. In relation to the second part of the empirical analysis, the study aims to analyze and to measure the impacts of the adoption of the new lease accounting model on companies’ financial statements and key performance indicators. For this purpose, a methodological approach capable of capturing the effect on the pre- and postimplementation variables has been implemented and then, using t-test models, the statistical significance mean the difference between variables has been analyzed. As expected, results show a relevant and statistically significant increase in the level of indebtedness and statistically significant changes with reference to companies’ financial structure. Also with reference to the performance analysis, results show statistically significant changes of the key accounting metrics and ratios, but in some cases less consistent than the expectations (and findings highlighted by previous researches) in the pre-implementation phase. Finally, the third part of this study analyzes the market’s reaction due to the implementation of IFRS 16, demonstrating a statistically significant decline in the EV/EBITDA multiple following the adoption of the new lease accounting model (IFRS 16). The content of this contribution appears to be interesting for practitioners, policy makers, and financial statements’ preparers as it helps to make clearer and evident the real consequences deriving from the adoption of the new lease accounting principle, which aims at eliminating—or at least reducing—off-balance sheet financing practices, making the financial statement more transparent and reliable. In the writer’s opinion, this research is of particular interest also for academic as it contributes to previous literature by providing empirical evidence on the magnitude of the effects deriving from the implementation of IFRS 16, confirming and, in some cases, disconfirming findings provided by previous studies conducted mainly through the application of theoretical models aimed at reconstructing the potential effects resulting from the capitalization of operating leases. The remainder of the manuscript is organized as follows. After the introduction, the first section provides an in-depth explanation of IFRS 16 and the main changes relative to IAS 17. The second section provides an analysis of the theoretical framework and literature review, through which hypotheses are proposed. The third section covers the sample selection and data source, methodology and results; discussion of the post-implementation analysis is illustrated. Finally, conclusions and limitations are presented.

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References Ang, J., & Peterson, P. P. (1984). The leasing puzzle. The Journal of Finance, 39(4), 1055–1065. Barone, E., Birt, J., & Moya, S. (2014). Lease accounting: A review of a recent literature. Accouting in Europe, 11(1), 35–54. Deloof, M., & Veruschueren, I. (1999). Are leases and debt substitute? Evidence from Belgian firms. Financial Management, 28(2), 91–95. Duke, J. C., Hsieh, S. J., & Su, Y. (2009). Operating and synthetic leases: Exploiting financial benefits in the post-Enron era. Advances in Accounting, 25(1), 28–39. Durocher, S. (2008). Canadian evidence on the constructive capitalization of operating leases. Accounting Perspective, 7(3), 227–256. Giner, B., Merello, P., & Pardo, F. (2019). Assessing the impact of operating lease capitalization with dynamic Monte Carlo simulation. Journal of Business Research, 101, 836–845. Goodacre, A. (2003). Operating lease finance in the UK retail sector. The International Review of Retail, Distribution and Consumer Research, 13(1), 99–125. Graham, J. R., Lemmon, M. L., & Schallheim, J. S. (1998). Debt, leases, taxes and the endogeneity of corporate tax status. The Journal of Finance, 53(1), 131–162. Grossmann, A. M., & Grossmann, S. D. (2010). Capitalizing lease payments: Potential effects of the FASB/IASB plan. CPA Journal, 80(5), 6–11. Imhoff, E. A., Lipe, R. C., & Wright, D. W. (1991). Operating leases: Impact of constructive capitalization. Accounting Horizons, 5(1), 51–63. Imhoff, E. A., Lipe, R. C., & Wright, D. W. (1997). Operating leases: Income effects of constructive capitalization. Accounting Horizons, 11(2), 12–32. Lasfer, M. A., & Levis, M. (1998). The determinants of the leasing decision of small and large companies. European Financial Management, 4(2), 159–184. Meeks, G., & Meeks, J. (2001). Toward a cost-benefit analysis of accounting regulation (pp. 1–71). London: Institute of Chartered Accountants in England and Wales, Centre for Business Performance. Morais, A. I. (2011). Accounting for leases: A literature review. Bamberg: EUFIN. Sharpe, S. A., & Nguyen, H. H. (1995). Capital market imperfections and the incentive to lease. Journal of Financial Economics, 39(2–3), 271–294. Wang, S. L. A. (2013). Financial communication (pp. 63–78). New York: Palgrave Macmillan. https://doi.org/10.1057/9781137351876.

Chapter 2

Lease Accounting Framework and the Development of International Accounting Standards

2.1

Lease Accounting Regulation Throughout the History

Lease is defined as a transaction between the owner of a property (lessor), who grants the use of that property to a third party (lessee), for a certain period of time defined in the contract, with the option for the lessee to acquire the good, return or to extend the contract. The legal framework proposes two kinds of lease agreement: the finance lease is usually used for the acquisition of property, plant, and equipment, while the operating lease is usually used to acquire assets for a shorter period of time and, in this case, the lessee simply uses this asset (typically equipment or property) until he gives it away. In this second case, the title related to the asset is not transferred to the lessee during or after the lease period, unlike in the finance lease where the lessee has the control over the asset as all risks and rewards related to the leased asset pass to the lessee (Revsine et al. 2017). The two different kinds of leases present several benefits and drawbacks that will be discussed in depth in the next paragraphs. Given that leases are an important way to finance businesses, lease accounting has been a controversial subject for a long time and the rapidly expanded use of operating lease contracts has offered incentives for regulators around the world to change and improve regulations of leases in corporations. Indeed, there are different reasons for using operating leases, and one of the most evident is that for financially distressed companies—that might be unable to raise debt or equity to purchase equipment, operating leases is an easy and good way to obtain it, and it does not affect companies’ financial position due to the fact that no liabilities are recorded in the balance sheet (Eisfeldt and Rampini, 2009; Cornaggia et al. 2013; Rampini and Viswanathan 2013). Obviously, if the leased asset is off-balance sheet, it does not impact on ratios involving debt or asset items and, therefore, it does not apparently affect companies’ profitability. Operating lease contracts, eventually, improve turnover ratios, as their assets contribute to the normal

© The Author(s), under exclusive license to Springer Nature Switzerland AG 2021 E. Raoli, IFRS 16 and Corporate Financial Performance in Italy, Contributions to Finance and Accounting, https://doi.org/10.1007/978-3-030-71633-2_2

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2 Lease Accounting Framework and the Development of International Accounting. . .

Table 2.1 Lease accounting regulation Year 1949

Author AICPA

Document ARB 38

1962 1964

AICPA APB

1966

APB

1972

APB

1973 1973

SEC SEC

ARS 4 APB Opinion 5 APB Opinion 7 APB Opinion 27 ARS 132 ARS 141

1973

APB

1973

SEC

1975 1975 1976

FASB FASB FASB

1976 1980 1982 1996

FASB IASC IASC G4+1

1997 1997

IASC IASC

1999

G4+1

2003

IASB

2016

IASB

APB Opinion 31 ARS 147 DM ED ED (Revised) FAS 13 ED (E 19) IAS 17 Special Report ED (E56) IAS 17 (Revised) Special Report IAS 17 (Revised) IFRS 16

Title Disclosure of Long-Term Leases in Financial Statements of Lessees Reporting of Leases in Financial Statements Reporting of Leases in Financial Statements of Lessees Accounting for Leases in Financial Statements of Lessor Accounting for Leases Transactions by Manufacturer or Dealer Lessors Reporting of Leases in Financial Statements of Lessees Interpretations and Minor Amendments Applicable to Certain Revisions of Regulation S-X Disclosure of Lease Commitments by Lessees Notice of Adoption of Amendments to Regulation S-X Requiring Improved Disclosure of Leases An Analysis of Issues Related to Accounting for Leases Accounting for Leases Accounting for Leases Accounting for Leases Accounting for Leases Accounting for Leases Accounting for Leases: A New Approach Leases Leases Leases: Implementation of a New Approach Leases Leases

production process, generating higher sales, without increasing companies’ debt or assets position. For the aforementioned reasons, lease accounting has been often undergone a series of changes and improvements. Table 2.1 provides the background for current lease accounting regulation. The earliest regulation on leases, ARB 38 (Accounting Research Bulletin no. 38, AICPA 1949), basically just required that material long-term leases had to be disclosed in the financial statement or notes of the company. After about 10 years, as the importance of the leases had grown and disclosure adjustment needed to be made for the financial statement in order to make it more relevant and informative,

2.1 Lease Accounting Regulation Throughout the History

9

the AICPA (American Institute of Certified Public Accountants) issued the new Accounting Research Study no. 4—Reporting of leases in financial statements (ARS 4, AICPA 1962), in which was argued the relevance of the right-of-use asset in case the lessor does not have the ownership of the asset and, as a consequence, all leases should be recorded on the balance sheet at the discount present value of the future cash flow resulting from the lease contract (IASB 2007). Two years later, the APB Opinion 5—Reporting of Leases in Financial Statement of Lessees—(APB 1964) was issued, as it was noted that previous requirements had not reached the expected results. In fact, from previous obligations no consistent part of the lease contract was disclosure and not enough capitalization of the leased property was reported in the financial statement. More specifically, Opinion 5 differentiated from ARS 4 in the definition of an asset, as it stated that property rights conveyed by a lease do not meet the definition of an asset themselves, but the lessee must also create equity through the lease contract for it to be considered as an asset. In the following years, two other APB Opinions on lease accounting were issued, mainly describing how lessor had to account and present leases on their financial statement (IASB 2007). Following this trend of accounting regulation production, in 1973, four regulatory documents were issued specifically with a focus on the lessees’ accounting and reporting of leases. Three of these documents were issued by the SEC.1 The first two documents did not present any innovative lease accounting model, but they only provided more insights about the way for the lessee to record lease contracts. After two SEC’s releases, the APB issued an Opinion that required less disclosure for lease than SEC, contrary to what was previously identify as necessary. The APB’s release, actually, provoked SEC’s last publication as a response to the mild disclosure requirements and it presented a most extensive recognition and disclosure requirements, criticizing the previous excessively light requirements. In 1974, the Financial Accounting Standards Board (FASB) through a Discussion Memorandum—An Analysis of Issues Related to Accounting for Leases (FASB 1974)—introduced a new lease accounting model, providing at the same time criteria for leases’ capitalization. During the following period, the FASB Memorandum was followed by two FASB Exposure Draft2 on the accounting for leases and, in the same year, the FASB issued the Standard FAS 13—Accounting for Leases—based on previous Exposure Drafts. Following this pattern of lease accounting regulations, in 1980, the International Accounting Standard Committee (IASC), aligned with SFAS 13 requirements, issued an Exposure Draft on lease accounting, and 2 years later this Exposure Draft led to the issuance of the International Accounting Standard on Leases (IAS 1

Reporting of Leases in Financial Statements of Lessees, ARS 132, SEC, 1973; Interpretation and Minor Amendments Applicable to Certain Revisions of Regulation S-X, ARS 141, SEC, 1973; Disclosure of Lease Commitment by Lessees, APB Opinion 31, APB, 1973; Notice of Adoption of Amendments to Regulation S-X Requiring Improved Disclosure of Leases, ARS 147, SEC, 1973. 2 Accounting for Leases, Exposure Draft, FABS, 1975; Accounting for Leases, Exposure Draft, FABS, 1976.

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2 Lease Accounting Framework and the Development of International Accounting. . .

17). In addition to lease Standard, over the period 1996–1999, two other special reports were published by Australia, Canada, New Zealand, the United Kingdom, and the United States—named G4+1—together with the International Accounting Standard Committee, having the scope to develop a common set of rules for leases and to combine lease accounting treatments. At that time, the use of lease agreement grew steadily worldwide and the G4+1 Group proposed new criteria for lease accounting and disclosure to be considered in order to increase and ensure comparability and usefulness of companies’ financial statements. In this context, the new lease accounting elements were focused on fair value accounting rights and obligations conveyed by a lease, introducing the accounting entry of the lease agreement at the present value of the minimum payments required by the lease plus any other incurred liabilities. Differently, the lessor should report financial assets representing the amounts of receivables from the lessee and residual interests as separate assets.

2.2

The Statement of Financial Accounting No. 13: Accounting for Leases (SFAS 13)

The Financial Accounting Standards Boards—FASB—is responsible for US Corporations’ Generally Accepted Accounting Principle (GAAP), and it regulates lease accounting through the SFAS 13—Accounting for Leases.3 The accounting principle SFAS 13 defines lease as a contract through which the right-to-use of an asset is transferred for a defined period of time. The SFAS 13 is mainly based on a risk-reward relationship and it makes the substance of the business transaction prevail over the legal form of the lease contract. This Standard identifies two types of lease contracts: finance (capital) and operating leases. According to the SFAS 13 requirements, in case only one of the following criteria is met (at the inception date of the lease contract), then the lease has to be classified as a finance lease and the company has to capitalize it on its balance sheet: – The lessor transfers the ownership of the asset to the lessee by the end of the lease term. – The lease contains a bargain purchase option for the lessee. – The lease term is equal or exceeds 75% of the asset’s estimated economic life. – The present value of the minimum lease payments at the inception date is equal or exceed 90% of the asset’s market value. Based on the aforementioned criteria, the lessee is, therefore, considered as the “substantial” owner of the asset covered by the finance lease contract. As a consequence, the lessee has to proceed with the recognition of the leased asset in the

3 The most recent version of the FAS 13 has been introduced in February 2016 (the Standard is also known as Accounting Standards Codification (ASC) Topic 842).

2.2 The Statement of Financial Accounting No. 13: Accounting for Leases (SFAS 13)

11

financial statement asset side and an obligation towards the lessor on the liability side (equal to the present value of the lease payments over the lease term). More precisely, the value to be recorded in the financial statement—under asset and liability—corresponds to the lower between the fair value and the present value of all lease minimum payments, discounted at the implicit interest rate of the lease contract. In addition, during the contractual period, each installment has to be recorded in the balance sheet, reducing the debt towards the lessor and in the income statement as financial expenses. Differently, all lease contracts that do not meet any of the previous requirements are classified as an operating lease. In this case, the owner of the asset remains the lessor and the accounting model for the lessee merely requires the recognition of the annual rental fees due to the lessor as a cost in the income statement. Finally, the lessee is asked to provide information in the related notes of the financial statement. Despite the specific requirements set by SFAS 13 for the classification between operating and finance leases, a discretionary edge has been highlighted by SEC through a specific document “Report and recommendations pursuant to Section 401 (c) of the Sorbanes-Oxley-Act of 2002 on arrangements with off-balance sheet implications, special purpose entities, and transparency of filings by issuers (SEC 2003a)”. With regard to the lessor, SFAS 13 provides the classification of the lease contract into four categories: – Sales-type leases, is a lease contract in which the manufacturer or supplier of the asset is the same as who leases it, using this contract as a way to market the product or good. – Direct financing lease, is a lease contract in which the cost (or the book value) is equal to the fair value of the leased asset at the end of the lease contract. – Leverage lease, is a lease contract in which the lessee undertakes a long-term financing in order to be able to rent a property. – Operating lease, is a lease contract that represents the residual classification, including any other type of lease contract. Therefore, based on the SFAS 13 requirements, the definition and the classification of the lease contract by the lessee and the lessor represent a key stage in order to provide the proper representation and evaluation on companies’ financial statements. Specifically, in the case of financial lease, the underlying asset covered by the contract is recorded in the asset side of the balance sheet and, consequently, the obligation towards the lessor is recognized on the liability side. Differently, in the case of operating lease no items are recorded under assets and liabilities on the balance sheet, and only the annual fees are recognized as a cost in the income statement. Consequently, operating lease is not recognized by the lessee on its balance sheet and it does not affect lessees’ assets and/or liabilities position.

12

2.3

2 Lease Accounting Framework and the Development of International Accounting. . .

The International Accounting Standard 17: Leasing (IAS 17)

In 1980, the International Accounting Standard Committee (IASC) issued the Exposure Draft n.19 on lease accounting. The document was similar to FASB’s Statement 13 (SFAS 13) in force at that time, which, as illustrated, provides four criteria for lease contracts to be classified as finance lease and then, recognized by the lessee on its balance sheet. In 1982, the International Accounting Standard Committee issued the International Accounting Standard 17,4 which was basically unchanged compared to Exposure Draft 19, with the only exception of the removal of the information related to the percentage (75%) for the lease term that would cover most of the economic useful life of the leased asset and, for the 90% as a basis of the test to define if the present value of the minimum lease payment would be greater than or equal to the market value of the leased asset at the time of contracting. IAS 17 has been issued in its final version in 1997 (even though it was amended few times after that) with the objective to “prescribe, for lessees and lessors, the appropriate accounting policies and disclosure in relation to leases” (IAS 17, paragraph 1). Based on IAS 17 requirements, lease is defined as an “agreement whereby the lessor conveys to the lessee the right to use an asset for an agreed period of time in return for a payment or a series of payments” (IAS 17, paragraph 4). In line with SFAS 13, IAS 17 provides a distinction between operating and finance leases, based on which the finance lease is a transaction that transfers “substantially all the risks and rewards incidental to ownership of an asset” (IAS 17, paragraph 4), essentially meaning that at the end of the lease term, the lessee might decide to get the ownership of the asset. On the contrary, in relation to operating lease IAS 17 is vaguer stating only that an operating lease is a “lease other than a finance lease,” not allowing the possibility of obtaining the ownership of the asset at the maturity of the lease contract. Substantially, also the criteria provided by IAS 17 assess that the definition of the lease contract is based on the extent to which risks and rewards incidental to the ownership of the asset affect lessees and/or lessors. In this regard, by risk IAS 17 implies the “possibility of losses” that stem from the “idle capacity” or “technological obsolescence” as well as “variations in return” as a result of shifting economic conditions (IAS 17, paragraph 7). Rewards are, instead, defined as the “expectation of profitable operation over the asset’s economic life” as well as a gain stemming from “appreciation in value or realization of a residual value.” Thus, if risks and rewards remain in the hands of the lessor, the lease contract is to be classified as operating. Differently, under IAS 17 if the lease is classified as finance—actually detecting a situation of buying and selling—then, the lessee can use the asset as if she/he were 4 IASB regulates lase accounting by IAS 17—Leases—which became effective in 1997 ad was revised in 2010.

2.3 The International Accounting Standard 17: Leasing (IAS 17)

13

the owner, even if the title of ownership will not be transferred to her/him until lease term. In this aspect, a finance lease is similar to interest payments paid in order to obtain a loan, with the main difference that the lessor uses the leased asset as a collateral for the entire duration of the lease contract, regardless of whether ownership will be transferred or not (Savioli and Gianfelici 2008). To better clarify the distinction between finance and operating leases, IAS 17 provides several examples of the situation in which the contract has to be defined as a finance one (IAS 17, paragraphs 10–11): – The lease transfers ownership of the asset to the lessee by the end of the lease term. – The lessee has the option to purchase the asset at a price that is expected to be sufficiently lower than the fair value5 at the time in which this option can be exercised. – Even with a lack of ownership transfer, the duration of the lease contract is at lease long as the “major part of the economic life6 of an asset.” Actually, IAS 17 does not quantify the meaning of “major part,” and typically it refers to the 75% of the economic life as assessed in SFAS 13 (Savioli and Gianfelici 2008). – The present value of the minimum lease payments at the inception of the lease contract is at least equal to the fair value of the asset. Again, the standard does not provide any specific information on what the present value should amount to with respect to the fair value, and a useful benchmark is the 90% set by SFAS 13. – The leased assets are of such a specialized nature that only the lessee can use them without major modifications. – If the lessee can cancel the lease, the lessor’s losses associated with the cancellation are covered by the lessee. – The lessee has the ability to continue the lease contract over a secondary period at a rent fee that is substantially lower than the market rent. While the list presented above attempts to be exhaustive, it does not account for all possible contractual and accounting situations. Therefore, regardless of the situation the key elements to look at is the transfer of risks and rewards. Even if one or more of the requirements above were to be present, in case the lease contract does not transfers risks and rewards associated with the ownership of the leased asset, the contract has to be classified as operating. Roughly speaking, regardless of the situation, the main element to look at is the transfer of risks and benefits; therefore, even if one or more of the criteria above were to be present, if the contract ultimately does not transfer the risks and benefits associated to ownership, the contract would be classified as an operating lease. The fair value of an asset is defined by IAS 17 (paragraph 4) as “the amount for which an asset could be exchanged, or a liability settled, between knowledgeable, willing parties in an arm’s length transaction.” 6 The economic life of an asset is defined by IAS 17 (paragraph 4) as either “the period over which an asset is expected to be economically usable by one or more users” or “the number of production or similar units expected to be obtained from the asset or by one or more users”. 5

14

2.4 2.4.1

2 Lease Accounting Framework and the Development of International Accounting. . .

Lease Accounting for the Lessee Under the IAS 17 Finance Lease

According to IAS 17, at the commencement of the lease term, if the contract is classified as finance lease, the lessee shall “recognize financial leases as assets and liabilities in their statement of financial positions at amounts equal to the fair value of the leased property or, if lower, at the present value (the present value is to be calculated using the interest rate implicit in the lease if it can be determined) of the minimum lease payments,7 each determined at the inception of the lease” (IAS 17, paragraph 20). Therefore, under IAS 17, finance lease entails the transfer of economic benefits and risks to the lessee and the contract has to be recorded in the lessee’s financial statement bot in the liability (as the obligation for future payments) and in the asset, reflecting in ratios analysis the fact that the lessee is drawing economic benefits from that contract (IAS 17, paragraph 23).8 Moreover, after the initial recognition, under IAS 17 subsequent measurements are required. Specifically, the lessee should consider the breakdown of the minimum lease payments as well as depreciation costs. In relation to the minimum lease payments, for each period, they shall be allocated among financial expenses and the reduction of the outstanding liability, as follows: (a) The capital repayment is recorded through the reduction of the finance debt liability in the lessee’s balance sheet. (b) The finance charges shall be allocated in the income statement to each period during the lease term. Moreover, the lessee needs also to take into account depreciation expenses aligned with the finance lease contract,9 being these costs inherent with the existence of the lease contract (since all risks and rewards incidental to ownership are transferred to the lessee). The depreciation method applied should be consistent

7 IAS 17, paragraph 4, Minimum lease payments are the payments over the lease term that the lessee is or can be required to make, excluding contingent rent, costs for services and taxes to be paid by and reimbursed to the lessor, together with any amounts guaranteed by the lessee or by a party related to the lessee (for the lessee), and, for the lessor, any residual value guaranteed to the to the lessor by the lessee, a party related to the lessee, or a party not related to the lessor that is financially able of discharging the obligations under the guarantee. 8 According to IAS 17, paragraph 23, “If for the presentation of liabilities in the statement of financial position a distinction is made between current and non-current liabilities, the same distinction has to be made for lease liabilities.” That is to say, in this case the lessees are to distinguish between current and non-current liabilities stemming from the lease contract. 9 The depreciation policy for depreciable leased assets shall be consistent with that for depreciable assets shall be consistent with that for depreciable assets that are owned, and the depreciation recognized shall be calculated in accordance with IAS 16 Property, Plant and Equipment and IAS 38 Intangible Assets. (IAS 17, paragraph 27).

2.4 Lease Accounting for the Lessee Under the IAS 17

15

with the depreciation policy the lessee adopts for all other depreciable assets. In addition, if there is “no reasonable certainty” that the lessee will indeed obtain ownership of the underlying asset at the end of the lease contract, the leased must be fully depreciated either by the end of the lease term or by the end of its useful life, depending on which one of the two is shorter. Contrary, if there is “reasonable certainty” that the lessee will obtain ownership by the end of the contract, the asset shall be depreciated according to the expected useful life (IAS 17, paragraph 28).). Under IAS 17, additional information should be then provided in terms of compliance with other accounting standards, and the lessee, using the asset through a finance lease, needs also to be compliant with IAS 16, IAS 36, IAS 38, IAS 40, and IAS 41.10 Finally, for finance leases, the lessee needs to provide information on: (a) The net carrying amount at the end of each reporting period for each class of leased assets. (b) The reconciliation among the total of future minimum lease payments and their present value at the end of the reporting period (These disclosures need to be made within 1 year, between 1 and 5 years, after 5 years). (c) The contingent rents11 recognized as an expense for the period. (d) The total future minimum payments that are expected to be received under noncancelable12 subleases at the end of the reporting period. (e) A general description of the lessee’s material leasing agreements Figure 2.1 provides a graphical representation of the finance lease contract under IAS 17 in the lessee’s financial statement. Similarly, in the next paragraph, the accounting treatment of the operating lease contract in the lessee’s financial statement is illustrated.

2.4.2

Operating Lease

Under IAS 17 operating leases are recorded differently from finance leases, and this difference in the accounting model has generated much debate on the accounting 10 IAS 16—Property, Plant and Equipment; IAS 36—Impairment of Assets; IAS 38—Intangible Assets; IAS 40—Investment Property; IAS 41—Agriculture. 11 According to IAS 17, paragraph 4, a contingent rent is that portion of the lease payments that is not fixed in amount, but is based on the future amount of a factor that changes other than with the passage of time (e.g., percentage of future sales, future price indices) 12 IAS 17, paragraph 4, defines a noncancelable as a lease that is cancellable only:

(a) (b) (c) (d)

Upon the occurrence of some remote contingency With the permission of the lessor. If the lessee enters into a new lease for the same or an equivalent asset with the same lessor; or. Upon payment by the lessee of such an additional amount that, at the inception of the lease, continuation of the lease is reasonably uncertain.

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2 Lease Accounting Framework and the Development of International Accounting. . .

January 1st

December 31st

BALANCE SHEET

BALANCE SHEET

ASSETS

LIABILITIES

ASSETS

LIABILITIES

Bank Account Finance Lease Debt Leased Assets

Finance Lease Debt Leased Assets (-)

INCOME STATEMENT COSTS

REVENUES

INCOME STATEMENT COSTS Interest Expenses Depreciation Expenses

REVENUES

Fig. 2.1 Finance lease accounting for lessee under IAS 17

standard, becoming the main reason for the introduction of the new IFRS 16 (which will be analyzed in the following paragraphs). Regarding the operating lease, IAS 17 states that “lease payments under an operating lease shall be recognized as an expense on a straight-line basis over the lease term unless another systematic basis is more representative of the time pattern of the user’s benefit” (IAS 17, paragraph 33). Therefore, the operating lease accounting model requires that the installment is recorded only as an expense in the lessee’s income statement, without taking into consideration the allocation among capital and interest repayment (as in the case of finance lease). Only if the service is ongoing at the end of the year, the proper year-end adjustment should be made to record the payments for future periods. The operating lease accounting procedure, thus, does not disclose the right-to-use of the asset and, on the contrary, the amount of liabilities towards the lessor, ending up offsetting financial ratios and providing faulty information on the lessee’s statement of financial position. Given the extent and the volume of operating leases (provided in Chap. 1), the impacts of a change in the lease accounting model are predicted to have a remarkable effect on the financial positions of companies all around the world. As for finance leases, also for operating ones, IAS 17 requires additional disclosure to be provided in the related notes (IAS 17, paragraph 35), specifically: (a) The total amount of future minimum payments under noncancelable operating leases (within 1 year, between 1 and 5 years, and later than 5 years). (b) The total of future minimum sub-lease payments expected to be received under noncancelable subleases at the end of the reporting period.

2.5 Lease Accounting for the Lessor Under IAS 17

17

January 1st

December 31st

BALANCE SHEET

BALANCE SHEET

ASSETS

LIABILITIES

ASSETS

LIABILITIES

Bank Account

INCOME STATEMENT COSTS

REVENUES

INCOME STATEMENT COSTS

REVENUES

Services

Fig. 2.2 Operating lease accounting for lessee under IAS 17

(c) Lease and sublease payments recognized as an expense in the period, with separate amounts for minimum lease payments, contingent rents, and sub-lease payments. (d) A general description of the lessee’s significant leasing arrangements including the basis on which the contingent rent payable is determined, the existence of terms of renewal or purchase options, and escalation clauses and restrictions imposed by lease arrangements. Figure 2.2 provides a graphical representation of the operating lease contract under IAS 17 in the lessee’s financial statement. The previous simplified representation shows how the accounting treatment of the operating lease under IAS 17 does not require any impact neither in the assets nor in the liabilities of the lessee’s financial statement.

2.5 2.5.1

Lease Accounting for the Lessor Under IAS 17 Finance Lease

IAS 17 requires, at the initial recognition, all lessors to identify the assets that are “held under a finance lease in their statement of financial positions and present them as a receivable at an amount equal to the net investment in the lease” (IAS 17, paragraph 36). As previously illustrated, through a finance lease, all risks and rewards incidental to ownership are substantially transferred to the lessee and, as a consequence, the lessor should record the amount of receivables in the asset side (as the repayment of the principal) and the financial income (as a remuneration for

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2 Lease Accounting Framework and the Development of International Accounting. . .

the investment). Hence, the lessor instead of recognizing the leased asset shall record in its asset side the credit vis-à-vis the lessee that is equal to the net investment carried out through the acquisition of the good. More precisely, the net investment of the lessor is equal to the present value of13: (a) The minimum lease payments that the lessee is required to make to the lessor and (b) The residual value of the good that is not guaranteed14 (Savioli and Gianfelici 2008) In addition, on the contrary to what is accounted for on the asset side, the lessor shall record either: – The debt towards the producer of the asset that is being leased or – The derecognition of the good being leases from the asset, in case the lessor had previously either produced or purchased and, thus, recorded the good in the inventory or – The revenues obtained from the leased asset in the income statement, in case the lessor had previously either produced or purchased and, thus, recorded the good in the inventory (Savioli and Gianfelici 2008) In this context, it is relevant to highlight the distinction between the lessor that is also manufacturer and producer of the asset and those who are not, acting more as intermediaries between lessor and lessee. Figure 2.3 provides an explanation. Lessors can also bear the initial direct cost,15 such as commission, legal fees, and internal costs attributable to negotiating and arranging the lease contract. This amount of initial cost shall be recorded differently depending on whether the lessor coincides or not with the producer/manufacturer of the asset (IAS 17, paragraphs 36–46). Specifically, in case the lessor does not coincide with the producer, the abovementioned costs are included in the initial amount of financial receivable and, as a consequence, they generate a decrease of the amount of income recorded over the lease period. in this situation also the implicit interest rate of the lease contract is

13

The present value is computed using a discount rate that is equal to the rate that it implicit to the contract. 14 IAS 17, paragraph 4, provides the distinction between guaranteed and non-guaranteed residual value. Specifically, the guaranteed residual value is: (a) For a lessee, that part of the residual value that is guaranteed by the lessee or by a party related to the lessee (the amount of the guarantee being the maximum amount that could, in any event become payable); and. (b) For a lessor, that part of the residual value that is guaranteed by the lessee or by a third party unrelated to the lessor that is financially capable of discharging the obligations under the guarantee. Instead, unguaranteed residual value is that portion of the residual value of the leased asset, the realization of which by the lessor is not assured or guaranteed solely by a party related to the lessor. 15 IAS 17, paragraph 4, initial direct costs are defined as incremental costs that are directly attributable to negotiating and arranging a lease, except if the costs are incurred by the manufacturer.

2.5 Lease Accounting for the Lessor Under IAS 17

19

Lessor coincides with

Producer Yes

No

Initial costs borne are not included in the initial valuation

Initial costs borne are included in the initial valuation

Recognized as an expense in the income statement

Reduce the amount of the income recognized

Fig. 2.3 Lessor breakdown producer versus intermediaries

computed in such a way that all the initial costs are automatically included in the finance lease receivable. Differently, in case the lessor is also the producer of the leased asset, the abovementioned costs cannot be included in the initial measurement, but they have to be recorded as expenses at the beginning of the lease term, since these costs are mainly related to the producer’s selling profit, actually representing profits or losses resulting from the sale of the good (IAS 17, paragraph 46). In fact, a finance lease gives the producer to sources of income (IAS 17, paragraph 43): 1. Profit (or loss) resulting from the sale of the asset that is being leased. In this case, the producer receives the normal selling price and, thus, the selling profit/loss is equal to the difference between the amount of sales revenue and the cost of sale (IAS 17, paragraph 44), computed according to the elements provided in Fig. 2.4. 2. Finance income over the lease term that is implicit in the installment payments. In order to determine the economic results, lessors shall always use the market interest rate, even if it differs from the one provided by the lease contract. In this regard, it was a common practice that lessors, to attract clients, decides to apply an “artificially low interest rate” (IAS 17, paragraph 45). Indeed, this situation would not allow to properly compute the income as defined in point (1), as the use of a lower interest rate leads to a greater portion of the total income recorded at the time of the sale. Therefore, similarly to what is stated for lessees, the installment shall be accounted for:

20

2 Lease Accounting Framework and the Development of International Accounting. . .

PROFIT/LOSS

Revenues from sales

The lower value between the fair value of the asset and the present value of the minimum lease payments Cost or if different carrying amount of the leased asset less present value of the unguaranteed residual value.

Cost of sale

Fig. 2.4 Profit/loss under IAS 17 January 1st

December 31st

BALANCE SHEET

BALANCE SHEET

ASSETS

LIABILITIES

ASSETS

Bank Account

Bank Account

Lease Receivable

Lease Receivable

INCOME STATEMENT COSTS

REVENUES

LIABILITIES

INCOME STATEMENT COSTS

REVENUES Interest Revenues

Fig. 2.5 Finance lease accounting for lessor under IAS 17

– The capital that reduces the amount of lease receivables. – The interest revenues are recorded in the income statement (IAS 17, paragraph 39). Finally, the valuation of the unguaranteed residual value (used to compute the lessor’s gross investment) should be reviewed regularly. If there is any reasonable reason to assume a reduction of unguaranteed value, it is necessary to revise the income allocation over the lease term (IAS 17, paragraph 41). Figure 2.5 provides a graphical representation of the finance lease contract under IAS 17 in the lessor’s financial statement.

2.5 Lease Accounting for the Lessor Under IAS 17

21

As for lessee, also for lessor IAS 17 requires additional information to be disclosed in relation to finance lease (IAS 17, paragraph 47): – A reconciliation between the gross investment in the lease at the end of the reporting period – The amount of unearned finance income – The unguaranteed residual values accruing to the benefit of the lessor – The accumulated allowance for uncollectible minimum lease payments receivable – Contingent rents recognized as income for the period – A general description of the lessor’s material lease arrangements In the following paragraph, the accounting treatment for the operating lease contract in the lessor’s financial statement is illustrated.

2.5.2

Operating Lease

Under operating lease, the underlying asset is to be recognized in the lessor’s asset side according to their nature (IAS 17, paragraph 49), since in the case of operating lease risks and rewards incidental to the ownership of the asset pertain to the lessor. Moreover, the periodic installments have to be recorded as revenues on a “straightline basis”, meaning that they should be recognized based on a constant rate (Or eventually according to other methods that better represent the timing with which benefits are received). Costs incurred during the lease period, such as depreciation expenses, have to be recognized in the lessors’ income statement, while initial costs shall be added to the asset carrying amount, usually corresponding to the cost of the assets minus depreciation expenses of the leased asset (IAS 17, paragraph 52). In the same way, depreciation policies shall be consistent with the lessor’s depreciation method for assets presenting similar nature, computed in compliance with IAS 16 and IAS 38, as well as in compliance with IAS 36 for impairment of assets (IAS 17, paragraph 53). Figure 2.6 provides a graphical representation of the operating lease contract under IAS 17 in the lessor’s financial statement. Finally, under IAS 17 the lessor shall disclose the following information (IAS 17, paragraph 56): – The future minimum lease payments under noncancelable operating leases for periods within 1 year, within 1 and 5 years, after 5 years. – Total contingent rents recognized as income in the period. – A general description of the lessor’s lease contract.

2 Lease Accounting Framework and the Development of International Accounting. . .

22

January 1st

December 31st

BALANCE SHEET

BALANCE SHEET

ASSETS

LIABILITIES

ASSETS

Bank Account

Bank Account

Property, Plant and Equipment

Property, Plant and Equipment

INCOME STATEMENT COSTS

REVENUES

LIABILITIES

INCOME STATEMENT COSTS

REVENUES

Depreciation Expenses Interest Revenues

Fig. 2.6 Operating lease accounting for lessor under IAS 17

2.6

Main Criticisms of IAS 17 and the Transition to the New Accounting Standard

As described under IAS 17, users have to distinguish between operating and finance lease contracts and based on this classification they apply two different lease accounting models. Taking into consideration this accounting regulation, many lease transactions were treated as operating lease, even though they entail risks and rewards incidental to ownership to be transferred to the lessee. As a consequence, under IAS 17 companies’ financial disclosure was often deficient, because it omitted from the balance sheet relevant information: the value of the right-of-use in the asset side and the amount of lease liabilities towards the lessor. This accounting treatment could not be considered acceptable from an investors perspective, as the dependence on the classification of the lease contract would result in different representation on the lessee’s financial statement, since in some case is recorded in the balance sheet and, in others, only reflected as rent expenses in the income statement (Lloyd 2016). In this regard, the most relevant issue related to IAS 17 is the relationship with a common practice known as “off-balance sheet financing,” representing in substance a source of financing that does not appear on companies’ balance sheets as it is not considered debt. Therefore, any investor needing to evaluate the company has to take into account these omissions and proceed with several adjustments on the lessee’s financial statement with the aim to recognized assets and liabilities that were “offbalance sheet”. Basically, investors proceed with a “re-performance” of companies’ economic and financial ratios. Usually, investors proceed with all adjustment taking

2.6 Main Criticisms of IAS 17 and the Transition to the New Accounting Standard

23

into consideration the additional disclosure provided by the company, in compliance with IAS 17, which often was not sufficient for a reliable estimation of companies’ value, specifically in relation to the lower amount of liabilities compared to the real debt position. As a consequence, financial ratios are flattened out, failing to provide a transparent representation of the companies’ economic and financial condition. Therefore, IAS 17 has often been accused of not promoting transparency by favoring accounting frauds in three main situations. Firstly, disclosure and measuring requirements that underpin the substance of the finance lease could be misinterpreted by financial statement preparers. Secondly, the changes in the interest rate could be deferred to existing leases if there were a significant impact on financial performance, smoothing income to favor management. Finally, the inaccuracies of the analysts’ predictions could mislead financial statement users about the long-term solvency (Edeigba and Amenkhienan 2017), causing distortions in the financial statement ratios and false impression on companies’ financial health, as perceived by investors and creditors. Easily, a company presenting a greater risk or difficulties in borrowing cost could enter in an operating lease, hiding its bankruptcy risk and low growth rate. Cornaggia et al. (2013), assuming the capital structure perspective, suggest that usually companies try to minimize taxes and financial costs, therefore, there might be a propensity for companies having poor financial reporting and worse financial ratios to use the operating lease as a source of financing. In addition to the possibility of potential investors being misled, manipulation of regulatory requirements imposed by IAS 17 affected clients, suppliers, employees, and other stakeholders who base long-term contracting decisions on perceived financial health (Cornaggia et al. 2013). Taking into consideration all the aforementioned issues, it seems to be relevant the need for a new international lease accounting standard able to avoid the dissemination of different accounting methods, thus resulting in better financial statement comparability and reducing reporting disparities (Cornaggia et al. 2013). The main proposal to amend IAS 17, were set out in the Exposure Draft/2010/9, whose main focus was to consider the substantial transfer of the risk and rewards to the asset, in order to recognize the lease, especially under the “usage right,” but without distinction between finance and operating term and, the following Exposure Draft/2013/6, through which the lease transactions were no longer classified as Operating or Finance, but Type A and Type B. Specifically, the classification was based on the economic life of the leased asset, as well as the application of the understanding of the usage right. However, concerns about improving financial and statements continue to grow, and other agencies such as the Securities Exchange Commission (SEC) expressed about the lack of information transparency on lease obligations, highlighting investors’ disappointments. The document Basis for Conclusions (IFRS 2016) brings these considerations about the lack of transparency and lack of attention to the financial statement users’ needs. After reviewing comments from countries around the world, the IASB found that many users adjusted lessee’s financial statements capitalizing operating leases and, in order to do that they tried to estimate the present value of the future lease

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2 Lease Accounting Framework and the Development of International Accounting. . .

payments (IFRS 2016). Because of the limited information available in the explanatory notes, however, they used approximation techniques to estimate the real level of indebtedness and the real amount of invested capital for operating activities, while other users were unable to make adjustments. Thus, these different approaches generate information asymmetries within financial markets (IFRS 2016). Also, the IASB in a 2016 report provides three main issues with IAS 17, as viewed by financial statements’ users: 1. Information related to operating leases lacked transparency and did not meet the needs of users of financial statements. As described before due to the lack of representation on the assets and liabilities bear through an operating lease, many users adjust financial statements through the information disclosed. 2. The existence of two different lease accounting models. In fact, assets and liabilities associated with leases are recorded only for finance lease and not for operating ones. Then, in case transactions are very similar from the economic point of view they will be accounted in different way, based on their classification, reducing financial statements comparability. 3. Requirements for lessors do not provide proper information about her/his exposure to credit and asset risk. In fact, for all equipment and vehicles under an operating lease, users could not assess how much credit risk and asset risk arising from the lease contract in the lessor’s financial statement. In reaction to all criticisms received for the lease accounting model under IAS 17, the IASB proposed a new lease accounting model through the issuance of IFRS 16, addressing and solving all issues that were raised by financial statement users.

2.7

The New International Financial Reporting Standard: IFRS 16

In January 2016, a new regulation for leases was issued by the International Accounting Standards Board (IASB) and, in the same period, FASB has also issued new and improved lease accounting standard FSAS 13. These standards were developed in cooperation, and both become mandated in January 2019. In this paragraph, the main requirements of IFRS 16 are illustrated. The new standard provides guidelines on lease accounting, specifying how lease contracts have to be recorded, measured, presented, and disclosed. In some respects, IFRS 16 presents similarities to previous IAS 17, but as will be described in detail, the new standard provides a single lease accounting model and it changes the lease accounting treatment mostly for the lessee, since it requires the lessee to record all lease contracts (longer than 12 months) in the assets side using the right-of-use (unless the lease presents low value). Based on an IFRS analysis (IASB 2016a, b), more than 85% of the lease agreement are estimated to be operating,

2.7 The New International Financial Reporting Standard: IFRS 16

25

therefore the new lease accounting model will generate a significant impact on companies’ financial statements. Other than providing a description of IFRS 16, along with a comparison with IAS 17 when required, this chapter also provides an overview of the main implications of the new standard and, especially, how the new accounting procedure will affect businesses. As mentioned before, IFRS 16 is in force since January 2019, and it must be applied to all lease contracts, providing the principles for the “recognition, measurement, presentation and disclosure” of leases. The main objective is then to “ensure that lessees and lessors provide relevant information in a manner that faithfully represents those transactions,” so that users of financial statements are able to assess the impact of leases on “financial position, performance position and cash flows of an entity” (IFRS 16, paragraph 1).16 The new standard includes also options for companies that do not apply it, in case of: (a) The lease term is equal to or lower than 12 months, but only in case, the contract does not allow to purchase the leased asset at the end of the lease period. (b) The underlying asset presents a low initial value. The exemption, in this case, can be applied to single assets (meaning separate leases) instead of the entire class. Omitting some assets that present low value will not have a substantial impact on financial ratios and/or other relevant financial information that is usually analyzed by financial statement users. In case the lessee decided to exempt the aforementioned leases, it should recognize the lease payments associated with those leases as an expense on a straight-line basis, or any another method that is more representative of the benefits pattern received through the contract.

2.7.1

Identifying a Lease

Based on IFRS 16 requirements, a contra is, or contains, a lease if “the contract conveys the right to control the use of an identified asset for a specified period of time in exchange for consideration” (IFRS 16, paragraph 9). The first element in

16

As with IAS 17, IFRS 16 provides the scope of its application. Specifically, the standard applies to all leases, including subleases, except for: (a) (b) (c) (d) (e)

Leases to explore for or use minerals, oil, natural gas and similar non-regenerative resources Leases of biological assets (IAS 41) Service concession arrangements (IFRIC 14) Licenses of intellectual property granted by a lessor within the scope of IFRS 1 Rights held by a lessee under licensing agreements within the scope of IAS 38 (including plays, manuscripts, motion picture films, etc. . .).

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identifying a contract is to determine whether it is possible to pinpoint the asset which will be lent, verifying the existence of the right to control. Specifically, in order to define a contract as a lease, the right-of-use needs to convey the right for the lessee to obtain substantially all the economic benefits from the use of the identified asset and, the right to direct the use of the identified asset during the lease period.17 In Appendix B, the standard provides a guideline that needs to be followed in order to define whether the contract contains or not a lease, and through a graphical representation invites users to understand if several conditions are met in order to verify the existence of the right to control the asset18 (Fig. 2.7). In this regard, it is important to underline that if a customer has the right to control the asset only for a period of time (described in terms of the amount of use of an identified asset), the agreement contains a lease only for that period of time and, a reassessment of this characteristics is needed only if the terms and conditions of the contracts are amended. IFRS 16 amends the requirements for identification of a lease, eliminating the condition that the fulfilment of the contract depends on the use of the asset. Differently, it requires that a contract have to identify, first of all, an asset, and base on this requirement the contract can involve a lease even though it does not present the lease’s legal form. Therefore, IFRS 16 requires lessors and lessees to distinguish the lease components of a contract from the non-lease components (IFRS 16, paragraphs 12–17).19 Consequently, the definition of an agreement under IFRS 16 is much broader than it was with IAS 17, causing that even some service contracts to be considered as leases. The key factors in identifying a lease are: leased asset identification, the customer deciding how to use the asset and gaining economic benefit from it, and the supplier can substitute the asset during the duration of the contract. IFRS 16 also provides a more extensive definition of the lease term of the contract, as the noncancelable period of a lease together with (1) the periods covered by an option to extend the lease if it is reasonable that the lessee will exercise that option, and (2) periods covered by an option to terminate the lease if it is reasonably certain that the lessee will not exercise that option.

17

Period of use: the total period of time that an asset is used to fulfil a contract with a customer (including any non-consecutive periods of time). 18 As mentioned above, the standard provides a descriptive analysis of the procedures that need to be followed by users, as well as explaining in detail all the components required to have the right to use the asset. Nonetheless, describing all in the information provided by the standard would have fallen outside the scope of this study, and is therefore largely summarized. 19 The standard allows users to use a practical expedient in this sense, allowing lessees to identify lease components and associated non-lease components as a single lease component.

2.8 Lease Accounting for the Lessee Under IFRS 16

Is there any identified asset?

27

No

Yes Does the customer have the right to obtain substantially all of the economic benefits from use of asset throughout the period of use?

No

Yes

Customer

Does the customer, the supplier or neither party have the right to direct how and for what purpose the asset is used throughout the period of use?

Supplier

Neither; how and for what purpose the asset will be used is predetermined

Yes

Does the customer have the right to operate the asset throughout the period of use, without the supplier having the right to change those operating transactions?

No Did the customer design the asset in a way that predetermines how and for what purpose the asset will be used throughout the period of use?

The contract contains a lease

No

The contract does not contain a lease

Fig. 2.7 IFRS 16. Flowchart for the assessment of whether a contract is, or contains, a lease

2.8

Lease Accounting for the Lessee Under IFRS 16

Based on the IFRS 16 requirements, at the commencement date, a lessee shall recognize a right-of-use asset and the related lease liabilities. The first and most relevant difference with IAS 17, is that under IFRS 16 lessees are not required to distinguish among operating and finance leases, treating all lease transactions using the same lease accounting model. Under the new standard, lessees always recognize the right-of-use asset, whereas, with the earlier treatment in case of operating lease, everything was recorded in the income statement. As far as the initial measurement of the right-of-use asset (I.e., asset that represents lessee’s right to use an underlying asset for the lease term) the lessee should recognize it at cost measurement. In this regard, the cost consists of:

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1. The amount of the initial measurement of lease liability. 2. Any lease payments made at or before the commencement date minus any lease incentives received. 3. The initial direct costs incurred by the lessee. 4. An estimate of costs to be incurred by the lessee in dismantling and removing the underlying asset, restoring the site on which it is located or restoring the underlying asset to the conditions required by the terms and conditions of the lease. On the contrary, the initial measurement of lease liabilities is entered in the debt position, at the commencement date, using the present value of the future lease payments (I.e. payments that are not made at that date). Similarly to IAS 17, the amount of future lease payments have to be discounted at an interest rate that, usually, is the implicit interest rate under the lease contract. In case the interest rate cannot be determined, then the lessees should use an incremental borrowing rate.20 Moreover, the lease payments that are used to compute the lease liability encompass a series of payments that the lessee needs to make in subsequent periods to obtain the right-of-use of the asset. These could be: (a) Fixed payments minus any lease incentive receivables (b) Variable lease payments that depend on an index or a rate like, for example, the consumer price index or LIBOR/EURIBOR (c) The exercise price of a purchase option if the lessee is reasonably certain to exercise that option and (d) Payments of penalties for terminating the lease, if the lease term reflects the lessee exercising an option to terminate the lease The distinction between the right-of-use asset and the lease liability has to be maintained even for subsequent measurements. In terms of the right-of-use assets, after the commencement date, a lessee shall measure it by applying a cost model, as described by the IAS 16—Property, Plant and Equipment. Based on the cost model, an asset shall be carried at its cost less any accumulated depreciation and any impairment losses, such that: Carrying amount ¼ Initial costs þ subsequent costs  accumulated depreciation  accumulated impairment losses Previous carrying amount should then be adjusted for any remeasurement of the lease liability (IFRS 16, paragraphs 29–30). The only exception to previous accounting treatment is in case the lessee applies a fair value model for investment properties as described by IAS 40, or the revaluation model as proposed by IAS 16. If either the lessee obtains the ownership of the asset at the end of the lease term, or if the 20

The incremental borrowing rate is defined as the rate of interest that a lessee would have to pay to borrow over a similar term, and with a similar security, the funds necessary to obtain an asset of a similar value to the right-of-use asset in a similar economic environment (IFRS 16, Appendix A— Defined Terms).

2.8 Lease Accounting for the Lessee Under IFRS 16

29

purchase option is already included in the cost of the asset, depreciation expenses need to cover the period from the commencement date of the agreement to the end of the useful life of the leased asset. Otherwise, if this were not the case, depreciation expenses need to be calculated considering the shorter between the lease period and the useful life of the leased asset. In relation to the subsequent measurement of lease liabilities, the lessee shall compute it by: – Increasing carrying amount in order to reflect the interests on the lease liability – Reducing the carrying amount to reflect the lease payment made and – Remeasuring the carrying amount to reflect any reassessment, lease modification, or revised fixed lease payments The lessee can also proceed to impairing the lease liability, by discounting the revised lease payments, if either there is a change in the amounts expected to be paid under a residual value guarantee, or if there is a change in the future lease payments due to changes of an underlying index or interest rate. As a consequence, the lessee should modify the lease liability to reflect changes in future payments only if there is a change in future cash flows. Moreover, the lessee should record in the income statement both the interest paid on the lease liability and the variable lease payments that were not included in the measurement of the lease liability. Finally, in the last sections, IFRS 16 provides a detailed explanation of the presentation of all the accounting procedures listed above and a detailed guideline to disclose information in the lessee’s financial statements.21 This aspect is very different from what was adopted by IAS 17, in which disclosure requirements were described, but not as much in detail as they are with the new accounting standard. This could be interpreted as a demonstration of how much more IFRS 16 has been tailored to the users’ needs. It is relevant to comment on this aspect, since in order to evaluate whether this new standard is an improvement of its predecessor; the detail in explanation and the tailoring to the necessities of users definitely aid it in its intent. In this regard, the standard itself states that the “objective of disclosures is for lessees to disclose information in the notes that, together with the information provided in the statement of financial position, statement of profit or loss and statement of cash flows, gives a basis for users of financial statements to assess the effect that leases have on the financial position, financial performance and cash flow of the lessee”. Therefore, the main purpose of the standard, other than correcting very obvious flaws such as off-balance sheet financing, is to really aid not only users of financial statements, but also companies themselves, by providing a much more detailed guide on how the accounting procedures should be followed. Figure 2.8 provides a graphical representation of the lease contracts under IFRS 16 in the lessee’s financial statement

21 The full presentation of all these elements is omitted from the study as, due to its length, it would fall outside the scope of the study.

2 Lease Accounting Framework and the Development of International Accounting. . .

30

January 1st

December 31st

BALANCE SHEET

BALANCE SHEET

ASSETS

LIABILITIES

ASSETS

Bank Account

Bank Account Lease Liability

Lease Liability

Right-of-use

Right-of-use

INCOME STATEMENT COSTS

LIABILITIES

INCOME STATEMENT

REVENUES

COSTS

REVENUES

Depreciation Expenses Interest Expenses

Fig. 2.8 Lease accounting for lessee under IFRS 16

2.9

Lease Accounting for the Lessor Under IFRS 16

Within the debate that leads to the creation of IFRS 16, the majority of users felt that accounting procedures for lessors had no significant faults, and therefore should not be modified. In respect to this view, IFRS 16 provides accounting treatments for lessors that are, in substance, equal to those previously provided by IAS 17. The only relevant aspect in the lease accounting for lessor is that, unlike lessees, under IFRS 16, I required to distinguish between finance and operating leases. Aligned with IAS 17, a finance lease transfers substantially all risks and rewards incidental of ownership of the underlying asset. In case this requirement is not meet, then the lease is classified as operating. As described in previous paragraphs, risks include the possibilities of technological obsolescence or of variation in returns due to shifts in economic conditions, while rewards represent a gain due to the appreciation of the asset or the realization of a residual value (IFRS 16, paragraph B53). Based on the distinction between finance and operating lease for lessors, in the following paragraphs, the accounting treatment is described.

2.9.1

Finance Lease

At the commencement date, lessors shall recognize assets held under a finance lease in the financial statement and present them as a lease receivable equal to the net

2.9 Lease Accounting for the Lessor Under IFRS 16

31

investment in the leased asset. More precisely, the amount of receivables have to be equal to the present value of the installments that have not been paid yet at the commencement date, plus any initial direct costs. These costs, other than the ones borne by manufacturers, decrease the amount of income recognized over the lease term. In case the lessor is also the producer of the asset, at the initial recognition, it should record for each finance lease: – The fair value of the asset, or, if lower, the present value of the lease payments accruing to the lessor as a revenue – A cost represented by the cost of sale, or the carrying amount, of the asset minus present value of the unguaranteed residual value and – Selling profit or loss, equal to the revenue minus the cost of sale22 As far as the subsequent measurements are concerned, a lessor should record the income over the lease period, based on a pattern representing a constant periodic rate of return on the lessor’s net investment in the lease. Also for the lessor, the lease payments should then be allocated among the principal and the unearned finance income. Finally, a lessor should account for modification to a finance lease as a separate lease if: (a) The modification increases the scope of the lease by adding the right to use one or more underlying assets and (b) The payment made to the lessor increases by an amount that is proportional to the standalone price of the asset, intended as the price at which an entity would sell a good separately to a customer In conclusion, lessors’ accounting model for finance lease under the IFRS 16 is substantially the same as the accounting procedure provided by previous IAS 17.

2.9.2

Operating Lease

In the case of operating lease, lessors shall recognize the lease payment as income either on a straight-line basis or any other systematic basis which is more representative of the benefits received from the use of the underlying asset. Aligned with IAS 17, also under IFRS 16, the lessor has to recognize costs, including depreciation as expenses in the income statement. Therefore, as the accounting procedure is the same as the one required by IAS 17, for a detailed description refers to previous paragraphs related to IAS 17.

22 The same considerations as seen in IAS 17 with regards with incentives that manufacturers may provide customers apply here.

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2.10

2 Lease Accounting Framework and the Development of International Accounting. . .

The Relevant Changes Introduced by IFRS 16

2.10.1 Lease Definition Based on the definition provided by IFRS 16, a lease is a contract (or part of a contract) that transfers to the lessee the right-to-use of the underlying asset for a determined period in exchange for cash payments. IFRS 16 introduced a new and a broader definition to identify business transactions under the lease contract. Specifically, as required by the new lease accounting standard, to determine whether the right to control of the asset is transferred to the lessee, it is necessary to evaluate if the lessee has the right to substantially obtain all economic benefits deriving from the use of the leased asset and, at the same time, the lessee has also the right to control the use of the underlying asset. Thus, the lease definition provided by IFRS 16 focuses on the subject who has the substantial control of the leased asset and the accounting treatment reflects the economic element of a lease contract, since the right-of-use the asset is transferred from the lessor who renounces this right by making the asset available for the user to the lessee. Differently, according to IAS 17 requirements, a lease is defined as an agreement whereby the lessor transfers the right to use of an asset for a determined period in exchange for a single payment or a series of payments. Analysing this definition, it seems to be relevant to highlight that the risks and benefits associated with the use of the asset are transferred jointly with the asset from the lessor to the lessee. In fact, analysing the interpretation provided by IFRIC 4, the contract does not need to transfer the right to control the use of the asset in order to define a lease contract. Therefore, the new IFRS 16 has broadened the lease definition, including all rental contracts that present the requirement related to the transfer of the right to control the use of the underlying asset form the lessor to the lessee.

2.10.2 Lease Classification Once the lessee has determined whether the contract meets the definition of lease, this contract has to be recorded in the financial statement considering an accounting treatment that does not differ from finance and operating leases, since their different classification no longer exists, with the only exception of short-term contracts and low economic value, for which different accounting model can be used based on the choice of the lessee. Therefore, based on the new IFRS 16, the distinction between finance and operating leases remains only for the lessor. Under the previous IAS 17, at the inception date of the contract, the lease had to be classified as a finance lease or as an operating lease, depending substantially on the transferring of all risks and rewards resulting from the ownership of the asset. Only in the case of short-term lease contracts, IFRS 16 requires that this contract can be recognized in accordance with IAS 17. Thus, if the contract is classified as

2.10

The Relevant Changes Introduced by IFRS 16

33

operating lease will be an off-balance sheet lease. The same option can be applied for lease contracts involving low economic value assets. However, while the latter option can be applied to all types of lease, the former is only available for certain classes of assets.

2.10.3 The Initial Recognition and the Subsequent Measurement IAS 17 requires, at the beginning of the lease contract, the recognition in the assets and liabilities only in case the contract is classified as finance lease, taking into account the lower between the fair value asset and the present value of the future minimum payments. Then, after the initial recognition, the asset is depreciated according to depreciation criteria used by the lessee for similar assets and considering the assets’ useful life and the minimum lease payments should be allocated between financial charges and the decrease of the lease liability. Whenever possible, the company is required to use the lease’s implicit interest rate as the discount rate in the calculation of the present value of the future minimum payments. Otherwise, the lessee’s marginal financing rate can be applied. According to the new IFRS 16, in relation to the lessee, all lease contracts (with some limited exceptions described above) have to be recognized in the financial statement, using a single accounting model similar to the one provided by IAS 17 for finance leases. Lessees are, therefore, required to recognize an asset in the balance sheet, representing the right-to-use asset for the entire duration of the lease contract and, at the same time, a liability expressing the obligation towards the lessor for the lease payments. The amount recorded as the right-of-use asset is equal to the present value of the minimum lease payments discounted at the lease’s implicit interest rate or at the company’s marginal financing rate. Finally, the right to use asset is subject to the impairment test in accordance with the requirements of the accounting standard IAS 36. Lease liabilities are, instead, recorded considering the effective interest method (i.e. amortized cost model), using the same accounting treatment provided for all financial liabilities. The minimum payments are, then, divided between financial charges and the decrease in the payments’ obligation (in the liabilities), aligned with IAS 17. As illustrated, IAS 17 classifies leases as finance or operating, the first are those which essentially transfer all risks and rewards deriving from the ownership of the asset to the lessee and are recognized in the balance sheet under assets and liabilities. The latter are recognized off-balance sheet and the lease payments are recorded exclusively in the income statement according to the duration of the contract. Differently, IFRS 16 requires the recognition of all leases in the balance sheet. Consequently, the implementation of the new accounting standard might impact

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2 Lease Accounting Framework and the Development of International Accounting. . .

on the indebtedness level of a company, affecting also economic and financial ratios. Furthermore, IFRS 16 could also have a significant effect on the income statement due to the recognition of the financial charges on the debt recorded in the balance sheet and, at the same time, due to the amortization expenses of the right-of-use asset. Therefore, for lease contracts previously classified as operating leases, the total amount of costs at the inception date may be greater than the ones required under the IAS 17. From the lessor point of view, instead, the accounting treatment required by IFRS 16 remains, substantially, unchanged compare to the ones required by the IAS 17.

2.10.4 The Determination of the Right-of-Use Liability and the Right-of-Use Asset The determination of the “right-of-use liability” for a lease contract requires an assessment by the lessee of both the duration of the contract and the nature of the payments, which can be fixed or variable. In this regard, a distinction is made between: (1) variable payments which, however, substantially can be considered as fixed payments for lease; (2) variable payments related to changes in the market rate or in the index. With regard to the latter, the IASB has considered whether IFRS 16 should require the lessor to estimate the future index or rate in each “repricing date” over the period of the leasing contract, or whether to take into consideration the current index (or rate) at the inception date of the lease, as constant for the entire duration of the contract. Ultimately, the IASB rejected both of these approaches, since they could require lessees to make estimates using macroeconomic data, which might not be readily available and, therefore, the costs could outweigh the benefits for the financial statements’ users. Therefore, IFRS 16 does not require that the lessee make assumptions or obtain future forecasts. On the contrary, it requires the lessee to evaluate the lease liabilities using the lease payments that do not assume any change in the amount of fees over the leasing period. However, in case the fee changes as a result of leasing payments linked to rate or index, the amount of liabilities will have to be restated. Finally, with regard to the determination of the right-of-use asset, the direct incremental costs referring to a specific leasing can also be considered, precluding companies to capitalize an amount of operating expenses.

2.10.5 The Assessment of the Lease Term Lease contracts often grant the lessee the right to extend the lease term beyond the noncancelable period or, conversely, to terminate the contract before the

2.10

The Relevant Changes Introduced by IFRS 16

35

contractually agreed deadline. So, for example, depending on the terms and conditions of this option, a 6-year contract with a renewal option for another 6 years may automatically correspond to a 6-year noncancelable lease or a 12-year noncancelable lease. In any case, a lease contract providing for this option cannot be considered as a leasing contract without this option. Therefore, the evaluation of exercising or not the contractual option involved in the lease contract, requires taking into consideration all relevant facts and circumstances, that might create an economic incentive for the lessee to exercise this option. Thus, the determination of the duration of the lease contract is particularly relevant also for the application of the exemption related to short-term leases. Specifically, the duration of the lease, as defined by IFRS 16, also includes reasonably certain extension periods, which can be exercised by the lessee, while the existence of termination options exercisable on by the lessor is not taken into account. Finally, if the lessee (lessor) has the option to terminate the lease without the lessor’s (lessee’s) approval, then the term of the lease has to take these termination options into account.

2.10.6 The Discount Rate According to IFRS 16, the discount rate to be used when assessing the lease must reflect the current value of the lease contract. Specifically, the accounting standard suggests the use of the implicit interest rate is determinable, corresponding to the lessee’s marginal financing rate, since both take into account the lessee’s lending capacity, the duration of the lease contract, the nature of the guarantee provided, and the economic context in which the transaction takes place. However, the implicit lease interest rate is influenced by the lessor’s estimate of the residual value of the asset at the end of the lease contract, considering also taxes and any other factors known only by the lessor. Based on these considerations, the IASB argues that the determination of the implicit interest rate could be difficult for many lessees, in particular for those with underlying asset having a significant residual value at the end of the leasing contract, established that the lessee can use the marginal financing rate defined in such a way as to take into account all the conditions of the lease contract. Although the application of the requirements of the new accounting standard must be coherent, it is important to underline that also the determination of the lessee’s marginal financing rate might require a personal judgment by the lessee itself and, therefore, represents a challenge for some lessees with not comparable financial position due to the differences in their financing activities.

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2.10.7 Sub-leasing Accounting The requirements provided by IFRS 16 for the sub-leasing accounting appear to be pretty strict and, in some cases, do not allow a clear representation of the economic substance of the transaction. From a legal perspective, in fact, it is correct to treat the primary and the secondary leases separately and independently, due to the fact that they are contracts with different counterparties, but this does not always occur from a substantially point of view. For example, if the primary lease is interrupted, this circumstance affects the intermediate lessor who can no longer allow the use of the asset to the final lessor. Moreover, the intermediate lessor, who accounts for the two transactions separately, has also to be in compliance with the disclosure requirements of IFRS 16, for both the lessee of the primary lease and the lessor of the secondary lease. Therefore, a review of the requirements for detecting the sub-leasing could be probably necessary in order to better represent the economic and operational characteristics of the lease transaction, or at least to reduce the disclosure requirements to the intermediate lessor.

References AICPA (American Institute of Certified Public Accountants). (1949). Disclosure of long-term leases in financial statements of lessees—ARB 38, AICPA. AICPA (American Institute of Certified Public Accountants). (1962). Reporting of leases in financial statements—ARS 4, AICPA. APB (American Principles Board). (1964). Reporting of leases in financial statements of lessees— ABP opinion no.5, APB. APB (American Principles Board). (1966). Accounting for leases in financial statements of lessor— APB opinion no.7, APB. APB (American Principles Board). (1972). Accounting for leases transactions by manufacturer or dealer lessor—APB opinion no. 27, APB. APB (American Principles Board). (1973). Disclosure of leases commitments by lessees—APB opinion no. 31, APB. Cornaggia, L., Kimberly, J., Franzen, L. A., & Simin, T. T. (2013). Bringing leases asset onto the balance sheet. Journal of Corporate Finance, 22, 345–360. Edeigba, J., & Amenkhienan, F. (2017). The influence of IFRS adoption on corporate transparency and accountability: Evidence from New Zealand, Australasian accounting. Business and Financial Journal, 2(3), 3–19. Eisfeldt, L., & Rampini, A. (2009). Leasing, ability to repossess and debt capacity. Review of Financial Studies, 22(4), 1621–1657. FASB (Financial Accounting Standard Board). (1974). An analysis of issues related to accounting for leases. Discussion memorandum, July 2, 1974. FASB (Financial Accounting Standard Board). (1975a). Accounting for lease—Exposure draft, FASB. FASB (Financial Accounting Standard Board). (1975b). An analysis of issues related to accounting for leases—DM, FASB. FASB (Financial Accounting Standard Board). (1976a). Accounting for lease—Exposure draft (revised), FASB.

References

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FASB (Financial Accounting Standard Board). (1976b). Statement of financial accounting standard no. 13—Accounting for leases (SFAS 13), FASB. G4+1. (1996). Accounting for leases: A new approach—Special report, G4+1. G4+1. (1999). Leases: Implementation of a new approach—Special report, G4+1. IASB (International Accounting Standard Boards). (2003a). Leases—IAS 17 (Revised), IASB. IASB (International Accounting Standard Boards). (2003b). IAS 16—Property, plant and equipment, IASB. IASB (International Accounting Standard Boards). (2003c). IAS 40—Investment property, IASB. IASB (International Accounting Standard Board). (2007). Public Consultation on a future standard on lease accounting, IASB IASB (International Accounting Standard Boards). (2010). IAS 17—Leasing, IASB. IASB (International Accounting Standard Boards). (2016a). Leases—IFRS 16, IASB. IASB (International Accounting Standard Boards). (2016b). Effects analysis—IFRS 16 Leases, IASB. IASC (International Accounting Standard Committee). (1980). Exposure draft E19—Accounting for leases (ED 19), IASC. IASC (International Accounting Standard Committee). (1982). Accounting for leases—IAS 17, IASC. IASC (International Accounting Standard Committee). (1997a). Leases—Exposure draft 56, IASC. IASC (International Accounting Standard Committee). (1997b). Leases—IAS 17 (Revised), IASC. IFRS (International Financial Reporting Standard). (2016). Basis for conclusions. IFSR. Lloyd, S. (2016). A new lease of life—Investor perspective. IFRS, IASB. Rampini, A. A., & Viswanathan, S. (2013). Collateral and capital structure. Journal of Financial Economics, 109(2), 466–492. Revsine, L., Collins, D., Jonson, W., Mittelstaedt, H., & Soffer, L. (2017). Financial reporting & analysis (6th ed., pp. 687–706). New York: McGraw-Hill. Savioli, G., & Gianfelici, C. (2008). I Principi Contabili Internazionali. Milano: Giuffrè Editore. SEC (Securities and Exchange Commission). (1973a). Accounting Series Release no. 147—Notice of adoption of amendments to regulations S-X requiring improved disclosure of leases (ARS 147), SEC. SEC (Securities and Exchange Commission). (1973b). Interpretation and minor amendments applicable to certain revisions of regulation S-x—ARS 141, SEC. SEC (Securities and Exchange Commission). (1973c). Reporting of Leases in Financial Statements of Lessees—ARS 132, SEC. SEC (Securities and Exchange Commission). (2003a). Report and recommendations pursuant to Section 401(c) of the Sarbanes-Oxley Act of 2002 on arrangements with off-balance sheet implications, special purpose entities, and transparency of filings by issuers, SEC.

Chapter 3

Lease Accounting Literature Review and Hypotheses Development

The reasons driving companies to use accounting standards are also related to benefits resulting for managers and shareholders. In this regard, Watts and Zimmerman have proposed the Positive Accounting Theory, useful theory to explain the use of accounting standards (Watts and Zimmerman 1978, 1979, 1986). In fact, the authors of the Positive Accounting Theory claim that “management plays a central role in the determination of standards” and “one function of financial reporting is to constrain management to act in the shareholders’ interest,” thereby, this theory became an academic theory which helps in explaining and predicting practices in accounting. This theoretical framework highlighted also how the importance of adopting new and good accounting standards, specifically for large companies, can help to solve classic problems related to the agency theory (i.e., problems related to the difference in interests between shareholders and managers). In this context, Brown (2011) states that “accounting standards are important in a welldeveloped capital market because they help to resolve a serious agency problem. Insiders (managers) are better informed than outsiders (shareholders) about their firms’ investment opportunities, how hard they, the managers, will work and the perks they will consume and how well the firm is doing overall.” Therefore, uniform accounting and auditing standards are necessary because they are a relatively low-cost solution to a serious agency problem and providing clear and transparent information within the financial statements, allowing the interests of managers to be aligned to those of shareholders. Indeed, the issuance of new accounting standards should take into consideration all of these aspects: better quality information (more accurate, comprehensive, and timely financial statement information); the minor difference in the knowledge of information between small investors and professionals (adverse selection); greater comparability, eliminating many international differences in accounting standards and standardizing reporting formats (Ball 2006; Brown 2011). According to Ball (2006), higher-quality information “should reduce both the risk to all investors from owing shares and the risk to less-informed investors due to adverse selection. In theory, it should lead to a reduction in firms’ cost of equity capital.” © The Author(s), under exclusive license to Springer Nature Switzerland AG 2021 E. Raoli, IFRS 16 and Corporate Financial Performance in Italy, Contributions to Finance and Accounting, https://doi.org/10.1007/978-3-030-71633-2_3

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In this regard, the scope of the International Accounting Standard Board (IASB) is to make certain that, in order to take useful decisions, current and potential investors are provided with high quality, transparent, and comparable information, through the financial statements (IFRS Foundation 2013). For several years, has been complained to the IASB that lease accounting—under IAS 17—did not meet investors’ needs, as illustrated in previous Chapter II. Lease accounting applying IAS 17 depended on whether the lease contract is qualified as an operating or finance in the lessee’s financial statement and base on this classification some leases would end up on the balance sheet while most would result only as rent expenses in the income statement. This issue has been analyzed in the existing literature by assuming different perspectives. First, previous research provides several methodological approaches to empirically investigate the determinants (or explanatory variables) for off-balance sheet financing activities. Secondly, it has been analyzed that the capitalization of the operating leases impacts on economic and financial ratios (Barone et al. 2014). This field of research has been broadened over the years proposing an examination of the determinants (explanatory variables) of off-balance sheet financing, as a consequence of the several proposals of the IASB and the FASB to identify the representation and the assessment in the financial statements of the operating lease contacts through their capitalization, considered as off-balance sheet obligations (see Chap. 2). In fact, based on the proposals made by IASB and FASB over the years—which then become the requirements of the new IFRS 16—several scholars aimed at identifying the relationship and the impacts between companies’ characteristics and the capitalization of operating lease contracts. The last classification is related to the perception by financial statement’s users— such as market operators, auditors, and preparers—of the proposal to capitalize on the balance sheet operating lease contracts, by eliminating the classification between finance and operating leases (Barone et al. 2014; Spencer and Webb 2015). The analysis of the literature proposed in this Chapter uses a classification approach similar to that Barone et al. (2014) and Spencer and Webb (2015)— highlighting some distinctive features attributable to the contents of the Exposure Draft 2010, Exposure Draft 2012, and IFRS 16 (see Chap. 2)—and it presents the relevant studies focusing on the influence of some specific company’s explanatory variables on off-balance sheet financing phenomenon. Finally, the existing literature is useful in order to analyze the postimplementation effects of the new lease accounting model (IFRS 16) on the financial statements of the Italian listed companies and the impact of the capitalization of operating leases on companies’ economic and financial performance. Thus, the following theoretical framework is analyzed to support the development of the proposed hypotheses.

3.1 The Determinants (Explanatory Variables) of Off-Balance Sheet Leases

3.1

41

The Determinants (Explanatory Variables) of Off-Balance Sheet Leases

Within the lease accounting literature, one area that has been researched intensively is related to the determinants of leases. Some existing studies investigated separately the determinants of finance leases (Lasfer and Levis 1998; Ang and Peterson 1984; Deloof and Veruschueren 1999) and operating leases (Sharpe and Nguyen 1995; Graham et al. 1998, Duke et al. 2009), while some other authors did not distinguish between operating and finance leases (Adams and Hardwick 1998), demonstrating that the determinants may not be the same, due to the differences in the accounting treatment of each type of lease contract. One of the first and relevant study relating to the determinants of leasing is the one provided by Smith and Wakeman (1985), in which the authors identified eight reasons for leasing besides tax motivation: (1) asset values are not tied to use and maintenance; (2) assets are not specialized for the company; (3) the useful life of the asset exceeds the lessee’s expected period of use of the asset; (4) the lessee’s bonds contain specific financial policy covenants; (5) management compensation is a function of the return on invested capital; (6 company is closely held; (7) the lessor has market power and (8) the lessor has a competitive advantage in disposing of the asset. Several other studies investigated the relationship between lease contracts (finance and/or operating leases) and some specific companies’ determinants (explanatory variables). Thus, the existing literature analyzing those determinants in the decision to enter into a lease contract is illustrated in the next paragraphs, supporting the hypotheses development.

3.1.1

Leverage and Financial Constraints

Prior empirical studies have used the level of indebtedness to third parties as an explanatory variable of off-balance sheet financing, suggesting that companies having a high leverage—since they reduce the possibility of further sources of external financing—use lease contracts more than other forms of financing (Smith and Wakeman 1985; Erickson 1993; Sharpe and Nguyen 1995; Eisfeldt and Rampini 2009; Mehran et al. 1999; Beatty et al. 2010; Callimaci et al. 2011; Zhang 2011). In particular, Eisfeldt and Rampini (2009) and Sharpe and Nguyen (1995) found that companies dealing with greater financing constraints, due to information asymmetries, present greater propensity to undertake off-balance sheet operating lease contract. Those authors pointed out that lease contracts provide creditors with more security, higher priority in case of bankruptcy, and an effective way of reducing adverse selection and moral hazard problems arising from information asymmetries. In this context, another relevant contribution is the one provided by Slotty (2009), who analyzing German SME found that the amount of total annual lease expense

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attributable to either finance or operating leases is considerably higher for financially distressed companies, as well as for small and fast-growing small and medium enterprises, those likely to face higher agency-cost premiums on marginal financing. Moreover, several researches demonstrated that companies undertake leases to avoid debt financing (Myers et al. 1976; Ang and Peterson 1984; and Marston and Harris 1988) and to obtain a lower cost of financing by passing tax allowances that the company cannot claim when buying the asset to the lessor (Barclay and Smith 1995; Sharpe and Nguyen 1995; and Graham et al. 1998), and to mitigate the agency conflicts, as the asset substitution problem (Stulz and Johnson 1985; Smith and Wakeman 1985). In 1986, a study by El-Gazzar et al. provided evidence on the relationship between leverage (measured by debt-equity ratio, the change in debt-equity ratio, and the industry-adjusted debt-equity ratio) and lease contracts. They found that companies with financial ratios that are closer to the limits of covenants tend to choose operating leases instead of finance leases. Therefore, leasing theory predicts that financially distressed companies are able to get more favorable financing terms from lessor than from traditional creditors because of the priority of lessors’ claims in bankruptcy proceedings. In this regard, Krishnan and Moyer (1994) specifically demonstrated that as bankruptcy potential increases, leases as a source of financing become attractive. They empirically investigated the relation between capital (on-balance sheet) leases and the costs of bankruptcy, finding a significant and positive relationship between the two variables. By extending the previous study Graham et al. (1998) demonstrate this positive relationship also for operating (off-balance sheet) leases. Finance theory and empirical evidence further suggest that the cost of external funds is higher when information asymmetry, agency problems, and underinvestment problems are more severe (Mayers and Majluf 1984; Sharpe and Nguyen 1995; Graham et al. 1998). In this context, empirical analysis on lease theory also suggests that companies having greater costs of external funds tend to reduce investment costs by leasing assets. A not very recent but still relevant contribution by Fawthrop and Terry (1975) provide evidence on how UK corporate financial managers perceived and used leases. They found that the relevance of the key factors in determining the use of leases varied across companies, concluding that leases policies are the output of single financial circumstances. In this context, some other authors demonstrated that small companies tend to use leases to avoid large capital outlays (Tomkins et al. 1980; Mayes and Nicholas 1988). These results have been confirmed by Drury and Braund (1990), who conclude that the relative cost of leases, as well as tax reasons, seemed to be a determinant of the decision to lease for large companies. Lastly, Beattie et al. (2006a, b) basing the analysis on a survey on the leases’ decision across UK listed companies, demonstrated that avoiding large capital outlay and cash flow considerations are important for companies in the decision to lease all asset types. Based on the existing literature, seems to be clear that the level of indebtedness could be analyzed as a determinant (explanatory variable) of off-balance sheet financing. Therefore, with the aim of specifically analyzed the role of companies’

3.1 The Determinants (Explanatory Variables) of Off-Balance Sheet Leases

43

indebtedness level in the decision to use off-balance sheet lease contracts—which following the adoption of the new accounting model provided by the IFRS 16—have necessarily emerged in the financial statements, the following hypothesis is proposed: H1a: the level of lease liability resulting from the implementation of the new lease accounting model (IFRS 16) is positively associated with previous year level of indebtedness.

3.1.2

Ownership Structure

The existing literature considers the ownership structure as an explanatory variable of off-balance sheet financing. Prior studies demonstrated that higher levels of managerial ownership tend to be associated with a greater level of debts, finance leases, and operating leases (Alchian and Demsetz 1972; Flath 1980; Smith and Wakeman 1985; Duke et al. 2002). Within this field of research, Flath (1980) Smith and Wakeman (1985) explored the role of ownership structure in the decision to lease assets, providing evidence that more closely held companies tend to have more lease contracts. The explanation is related to the fact that debts and lease contracts expose the owner of the company to financial risk, but when an asset is leased for a period shorter than its useful life, the lessor supports most of the risk of obsolescence or other changes in asset value. In fact, lessor company having a diversified asset portfolio and widely dispersed ownership may be able to bear such risks more cheaply. Moreover, Alchian and Demsetz (1972) pointed out that lease contracts involve agency costs due to the separation of ownership and control of capital and the lessee might not have the same incentives as an owner to properly use or maintain the capital. In this regard, Mehran et al. (1999), always investigating the relationship between leases and ownership, found that companies whose CEOs have a larger ownership tend to use more leases than other companies, with the aim of reducing their exposure to obsolescence and other asset-specific risks. Therefore, previous studies consider companies’ ownership structure as a determinant (explanatory variable) of off-balance sheet financing. With the aim of specifically analyzed the relationship between companies’ ownership structure and the propensity to use lease contracts (operating and financial), the following hypothesis is proposed: H1b: the level of lease liability resulting from the implementation of the new lease accounting model (IFRS 16) is higher in closely held companies.

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3.1.3

3 Lease Accounting Literature Review and Hypotheses Development

The Nature of Underlying Asset

Prior research considers the nature of the asset under lease contract as a determinant (explanatory variable) of off-balance sheet financing. Companies enter into a lease contract that concerns both generic and specific goods, as they are immediately transferable and to a greater extent available on the market (Smith and Wakeman 1985). Typically, fixed assets of general usage (such as real estate, aircraft, trucks and automobiles, electronics, and computer equipment) are readily transferable and, as a result, they have greater availability on leasing markets. On the contrary, the economics of specialized assets suggest conventional debt (or equity) financing, due to their few alternative uses. Assuming this perspective, Graham et al. (1998) and Sharpe and Nguyen (1995) report a negative relationship between leases and proxies for asset specificity. Also in older researches, some authors demonstrated that more specific assets are more likely to be owned (due to a vertical integration strategy), while more generic assets are more likely to be leased (Klein et al. 1978; Smith and Wakeman 1985; Krishnan and Moyer 1994), and looking at some industries aspects, Erickson (1993) found that asset-specific factors, as proxied by industry, might be considered as one of the most important determinants of lease use. Williamson (1988) and Lasfer and Levis (1998) argued also that generic goods are more easily re-deployable and therefore more suitable both for lease contract and as a guarantee for other forms of financing. Finally, a more recent study provided by Gavazza (2010), using data from commercial aircraft, found that the liquidity level that characterizes the asset affects leases’ decisions, demonstrating that more liquid assets make leases—in particular operating leases—more likely. The literature shows that even if the nature of the underlying asset is considered as a determinant (explanatory variable) of off-balance sheet financing, prior empirical studies conducted in this field have not provided unequivocal results. Thus, the following hypothesis is proposed: H1c: the level of lease liability resulting from the implementation of the new lease accounting model (IFRS 16) is associated with the nature of the underlying asset.

3.1.4

Growth Opportunities

In this field of research, some authors supported and empirically demonstrated the hypothesis that companies having a high growth rate prefer to link their investment opportunities to long-term activities entering into finance leases, allowing to control the replacement of assets (Smith and Warner 1979; Stulz and Johnson 1985; Adams and Hardwick 1998). Other researchers pointed out that the flexibility and the limited risk transferred from the lessor to the lessee, it can be considered as valuable incentives to enter into a lease contract rather than into other forms of financing

3.1 The Determinants (Explanatory Variables) of Off-Balance Sheet Leases

45

(Smith and Warner 1979; Graham et al. 1998; Lasfer and Levis 1998; Mehran et al. 1999; Eisfeldt and Rampini 2009). According to the existing literature, seems to be clear that companies’ growth opportunity could be analyzed as a determinant (explanatory variable) of off-balance sheet financing. Therefore, aiming at verifying the role of companies’ growth opportunity in the decision to use off-balance sheet lease contracts which, following the adoption of the new accounting model provided by the IFRS 16, have necessarily emerged in the financial statements, the following hypothesis is proposed: H1d: the level of lease liability resulting from the implementation of the new lease accounting model (IFRS 16) is positively associated with companies’ growth opportunity.

3.1.5

Taxes

Taxes have been, generally, considered as a relevant factor in the decision of leasing instead of buying, specifically within the literature focusing on the decision of lease or buy based on tax incentives (Miller and Upton 1976; Lasfer and Levis 1998). The idea is that if a company is not in a full tax pay position, buying and depreciating the asset allow to deduct less taxes than to lease, since the company—in case of leasing—can deduct not only depreciation costs but also related financial expenses. Therefore, using the effective tax rate as a measure of political costs and as a proxy for tax incentives, El-Gazzar et al. (1986) found that low tax rate companies are more likely to use operating leases instead of finance leases, which is consistent with the hypothesis that companies with high effective tax rate are more likely to adopt income decreasing strategies, such as finance leases. In this path of research, Sharpe and Nguyen (1995) using two different variables for the tax status of a company (specifically, tax expense divided by pre-tax income and tax-loss carry forwards) found a significant positive relationship between highloss carry forward and leases. Moreover, their findings also show that capital leases (on-balance sheet) are used more in companies for which tax benefits of buying appear low and low tax rate companies tend to have more operating leases. Later on, Graham et al. (1998) questioning the findings of Sharpe and Nguyen (1995) argue that their tax results were caused by the endogeneity of corporate tax status, because using leases can lower a company’s observed tax rate, therefore in order to develop their analysis they used a dummy variable that indicates the presence of high or low loss carry forward. Companies with significant tax-loss carry forward will be tax-exhausted for a period of years, and thus able to get full advantages of tax benefits from the ownership of the asset, including accelerated depreciation and investment tax credits. As far as the tax rate is concerned, no significant relationship with leasing has been found. The same authors investigated also if low tax rate companies lease more

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than high tax rate companies, arguing that the use of operating leases should be negatively associated with the company’s tax rate. In order to avoid endogeneity issues, they simulated the before-financing decision marginal tax rate, assuming the company’s taxable income follows a random walk and, their findings show a significant and negative relationship with operating lease intensity. Based on the same approach, other authors suggested that companies with little or no tax liabilities would be less likely to use debt financing, but they would be more likely to lease assets. They found results contrary to Graham et al. (1998), that they justified through the larger sample used in the Graham et al. (1998)’ contribution. One limitation of this previous research is related to the fact that Graham et al. (1998) used only operating leases, while Mehran et al. (1999) used indistinctively operating and finance leases. Finally, Lasfer and Levis (1998) showed that lease is a substitute for debt financing and it is driven by taxes only for larger companies. Their main conclusion is that companies using leases are more likely to have tax losses, although this is not the major determinant for small companies. Moreover, they investigated if tax differential between lessee and lessor can be considered one of the three main reasons for the existence of leases, involving in their model five different tax variables (Tax charge/Earnings before taxes; Tax carried forward/total assets; recoverable advanced corporate tax/market value of equity; Provision advanced corporate tax/market value of equity and written of advanced corporate tax/market value of equity). One of the most relevant limitations of this study concerned to the fact that tax differential among lessee and lessor relates most on the operating leases, while Lasfer and Levis (1998) focused on finance leases. Based on previous contributions, the effective tax rate could be considered as a determinant (explanatory variable) of off-balance sheet financing. The aforementioned studies support the hypothesis that the use of operating leases is more frequent for companies characterized by lower tax rates, while companies having higher tax rate prefer to enter in finance lease as a strategy for taxable income reduction. Following the adoption of the new lease accounting model provided by the IFRS 16, all operating leases undertaken for tax reasons have necessarily emerged in the companies’ financial statements increasing liabilities. Therefore, in order to test the role of the effective tax rate as an explanatory variable of off-balance sheet leases, the following hypothesis is proposed: H1e: the level of lease liability resulting from the implementation of the new lease accounting model (IFRS 16) is negatively associated with companies’ effective tax rate.

3.1 The Determinants (Explanatory Variables) of Off-Balance Sheet Leases

3.1.6

47

Size

As far as the dimension of the company is concerned the existing literature has produced controversial results. Most of the researchers found a significant relationship between size and lease intensity, however, several studies (Sharpe and Nguyen 1995; Graham et al. 1998; Adams and Hardwick 1998; Mehran et al. 1999) found a negative relationship, while others (Lasfer and Levis 1998; Deloof and Veruschueren 1999) found a positive relationship. Differently, some others do not find any significant relationship between size and leases (El-Gazzar et al. 1986; Ang and Peterson 1984). In general, the dimension of the company has been considered a relevant characteristic to explain the use of the lease contracts, for several reasons. First, the company’s dimension is related to the costs of obtaining external funds. Specifically, smaller companies tend to bear the higher cost for obtaining external financing, basically due to information asymmetry (Graham et al. 1998). Therefore, lessor/lenders may choose to reduce this uncertainty by satisfying their claims by leasing rather than lending to small companies. In this context, leases are preferred because the lessor’s security is tied to the asset itself rather than to the general credit of the lessee. As a consequence, smaller companies are intended to lease relatively more, suggesting a negative relationship between size and leases. Second, the company’s dimension is related to diversification. Usually, larger companies tend to be more diversified than smaller ones. Mehran et al. (1999), arguing that company size might be a proxy for the cost of issuing securities and for the company’s investment flexibility and diversification possibilities, they investigated the relationship between total lease and size (measured by total sales). Their results demonstrate that size has a strong positive effect on debt financing, and it is positively related to the leases share of total capital costs. Lasfer and Levis (1998) pointed out that company size can be a measure of the extent to which companies have the ability to reallocate assets internally, and this might indicate that large companies are less likely to lease assets. Thus, including size (measured through three different variables: total assets, market value of equity, and sales) as explanatory variable, they demonstrated that the determinants of the finance lease decisions (such as tax reasons and growth opportunities) depend also on companies’ dimension. In large companies, profitability, leverage, and taxation were found to be positively correlated with leases, whereas in small companies the leasing decision did not appear to be driven by profitability or taxation reasons, but mainly by growth opportunities. Deloof and Veruschueren (1999), using total assets as a measure of size, investigated the determinants of finance lease decisions. They show that the coefficient of size is significant and positive for the entire sample, and it remains significant if case the sample is divided between small and large companies. One more reason is related to the fact that size can be used as a measure of political costs, assuming the perspective that larger companies are more likely to face political exposure penalties than smaller companies (Watts and Zimmerman 1978; Holthausen and Leftwich 1983; Cooke 1989), as they have greater availability wealth to be taxed by government or appropriated by specialist interest (Hand and

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Skantz 1997). Moreover, the efficient contracting theory assumes that managers choose accounting policies so as to minimize political exposure and agency costs. These studies showed that large companies have greater incentives to adopt income decreasing methods, in order to reduce the expected costs of political visibility, suggesting that larger companies tend to avoid operating leases because they are more likely to adopt accounting methods that decrease current income. In this regard, some other authors have used the annual turnover as a measure of size. Specifically, Adams and Hardwick (1998) investigated whether a change in company size had the same effect on the total leases for companies of all size, demonstrating that size variable (sales) was significantly less than zero which provided support for the view that small companies are more likely to lease than large companies. In addition, their results showed that leases share tended to fall as company size increased. Lastly, Sharpe and Nguyen (1995) using size as a proxy variable for the flexibility of companies’ investments found that small companies lease more than large companies, demonstrating a significant and negative relationship between size and lease intensity. With the aim to avoid endogeneity problems, they used the log of the number of employees as a proxy for the size of the company. Their findings illustrate that while large companies are more likely to have alternative uses for equipment that is no longer used or that they might have a well-developed mechanism for remarking equipment, smaller companies have greater uncertainty regarding their future need for equipment or buildings. Moreover, they also showed that companies with higher costs of external capital tend to lease more and, within the same path of research, Graham et al. (1998) assumed that larger companies tend to use more debt financing (instead of operating leases) than smaller companies. Based on the authors’ assumptions, this is due to three main reasons: larger companies are more diversified and therefore cash flows present greater stability; larger companies have more economies of scale in issuing securities; and due to the information asymmetry, smaller companies have to bear higher costs for obtaining external funds. From an empirical perspective, using the natural log of the market value of equity, they found a significant negative relationship between size and operating lease to the market value of a company. As illustrated through previous contributions, empirical analyses on companies’ dimension as explanatory variable of off-balance sheet leases have provided controversial results and, in this regard, there are also several studies that did not find any significant relationship between leases and size (Ang and Peterson 1984; El-Gazzar et al. 1986). In particular, Ang and Peterson (1984) using the total assets at year-end as a proxy for size, did not find any concrete finding since results changes each year during the investigated period (1976–1981), while El-Gazzar et al. 1986 investigating the size as a measure of political costs find a positive but not significant relationship between companies’ dimension and leases. Being the companies’ dimension considered by the existing literature an explanatory variable of the off-balance sheet leases, with the aim of testing the relationship between the size and the use of leases, the following hypothesis is proposed:

3.2 The Relationship Between Capitalization of Off-Balance Sheet Leases and. . .

49

H1f: the level of lease liability resulting from the implementation of the new lease accounting model (IFRS 16) is associated with companies’ dimension.

3.2

The Relationship Between Capitalization of Off-Balance Sheet Leases and the Economic and Financial Performance

Even though using different methodological approaches, previous studies in the literature demonstrated that operating leases under IAS 17, being an off-balance sheet financing method, improve the company’s profitability, while worsen the company’s liquidity and debt exposure to third parties. These studies have also shown that the results do not change considering different accounting systems, such as United States, Canada, Australia, New Zealand, and Europe, highlighting an important result in terms of accounting harmonization. In fact, it should not be forgotten that, despite has been introduced and partially obtained a certain level of harmonization due to the adoption of IFRS and the reduction of the differences between US GAAP and IFRS, for audit rules and for recognition and evaluation in the financial statement of lease contracts, each country maintains its accounting system mainly related to economic, political and social context. One of the first study, analyzing the consequences of capitalizing operating leases on economic and financial performance is the one provided by Nelson (1963), which shows how the capitalization of off-balance sheet debt, as leases having operating nature, significantly increases the reliability of the economic and financial ratios in a sample composed by United States companies. Based on a similar approach, Imhoff et al. (1991) developed the constructive capitalization model to assess the impact on the economic and financial performance of the recognition and evaluation of the operating lease in the balance sheet. They found that companies in different industries reported very large noncancelable operating lease commitments and those companies were using significantly more assets to generate revenues than they reported in their balance sheet, and they also presented much more leverage than their reported debt-to-equity ratio would suggest. The constructive capitalization model (Imhoff et al. 1991) allows to get the amounts of unrecorded assets and liabilities, and it has been widely used in the academic literature to measure the monetary effects of operating leases, affecting assets, liabilities, and net income. In order to apply the constructive capitalization method, it is necessary to estimate the amount of the liabilities related to lease and, to obtain this estimation the minimum future payments from operating leases with remaining non-cancelable lease terms—in excess of 1 year—should be determined. That amount is then recorded for the next 5 years, following a simple lump sum of all remaining payments after the fifth year (Imhoff et al. 1991). The minimum future cash flows are then discounted using an estimation of the firm’s borrowing rate and an estimation of the remaining life of the leased asset. The result is the estimation of

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3 Lease Accounting Literature Review and Hypotheses Development

the present value of the remaining operating lease, which represents the amount to be recorded as liability (Imhoff et al. 1991). Theoretically, this amount recorded in the liabilities is the same amount that would have been recorded if the lease had been accounted as a finance lease. Thus, the future cash flows which are used in the constructive capitalization model represent the same minimum lease payments which would have been used to measure the liability they had been classified as finance leases. As a consequence, after the liability is measured, the unamortized off-balance sheet asset is estimated by examining the relationship between assets and liabilities. However, to assess the amount of assets, an estimation of the weighted average total life of the leased asset, as well as the depreciation method, is required. Most assets are depreciated using the straight-line depreciation method, so it is applicable, but the total life of the asset is harder to assume. According to Imhoff et al. (1991) assets are usually between 60 and 80% of the unrecorded liability, and it is reasonable to a rule-of-thumb of 70%. Therefore, taking into consideration these assumptions the authors estimated the amount of assets that would be reported on the balance sheet, and through their contribution published on Horizon, Imhoff et al. (1991) illustrated how to constructively capitalize operating leases. Nevertheless, their first study focused exclusively on the balance sheet effects and assumed the income statement effects were negligible. In order to overcome this limitation, in 1997 the authors published a new research suggesting that the net income effect may be material, and they illustrated how to estimate the impact of constructive capitalization of operating leases on both operating incomes (before interest expense) and net income. Using a sample of US corporations, they provided evidence that the income effects of off-balance sheet leases can materially alter impressions about the relative financial performance of firms. The constructive capitalization model proposed by Imhoff et al. (1991, 1997) has been then widely adopted in the lease accounting literature. Some studies have applied this method in specific industries in the United States, such as the retail sector (Mulford and Gram 2007), utilities and banking sector (Duke et al. 2009), and restaurant businesses (Sing 2011), all of them confirming the results obtained by Imhoff et al. (1991, 1997). In particular, Mulford and Gram (2007) demonstrated that excluding operating leases from the balance sheet induces a material distortion of the financial position of the company, which is further evidenced in understated the Earning Before Taxes (EBT), Depreciation and Amortization (D&A) and overstated income from continuing operations. Additionally, their results also demonstrated that key cash flow metrics are understated by the exclusion of operating leases. Despite the industries specific characteristics, previous empirical contributions show a negative change in companies’ profitability and a positive change in the level of indebtedness, which would not have been recognized if operating leases had not been capitalized. Therefore, previous authors suggested in their conclusion that an accounting principle establishing the recognition of operating leases in the balance sheet would have allowed a more accurate and truthful assessment of the risks assumed by the company and its real ability to generate income. Basically, previous

3.2 The Relationship Between Capitalization of Off-Balance Sheet Leases and. . .

51

studies suggest that if the accounting of the operating lease was not applied there would be a biased evaluation of the companies’ economic and financial performance. In this regard, Grossmann and Grossmann (2010) based their analysis on the application of the constructive capitalization model by analyzing the Fortune 500 companies. Specifically, of the top 200 companies of the Fortune 500 list in 2009, 91 have been chosen for their study. The results demonstrated that, without discounting, 60 of the companies would have increased their current liabilities by less than 5%, while 21 would have increased them by at least 10%. With discounting, 70 of the companies would have effects of less than 5% for current liabilities, but 13 would have increases of at least 10%; for total liabilities, the effect was less than 5% for 50 companies but at least 10% for 29 companies. Substantially, the analysis confirms the results of previous research, even if the decline of the percentage values of greater magnitude for the level of indebtedness is such as to create difficulties of accessing external sources of financing if operating leases are recognized in the balance sheet. Moreover, Duke et al. (2009) and Grossmann and Grossmann (2010) added also evidence of a decrease in companies’ liquidity to the negative changes of the company’s profitability and to the positive changes of the levels of indebtedness. Similar conclusions are reported in the study provided by Bennett and Bradbury (2003), which use a sample of New Zealand companies found that the capitalization of operating leases not only have negatively impacts on leverage ratios, but also generate a decrease in the company’s liquidity and profitability. Durocher (2008) applied a refined constructive capitalization model, in which company’s specific assumptions such as interest rate, total/expired/remaining life of leased assets, and tax rate were used to analyze the impact of operating lease capitalization on key financial indicators for a sample of Canadian public companies. Their results show that capitalizing operating leases would lead to the recognition of important additional assets and liabilities on the balance sheet, significantly increasing the debt-to-asset ratio and significantly decreasing the current ratio. These findings were observed across all industries in the sample. Instead, significant changes on the return on assets (ROA), return on equity (ROE), and/or earnings per share (EPS) were noted only in three industries: merchandising and lodging, oil and gas, and financial services, while income statement effects were generally less material. In the same field of research, Wong and Joshi (2015) provided evidence on the impact of lease capitalization on the financial statements and financial ratios of the top Australian companies listed on ASX. Their findings demonstrated that the changes in financial statements (total assets, total liabilities, and total equity) are not as significant as the changes found in previous studies provided by Beattie et al. (1998) and Bennett and Bradbury (2003). Contrary, financial ratios such as D/E ratio, D/A ratio, and ROA change significantly under lease capitalization, while the change in ROE is insignificant. These findings are in line with the perspective of Graham and King (2011), who suggested that the right-to-use leased asset value is strongly associated with current and future return on assets.

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The constructive capitalization model provided by Imhoff et al. (1991, 1997) has been applied also in Europe, considering analysis approaching by industries or by different financial markets. Beattie et al. (1998) and Goodacre (2003) both analyzed the British context using respectively a sample of randomly selected listed companies in the retail industry. Specifically, Beattie et al. (1998) studied the effect of operating lease capitalization on accounting ratios and they found that lease capitalization significantly impacts on profit margin, return on assets, asset turnover, and gearing. These significant changes on the key accounting ratios and the shifts in company performance ranking suggest that capitalization impacts interested parties’ decisions and company cash flows. Goodacre (2003) assessed the potential economic consequences of the G4 + 1 report, proposed changes to lease accounting by examining companies in the UK retail sector over the 1994–1999 period. His study provides also evidence that operating leases were confirmed as a major source of finance in the retail sector. Indeed, the level of the off-balance sheet operating lease liability is much higher (around 3.3 times higher) than the level of on-balance sheet long-term debt. Thus, operating lease financing activities is significantly more important than long-term debt, information that is of major potential importance for users’ assessment of financial risk. By contrast, finance leases are essentially immaterial, as indicated by the analysis that operating lease liabilities are, on average, approximately 37 times the level of finance leases. Moreover, he confirmed that capitalization of operating leases would have a major impact on key accounting ratios, the ranking of companies changes markedly for asset turnover, interest coverage, and the three capital-based gearing measures. The findings highlighted by previous research are partially confirmed also by Fülbier et al. (2008) and Branswijck et al. (2011), which analyzing listed companies in Germany, Belgium, and the Netherlands, demonstrating that the effect of decreasing profitability and increasing in debt position take on more significant negative and positive percentage changes in some industries, such as fashion and retail businesses in Germany, manufacturing in Belgium and Netherlands. A decrease in the company’s liquidity is confirmed only in the study provided by Branswijck et al. (2011), without any differences within industries. Therefore, it seems that the capitalization of the operating lease could be affected by an effect of belonging to different industries only for profitability and the level of indebtedness, as already evidenced by Mulford and Gram (2007), Duke et al. (2009), and Singh (2010) in the United States. Always looking at the European countries, Fitò et al. (2013) and Pardo Pèrez et al. (2015), analyzing a sample composed of Spanish listed companies, they both reached findings in line with previous literature. Based on this stream of literature, over the consultation period opened to collect opinions on the contents of the Exposure Draft 2013, all interviewed companies expressed an opinion not favorable to the capitalization of the operating leases. The reasons are clearly related to the decrease in profitability and liquidity and to the increase in companies’ debt position. Nevertheless, studies belonging to lease accounting literature do not always provide a univocal interpretation of the potential effects deriving from the capitalization of the operating leasing on the economic and financial performances.

3.2 The Relationship Between Capitalization of Off-Balance Sheet Leases and. . .

53

Contrary to the findings of the aforementioned literature, Sari et al. (2016) using a sample of listed companies in Turkey, provides evidence that the capitalization of operating leases generates a positive effect on operating profitability and worsening the level of indebtedness, in particular for retail companies. In similar way, Cordazzo and Lubian (2015) analyze the consequences of the capitalization of operating leasing on the financial statements using a sample of Italian listed companies and, aligned with Sari et al. (2016), their findings show an improvement in profitability and a worsening in both the level of indebtedness and liquidity, particularly for businesses in the consumer services sector. The same results have been obtained by Maglio et al. (2017), which also demonstrated that changes in the financial structure ratios may influence the use of operating leasing contracts not only for companies belonging to the consumer services industry but also for those belonging to the technology sector. A study provided by Eisfeldt and Rampini (2009) suggests that more financially constrained firms benefit from the higher debt capacity of lease capital, and hence they will lease a larger fraction of their capital. When measuring the effects of financial constraints on investment cash flows, leased capital must be taken into account, otherwise, results are likely overstated. Small firms tend to lease more, about half of their capital, and the higher debt capacity of leasing is one important reason for that (Eisfeldt and Rampini 2009), suggesting that capitalization affects firms that are financially constrained as they will have to make some changes when their current operating leases are capitalized. At the same time, capitalization brings more transparency to financial statements, meaning that effects of financial constraints are likely overstated because of off-balance sheet debt. Enriching this field of research, more recent contributions have been developed with the aim of analyzing the impact of the capitalization of off-balance leases on the companies’ economic and financial performance (Morales-Diàz and ZamoraRamìrez 2018a; Giner et al. 2019; Joubert et al. 2017; Veverkovà 2019). However, most of this research focusing on IFRS 16 is only theoretic and the effects are described only considering the way in which financial statement metrics and economic and financial performance would potentially increase or decrease as resulting from the capitalization of all operating leases. In the end, all previous empirical studies were developed on “theoretical” data relating to the capitalization of operating leases which, for most of them, derive from the application of different approaches of the constructive capitalization model provided by Imhoff et al. (1991, 1997). Nowadays, there are no studies in the literature measuring the effective impact of the new lease accounting regulation on the financial statement and on the economic and financial performance, as resulting from the mandatory adoption of the new lease accounting principle (IFRS 16). Thus, existing literature measures the impact of the capitalization of operating leases (using either constructive or factor methods) on the magnitude of changes in accounting ratios and other metrics, dividing ratios into four categories:

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1. Ratios and metrics related to the financial structure, such as total assets and total liabilities structure, debt-to-equity ratio, etc.. . . . 2. Profitability ratios, such as Return on Asset (ROA), Return on Equity (ROE), Return on Investment (ROI), Capital Turnover, Return on Sale (ROS), etc.. . . . 3. Liquidity ratios, such as quick ratio or acid test. 4. Investment return and other ratios, such as Earnings per Share (EPS) or the EV/EBITDA multiple. As illustrated, the literature related to the ex ante impact analysis of the operating lease capitalization, over the period from 2007 to 2018, is quite extensive (Mulford and Gram 2007; Durocher 2008; Fülbier et al. 2008; Duke et al. 2009; Singh 2012; Grossmann and Grossmann 2010; Bryan et al. 2010; Fitò et al. 2013; Wong and Joshi 2015; and Pardo Pèrez et al. 2015) and provide different findings based on different features, such as sample composition (whole sample or focused on one or more industries); the methodology used (constructive or factor method, or both) and the ratios and metrics used for the analysis. Moreover, all previous studies were conducted through the construction of theoretical data, obtained through the application of the most common theoretical models, thus providing only insights on the potential effects deriving from the capitalization of operating leases. With the aim of analyzing the impact of the post-implementation of the new lease accounting requirements as prescribed by IFRS 16 on companies’ financial structure, economic performance, profitability, and liquidity, the following hypotheses are proposed: H2a: the implementation of the new lease accounting model significant impact on companies’ financial structure. H2b: the implementation of the new lease accounting model significant impact on companies’ economic performance. H2c: the implementation of the new lease accounting model significant impact on companies’ profitability. H2d: the implementation of the new lease accounting model significant impact on companies’ liquidity.

caused a statistically caused a statistically caused a statistically caused a statistically

In the existing literature has been demonstrated that some industries use operating leases more extensively than others, considering operating leases as an alternative to capital investment. Specifically, companies characterized by a more flexible structure, such as the retail industry (food retail, clothes retail, etc.), real estate goods (retail shop and business locations) are often leased. This industry has been generally identified as that which is most affected by the implementation of the new lease accounting regulation (Altamuro et al. 2014; Durocher 2008; Fitò et al. 2013; Fülbier et al. 2008; Mulford and Gram 2007), together with hotels and transportation (Fitò et al. 2013). Some other studies demonstrated that companies belonging to the primary and secondary business sector do not make high use of operating leasing contracts compared to the tertiary business sector (Sharpe and Nguyen 1995; Shanker 1997; Adams and Hardwick 1998; Callimaci et al. 2011).

3.3 Reactions of Market Operators and Financial Statements Users

55

Therefore, with the aim of analyzing if the impacts of the post-implementation of the new lease accounting model prescribed by IFRS 16 are influenced by the affiliation to the specific industry, the following hypothesis is proposed: H2e: The impacts of IFRS 16 on the key accounting ratios and metrics depend on the industry in which the company operates. Finally, Table 3.1 provides a summary of the relevant studies included in the previous literature review.

3.3

Reactions of Market Operators and Financial Statements Users

The proposal of the international accounting bodies (IASB and FASB)—through the issue of the Exposure Draft 2010, the Exposure Draft 2013, and the new accounting standard IFRS 16—to capitalize operating leases, in order to make financial statement uniform from the accounting policies point of view, led to different reactions from financial market operators and financial statement users. Almost all studies involved in the existing literature underline the relevance to have a uniform accounting treatment for operating and for finance leases, but not all of them agree with the elimination of the classification between finance and operating leases. In this context, Sakai (2010) investigated market reactions associated with the movement of the finance lease disclosure from footnotes to the body of financial statements, for a sample composed of Japanese listed companies. His findings suggested no reactions from the financial market, meaning that investors were not able to foresee changes in the lessee’s decision rather than the footnote disclosure was inferior to recognition on the balance sheets. Sengupta and Wang (2011) examined the impact of off-balance sheet financing arising from operating leases (and postretirement plans on bond ratings and yields). They found that corporate board ratings and yield are only associated with off-balance sheet debt arising from operating leases, but not associated with off-balance sheet debt arising from postretirement benefit plans. Therefore, their results suggest that putting postretirement benefit liability on the balance sheet may help bring these liabilities to the attention of credit-rating agencies, debt, and equity holders and alter the pricing mechanism of these market participants. A more recent contribution by Krishnan and Sengupta (2011) focused on auditor perception of recognized versus disclosed obligations related to operating leases and unfunded pension obligations. They evaluated the relation between two pairs of obligations (on-balance sheet and off-balance sheet obligations) and audit fees and goingconcern opinions, demonstrating that operating leases are positively associated with audit fees, whereas finance leases are not associated. Additionally, operating leases were seen to be associated with going-concern opinions (but pension

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Table 3.1 Literature review on operating lease capitalization Authors Nelson (1963, The Accounting Review Journal)

Sample 11 US companies for 15 ratios.

Ashton (1985, Accounting & Business Research) Imhoff et al. (1991, Accounting Horizons)

23 companies 14 US companies in 1987

Beattie et al. (1998, Accounting and Business Research)

300 listed industrial and commercial UK companies 1990–1994

Goodacre (2003, The International Review of Retail, Distribution and Consumer Research)

106 retail UK companies 1994–1999

Durocher (2008, Accounting Perspective)

100 largest Canadian public companies (by revenue).

Jesswein (2009, Academy of Accounting and Financial Studies Journal)

595 US non-financial sector companies

Grossmann and Grossmann (2010, The CPA Journal)

91 non-financial companies from the top 200 of the fortune 500 that had issued 2009 10-K reports 234 retail and restaurant firms; 2006–2008.

Singh (2010, Journal of Hospitality & Tourism Research)

Findings • Lease capitalization would make 12 of the 15 ratios give a less favorable representation of the company’s financial performance. • The debt/equity ratio is one of the most significantly impacted.. • Gearing ratio significantly affected.. • Average decrease in ROA of 34% for high lessees compared to 10% for low lessees; • Average increase of D/E for high lessees of 191% compared to 47% for low lessees.. Significant impact on six of the nine selected ratios: • Profit margin, ROA, asset turnover, and three gearing measures; • ROCE and interest coverage ratio not significantly affected.. Ratios with strong impacts that would alter the companies’ rankings: Operating margin, three return on capital measures, asset turnover, income gearing, and three capital gearing measures • Increase in the debt-to-asset ratio of 66.2% to 68.9% for all industry segments in the sample; • Significant decrease in the current ratio for all industry segments in the sample; • Significant impacts on ROA, ROE, and/or EPS noted only in three industry segments.. • Decrease in current ratio by 10% and in quick ratio by 12.1%; • Decrease in ROIC of 28.6%; • Interest coverage decrease of 78.47% and debt ratio increase of 72.7%.. • Significant decrease in the current ratio. • Increase in the ratio of total liabilities to total assets..

• Retail firms affected more than restaurant firms in relation to leverage financial ratios, profitability, and interest coverage; • Significant decrease in interest coverage ratios; (continued)

3.3 Reactions of Market Operators and Financial Statements Users

57

Table 3.1 (continued) Authors

Sample

Kostolansky and Stanko (2011, Journal of Business & Economics Research)

Standard and Poor’s 100 (S&P 100) companies.

Cornaggia et al. (2013, Journal of Corporate Finance)

Firms in the merged CRSP-Compustat database from 1980 through 2007

Fitò et al. (2013, Spanish Journal of Finance and Accounting)

Quoted Spanish firms with consolidated financial statements for the period 2008–2010.

Wong and Joshi (2015, Australasian Accounting, Business and Finance Journal)

Australian leasing companies listed on the Australian Stock Exchange (ASX); Year 2010.

Fafatas and Fischer (2016, The Journal of Corporate Accounting & Finance)

22 retailer companies with high operating leases.

Öztürk and Serçemeli (2016, Business and Economics Research Journal)

One airline company (Pegasus Airline Company); Turkey 2015

Morales-Diaz and ZamoraRamìrez (2018a, b, Accounting in Europe)

646 European quoted companies from a variety of sectors included in the STOXX Total market.

Findings • Significant increases in debt-related ratios such as leverage, and debt-toequity ratios.. • Significant increase in the total debt to total asset ratio with a median increase over 1%. Ex. from 64.48% to 66.29%. • Significant decrease in ROA. Ex. 7.12% to 6.85%.. • Conventional leverage, Z-score, levered beta, return on capital and other asset utilization measures underestimate risk and overstate the performance of firms relying heavily on off-balance sheet leasing.. • Equity to assets increasing on average by 6%; • Equity to liabilities decreasing 9% on average due to the impact on equity; • Debt quality decreasing 10%, on average due to the impact on noncurrent liabilities; • Financial leverage (FINLEV) increasing on average 11%; • Significant effects on ROA and ROE.. • Significant increase in the leverage ratios, particularly the D/E ratio, with an increase of 31.69%. • Drastic decrease in ROA (15.35%). The decrease in mean ROE is smaller but statistically significant.. • Average decline in the EBIT/Assets ratio of 407 basis points (4.07%). • Operating lease capitalization could result in a strong decline in ROA and ROIC ratios.. • D/E and D/A ratios present an increase trend of 75.3% and 16.9% respectively; • 34.4% decline in ROA and a 15.6% increase in ROE.. • Leverage (debt/assets) increasing by 9.28% (mean) in relative terms. • ROA increasing on average by 3.07%, which varies significantly according to each sector. • Interest coverage ratio (EBITDA/Interest Expense) decreasing by 13.6%.. (continued)

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Table 3.1 (continued) Authors International accounting standard board

Sample 20 European banks

European Banking Authority (2017)

65 banks across 19 countries in the European economic area (EEA).

Findings • The estimated decrease in reported equity is less than 0.5 percent of reported equity for all banks included in the sample.. • The EBA estimates that the impact of IFRS 16 to EU banks is of rather limited significance..

obligations were not), which led to the conclusion that companies using off-balance sheet operating leases face some additional costs from increased audit fees and increased going-concern opinion, especially for companies having a material operating lease. In the same context, Cotten et al. (2013) examined whether or not credit ratings reflect the debt characteristics of operating leases and, using the methodology provided by Damodaran (2010), they compared firm’s actual credit ratings with synthetic ratings calculated using both reported financial statements data and financial statement data adjusted to reflect the debt treatment of operating leases. The results of their study are very interesting since they show that the debt treatment of operating leases produces significantly lower coverage ratios and lower synthetic ratings than current treatment. Moreover, they found that actual ratings are significantly lower than unadjusted synthetic ratings, while synthetic ratings calculated using adjusted data approximate the actual ratings. Previous empirical analyses suggest that the capitalization of the operating lease, therefore, has an impact on debt position in the same measure as the liabilities that are recognized for the finance lease. Then, its recognition in the balance sheet is necessary in order to avoid a distortion in the rating phase of the debt by the rating agencies. However, Lim et al. (2003) pointed out that taking into account of off-balance sheet financing, on the one hand, can certainly improve the judgment of the companies’ economic and financial performance in the financial market, but on the other hand this implies that yield on debts would include the off-balance debt that, actually, cannot be assessed in similar way to other financial payables recognized in the financial statements. Within the same stream of literature, Beattie et al. (2006a, 2006b) elicited and compared the views of users and preparers on a range of issues surrounding lease accounting reform proposed in G4 + 1 “Lease accounting discussion paper.” They found that the views of expert users and preparers differed significantly. Both groups considered the UK lease accounting standard deficient in a number of aspects, such as the classification of deliberately structured leases as operating leases. They also found that expert users were strongly in favor of G4 + 1 proposal but preparers showed only moderate support. Based on their results, users and preparers considered that the recognition of all leases on the balance sheet will lead to recognition of borrowing covenants, reduction in credit ratings for some companies, and

References

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improvement of users’ evaluation of long-term financial commitments, improving at the same time companies’ comparisons. Similar conclusions were also reached in the study provided by Durocher and Fortin (2009), which adopting a users’ perspective and examining private bankers’ preferences on the issue of capitalizing all noncancelable lease contracts, highlight how these operators take into account both capital and operating lease information, but they attribute greater relevance to financial leasing. Their study also demonstrated that the capitalization of the operating leases would have a significant impact on key financial indicators of a sample of Canadian private companies. Bankers perceive that these changes in financial ratios would affect their assessment of borrower’s capital structure/solvency, liquidity, ability to repay, and risk rating. Hussey and Ong (2010), comparing the opinions of 63 qualified accountants in Canada and 54 qualified accountants in Malaysia, contributed to the academic and professional debate demonstrating that the results support the substance over-form model, without supporting the removal of the classification between financial and operating leases. On the contrary, Dhaliwal et al. (2011) support the proposal of the IASB and the FASB to eliminate the classification between the operating and finance lease and to capitalize the operating leases, since the association of the operating risk and the financial risk with the operating leasing is positive but less significant than that which is observed with financial leasing. Specifically, they investigated whether off-balance sheet assets and liabilities associated with operating leases have the same risk relevance for explaining ex ante measures of risk as a firm’s on-balance sheet items. Based on their results, the lower risk relevance assigned by investors to operating lease transactions is consistent with two alternative interpretations: firstly, investors believe that, compared to finance lease, operating leases expose the lessee to lower (but significant) ownership risk; secondly, investors believe that properly classified operating leases expose the lessee to no ownership risk, but they find it difficult to distinguish the “true” operating leases from the misclassified transactions that are in substance financial leases. Therefore, assuming the investor perspective and with the aim to verify the reactions of the financial market related to the implementation of IFRS 16 requirements, the following hypothesis is proposed: H3: the implementation of the new lease accounting model caused a statistically significant impact on companies’ market value.

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Kostolansky, J., & Stanko, B. (2011). The joint FASB/IASB lease project: Discussion and industry implications. Journal of Business & Economics Research, 9(9), 29–36. Krishnan, V., & Moyer, R. (1994). Bankruptcy costs and the financial leasing decision. Financial Management, 23(2), 31–42. Krishnan, G. V., & Sengupta, P. (2011). How do auditors perceive recognized vs. disclosed lease and pension obligations? Evidence from fees and going-concern opinions. International Journal of Auditing, 15(2), 127–149. Lasfer, M. A., & Levis, M. (1998). The determinants of the leasing decision of small and large companies. European Financial Management, 4(2), 159–184. Lim, S. C., Mann, S. C., & Mihov, V. T. (2003). Market evaluation of off-balance sheet financing: You can run but you can’t hide, working paper, Texas Christian University. Maglio, R., Rapone, V., & Rey, R. (2017). L’impatto della capitalizzazione del leasing operativo sulle società italiane IAS/IFRS adopter. Università di Napoli Federico II. Marston, F., & Harris, R. S. (1988). Substitutability of leases and debt in corporate capital structures. Journal of Accounting, Auditing & Finance, 3(2), 147–164. Mayers, S. C., & Majluf, N. S. (1984). Corporate financing and investment decisions when firms have information the investors do not have, NBER working paper series, National Bureau of Economics Research. Available at: https://www.nber.org/papers/w1396 Mayes, D. G., & Nicholas, C. S. (1988). The economic impact of leasing. New York: M Macmillan Press. isbn:978-1-349-09525-4. Mehran, H., Taggart, R., & Yermack, D. (1999). CEO ownership, leasing and debt financing – statistical data included. Financial Management, 28(2), 5–14. Miller, M. H., & Upton, C. W. (1976). Leasing, buying and the cost of capital services. The Journal of Finance, 31(3), 761–786. Morales-Diaz, J., & Zamora-Ramìrez, C. (2018a). IFRS 16 (leases) implementation: Impact of entities’ decisions on financial statements. The IEB International Journal of Finance, 17, 60–97. Morales-Diaz, J., & Zamora-Ramìrez, C. (2018b). The impact of IFRS 16 on key financial ratios: A new methodological approach. Accounting in Europe, 15(1), 105–133. Mulford, C., & Gram, M. (2007). The effect of lease capitalization on various financial measures: An analysis of the retail industry. The Journal of Applied Research in Accounting and Finance, 2(2), 3–14. Myers, S., Dill, D., & Bautista, A. (1976). Valuation of financial lease contracts. The Journal of Finance, 31(3), 799–819. Nelson, A. (1963). Capitalizing leases: The effect on financial ratios. Journal of Accountancy, 116 (1), 49–58. Öztürk, M., & Serçemeli, M. (2016). Impact of new standard “IFRS 16 leases” on statement of financial position and key ratios. A case study on an airline company in Turkey. Business and Economics Research Journal, 1(4), 143–157. Pardo Pèrez, F., Giner Inchausti, B., & Cancho Ortega, R. (2015). Operating leases: An analysis of the economic reasons and the impact of capitalization on IBEX 35 companies, working paper, University of Valencia. Sakai, E. (2010). The market reaction to the finance lease capitalization from the view point of risk assessment, working paper, Musashi University. Sari, E. S., Altintas, T., & Tas, N. (2016). The effect of the IFRS 16: Constructive capitalization of operating leases in the Turkish retailing sector. Journal of Business, Economics and Finance, 5 (1), 138–147. Sengupta, P., & Wang, Z. (2011). Pricing off-balance sheet debt: How do bond market participants use the footnote disclosures on operating leases and postretirement benefit plans? Accounting and Finance, 51(3), 787–808. Shanker, L. (1997). Tax effect and the leasing decisions of the Canadian corporations. Canadian Journal of Administrative Sciences, 14(2), 195–205. Sharpe, S. A., & Nguyen, H. H. (1995). Capital market imperfections and the incentive to lease. Journal of Financial Economics, 39(2–3), 271–294.

References

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Sing, A. (2011). A restaurant case study of lease accounting impacts of proposed changes in lease accounting rules. International Journal of Contemporary Hospitality Management, 23(6), 820–839. Singh, A. (2010). Proposed lease accounting changes: Implications for the restaurant and retail industries. Journal of Hospitality & Tourism Research, 36(3), 335–365. Singh, A. (2012). Proposed lease accounting changes: Implication for restaurant and retail industries. Journal of Hospitality & Tourism Research, 36(1). Slotty, C. (2009). Financial constraints and the decision to lease – evidence from German SME, working paper, 21st Australasian finance and banking conference 2008 paper, available at SSRN: https://ssrn.com/abstract¼1216582 or https://doi.org/10.2139/ssrn.1216582. Smith, C. W., & Wakeman, L. M. (1985). Determinants of corporate leasing policy. Journal of Finance, 40(3), 895–908. Smith, C. W., & Warner, J. B. (1979). On financial contracting. An analysis of bond covenants. Journal of Financial Economics, 7(2), 117–161. Spencer, A. W., & Webb, T. Z. (2015). Leases: A review of contemporary academic literature relating to lessees. Accounting Horizons, 29(4), 997–1023. Stulz, R. M., & Johnson, H. (1985). An analysis of secured debt. Journal of Financial Economics, 14(4), 501–521. Tomkins, C. R., Lowe, J. F., & Morgan, E. J. (1980). Lease finance in industrial markets. Managerial and Decision Economics, vol., 1(3), 150–157. Veverkovà, A. (2019). IFRS 16 and its impacts on aviation industry. Acta Universitatis Agriculturae Silviculturae Mendelianae Brunensis, 67(5), 1369–1377. Watts, R. L., & Zimmerman, J. L. (1978). Towards a positive theory of determination of accounting standard. The Accounting Review, 53(1), 112–134. Watts, R. L., & Zimmerman, J. L. (1979). The demand for and supply of accounting theories: The market for excuses. The Accounting Review, 54(2), 273–305. Watts, R. L., & Zimmerman, J. L. (1986). Positive accounting theory. Englewood Cliffs, NJ: Prentice-Hall. Williamson, O. E. (1988). Corporate finance and corporate governance. The Journal of Finance, 43 (3), 567–591. Wong, K., & Joshi, M. (2015). The impact of lease capitalization of financial statements and key ratios: Evidence from Australia. Australian Accounting, Business and Finance Journal, 9(3), 27–44. Zhang, N. (2011). Leasing uncertainty, and financial constraint, working paper, The University of British Columbia.

Chapter 4

Post-Implementation Analysis of IFRS 16 on Companies’ Financial Structure, Economic and Financial Performance

This chapter illustrates the methodology used to develop the empirical analysis and the related results. In line with the existing literature presented in the previous Chap. 3, the empirical analysis has been conducted on three main research lines. The first, related to the definition of the relationship between companies’ determinants (explanatory variables) and the level of lease liability emerging in the financial statement following the adoption of the new IFES 16. The second, relating to the analysis of the impact deriving from the implementation of the new lease accounting model on the financial structure and on economic-financial performance. The third, relating to the investigation conducted on the implementation of the new accounting standard and the reactions of market operators, with a particular focus on market value. As already outlined, the innovativeness of the empirical analysis lies in the adoption of real data extrapolated from the financial statements that incorporate the transition from the previous IAS 17 to the new IFRS 16. The adoption of such data and, at the same time, the effect of the First Time Adoption (FTA) mainly described in the related notes, allow to contribute to the existing literature providing real results on the effect deriving from the implementation of the new lease accounting model.

4.1

Sample Selection

The empirical analysis has been conducted on a sample composed of 167 Italian listed companies as of the end of 2019. The sample does not include companies belonging to the financial industry (banks, insurances, and other financial institutions) due to the peculiarities and accounting principles characterizing the preparation of financial statements for this industry. Moreover, taking into consideration that the aim of this empirical analysis is to measure the impact of the mandatory adoption of IFRS 16 on companies’ financial statements, economic and financial performance, all companies not having lease contracts at the end of 2019 are excluded from the sample. © The Author(s), under exclusive license to Springer Nature Switzerland AG 2021 E. Raoli, IFRS 16 and Corporate Financial Performance in Italy, Contributions to Finance and Accounting, https://doi.org/10.1007/978-3-030-71633-2_4

65

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4 Post-Implementation Analysis of IFRS 16 on Companies’ Financial Structure,. . .

Table 4.1 Sample selection Criteria Borsa Italiana’s Main market (MTA) Less: Exclusion banks and financial services industries companies Companies without lease contracts Companies presenting financial statements in infra-annual periods (different from December 31) Companies that have not published yet their financial statements using the Legislative Decree 18/2020—Crura Italia Sample Table 4.2 Distribution of the sample by industry (Super Sector Classification—Borsa Italiana)

Chemical Consumer goods Consumer services Healthcare IT Manufacturing Oil and gas Public utilities Telecommunications Total sample

Frequency 4 39 23 8 13 55 6 15 4 167

245 (59) (2) (6) (11) 167

Percent (%) 2.40 23.35 13.77 4.79 7.78 32.93 3.59 8.98 2.40 100

Therefore, data used for the empirical analysis are reported on the consolidated financial statements of Italian listed companies at the end of 2019, the year that by definition incorporates the full effects of the adoption of the new lease accounting model. More precisely, data relating to the impact on the financial statements deriving from the first application of the new accounting principle have been hand collected from the disclosure reported in the notes of the companies’ public financial statements. Additional economic and financial data have been collected from Datastream and Thomson Reuters Eikon databases. Table 4.1 describes the sample selection process and sample composition, while Table 4.2 illustrates the sample composition by industry.

4.2 4.2.1

The Empirical Analysis on Determinants (Explanatory Variables) of Off-Balance Sheet Leases Variables Description and Research Design

The capitalization of the lease contracts due to the mandatory adoption of IFRS 16, led to several changes in the accounting items recorded on the companies’

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financial statements (both balance sheet and income statements). These changes have determined an impact of the economic and financial performance that can be measured by computing economic and financial ratios (indicators), assuming the perspective of the analysis pre- and post-implementation of the new lease accounting model. For this empirical analysis, profitability, liquidity, and financial structure ratios have been chosen, since they show to a greater extent the impact of capitalization of all leases that before the new lease accounting model was considered off-balance sheet. Moreover, the empirical analysis presented in this Chapter is based on the theoretical framework related to the off-balance sheet financing activities, as described in the previous Chap. 3. More precisely, the aim is to measure the real (effective) impact on the companies’ financial statements deriving from the implementation of the new lease accounting requirements as prescribed by IFRS 16. Therefore, taking into consideration that IFRS 16 has been in force since January 1, 2019, the financial statement data collected on December 31, 2019, fully incorporates the effect of the new lease accounting model. Nevertheless, before developing and presenting the empirical analysis of the economic and financial performance, it is interesting to verify the effective “behaviour” of the determinants (explanatory variables) of off-balance sheet leases, as previously investigated by the existing literature (see paragraph 1, Chap. 3). The theoretical framework is related to the off-balance sheet financing and, previous empirical studies provide analysis based on several hypothetical models of capitalization of operating leases, such as the “constructive capitalization method” (Imhoff et al. 1991, 1997; Mulford and Gram 2007; Fülbier et al. 2008; Bennett and Bradbury 2003; Branswijck et al. 2011) and the “factor method” (intended as a modified version of the constructive capitalization method). Differently, the scope of the first part of the empirical analysis is to test the effective role of several variables (companies’ characteristics) considered by the existing literature as determinants of the lease contracts as a source of off-balance sheet financing. More specifically, the methodological approach used allows to demonstrate if and how some companies’ characteristics—recognized by the existing literature as having a role in the decision on the lease contracts as a source of off-balance sheet financing—are associated with the level of lease liability recorded in the balance sheet after the implementation of the accounting requirements prescribed by IFRS 16. For this purpose, a linear regression model (OLS) has been implemented considering the amount of lease liability (lease_liability) as the dependent variable, standardized by total sales in order to avoid any distorting effect due to the company’s dimension. Then, looking at the data relating to the dependent variable (lease_liability) they show an asymmetry to the right of the distribution, and in order to solve this distortion, the logarithmic transformation of the dependent variable (lnlease_liabilty) has been included in the regression model. Moreover, based on the existing literature and in order to test the determinants of the off-balance sheet lease contract, the following independent variables have been included in the regression model.

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4 Post-Implementation Analysis of IFRS 16 on Companies’ Financial Structure,. . .

In the hypothesis 1a (he level of lease liability resulting from the implementation of the new lease accounting model (IFRS 16) is positively associated with previous year level of indebtedness) the level of indebtedness to third party is assumed as an explanatory variable for the off-balance sheet debt, aiming to verify if companies having a high leverage—due to the reduction of the possibility of further sources of external financing—use more lease contracts as a source of financing activities. Therefore, aligned with previous studies (Smith and Wakeman 1985; Erickson 1993; Sharpe and Nguyen 1995; Eisfeldt and Rampini 2009; Mehran et al. 1999; Beatty et al. 2010; Callimaci et al. 2011; Zhang 2011) and in order to test H1a, the D/E ratio of the year before the mandatory adoption of IFRS 16 (D/E ratio_2018) has been included, as independent variables, in the regression model. According to previous research, the expected result is that companies presenting a high level of D/E ratio in the year before the adoption of the new lease accounting model, records a greater amount of lease liability, since these companies have used off-balance sheet lease contracts in order not to further increase the level of indebtedness. Hypothesis 1b (the level of lease liability resulting from the implementation of the new lease accounting model (IFRS 16) is higher in closely held companies) considers the structure of the ownership of the company as an explanatory variable for off-balance sheet lease contracts. Prior research suggested that higher level of managerial ownership tends to be associated with higher levels of debt and financial leasing. In particular, some authors (Flath 1980; Smith and Wakeman 1985; Mehran et al. 1999) explored the role of the ownership structure in the decision to lease assets, providing evidence that more closely held companies tend to have more lease contracts. Therefore, in line with previous empirical analysis companies’ ownership structure of the year before the mandatory adoption of the new lease accounting model (major_owner_2018) is included, as independent variable, in the regression model. The expected result is that more closely held companies record a higher level of lease liability (due to the mandatory adoption of IFRS 16), given that the use of operating leases reduces the level of indebtedness and, as a consequence, the associated risk for companies. Therefore, more closely held companies have used more operating leases in the years before the mandatory adoption of the new lease accounting model, which in 2019 comes out in their financial statements. Through hypothesis 1c (the level of lease liability resulting from the implementation of the new lease accounting model (IFRS 16) is associated with the nature of the underlying asset) the nature of the asset under the lease contract is taken into account as an explanatory variable of off-balance sheet lease contract. This variable is often related to the use and intensity of leases and, some authors (Graham et al. 1998; Sharpe and Nguyen 1995) demonstrated a negative relationship between leases and proxies for asset specificity, arguing that more specific assets are more likely to be owned while more generic assets are more likely to be leased. Thus, in order to test the role of the nature of the asset in the decision between leasing or owing the asset, a variable measuring the level of the right of use recorded in the balance sheet with respect to the total assets (lease_intensity) is included, as the independent variable, in the regression model. This variable is, therefore, used as a

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69

proxy for the specificity of the underlying asset of the lease contract, which due to the adoption of IFRS 16 comes out on companies’ financial statements. Some authors pointed out that companies having a high growth rate prefer to link their investment opportunities to long-term activities entering into a financial lease as it allows to control the replacement of the assets. In this context, through hypothesis 1d (the level of lease liability resulting from the implementation of the new lease accounting model (IFRS 16) is positively associated with companies’ growth opportunity) the investment opportunity is assumed as explanatory variable for off-balance sheet leases. Therefore, taking into consideration the existing literature the Tobin’Q (Tobin’s Q_2018) is included in the regression model as independent variable. Within the same stream of research, taxes have been commonly considered as a relevant factor of the decision of leasing instead of buying (Miller and Upton 1976; Lasfer and Levis 1998). In fact, if a company is not in a fully tax-paying position, buying and depreciating the asset allows to deduct less amount of taxes than lease contract, since the company can deduct not only depreciation costs but also financial expenses. The existing literature suggests that companies’ tax rate is considered as an explanatory variable on the decision to buy or to lease the asset. Previous research (El-Gazzar et al. 1986), using the effective tax rate as a proxy for the tax incentive, demonstrated that low tax rate companies are more likely to use operating lease instead of finance lease, which is consistent with the hypothesis that companies with high effective tax rate are more likely to adopt income decreasing strategies, such as finance leases. Therefore, in the hypothesis 1e (the level of lease liability resulting from the implementation of the new lease accounting model (IFRS 16) is negatively associated with companies’ effective tax rate) the effective tax rate of the year before the mandatory adoption of the IFRS 16 (tax_rate_2018) is considered as an explanatory variable of off-balance sheet leases and it is included in the regression model as the independent variable. The expected result is that companies presenting a lower tax rate—in the years before the implementation of the new lease accounting model—have had tax incentives to use more operating leases. Thus, subsequently to the adoption of IFRS 16, these companies have entered operating leases in the financial statements showing a greater level of the lease liability. Finally, prior studies suggested that the company’s dimension is considered as an explanatory variable of the off-balance sheet leases, providing controversial results. Some authors found a significant and positive relationship between size and the use of lease contracts (Lasfer and Levis 1998; Deloof and Veruschueren 1999), while some others found a significant and negative relationship (Sharpe and Nguyen 1995; Graham et al. 1998; Adams and Hardwick 1998; Mehran et al. 1999). In order to test hypothesis 1f (the level of lease liability resulting from the implementation of the new lease accounting model (IFRS 16) is associated with companies’ dimension) the amount of total sale (size) is included as independent variable in the regression model. Finally, a proxy for the duration of the lease contracts (contract_duration) is included in the regression model as control variable. As illustrated, this first part of the empirical analysis aims to demonstrate if and how the level of lease liability recorded in the financial statements due to the

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4 Post-Implementation Analysis of IFRS 16 on Companies’ Financial Structure,. . .

Table 4.3 Variables description Variable Dependent variable: lnlease_liability

Definition It represents the natural logarithm of the total amount of lease liability resulting from the adoption of the new lease accounting model provided by the IFRS 16

Independent variables: D/E ratio _2018 It is calculated as the ratio between total financial debts and total equity of the year (2018) before the adoption of the new lease accounting model provided by the IFRS 16 major_owner It is used as a proxy for ownership structure. It is calculated as the percentage of shares held directly by the main shareholders, representing the level of closely held ownership structure. underlying_asset It is used as a proxy of the nature of the underlying asset. Explain the magnitude of the lease capitalization resulting from the adoption of the new accounting model provided by the IFRS 16. It is calculated as the ratio between the right of use and total fixed asset. Tobin’s Q_2018 It is used as a proxy for the companies’ growth rate. It is calculated as the ratio between the total market value of the company and its total asset value. tax_rate_2018 It is used as a proxy for companies’ effective tax rate. It is calculated as the ratio between income taxes (as reported) and net income. Size It is used as a proxy for companies’ dimensions. It is assumed to equal to the total amount of sales. Control variables: contract_duration Proxy for the lease contracts duration. It is equal to the ratio between the amount of lease payments other than 5 years and the lease payment due to in the fifth year, plus 5 year. Industry Dummy variable identified the industries super sector classification (Borsa Italiana).

implementation of IFRS 16 presents a relationship with the determinants of off-balance sheet leases. Consequently, in order to test hypotheses from H1a to H1f, the following ordinary least-squares (OLS) model has been estimated based on the whole sample: lnlease liabiltyit ¼ ß0 þ ß1 D=E ratio 2018it þ ß2 major owner 2018it þ ß3 lease intensityit þ ß4 Tobin’s Q 2018it þ ß5 tax rate 2018it þ ß6 size þ ß7 control variablesit þ εit Table 4.3 provides a description of all variables used to test the hypotheses from H1a to H1f. Table 4.4 shows the results of the descriptive statistics for all variables included in the regression model.

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71

Table 4.4 Descriptive statistic Variable lnlease_liability D/E ratio _2018 major_owner underlying_asset Tobin’s Q_2018 tax_rate_2018 Size contract_duration

4.2.2

n 167 167 167 167 167 167 167 167

Mean 3.2085 0.7564 45.9578 0.1005 1.8935 0.4448 2.624Eþ09 8.0207

Median 3.2737 0.3915 0.0366 1.4133 0.2564 4.19Eþ08 6.453

Std. Dev. 1.44255 1.44691

Min. 7.72 0.61

Max. 0.48 10.73

0.22843 2.23397 2.62561 9.6Eþ09 5.30029

0 12.71 4.56 287642 5

1.77 9.05 27.76 8.033Eþ10 51.37

Results and Discussion

In order to test the hypotheses, a multilinear regression model has been used. As known, it is a linear dependency model, through which it is possible to analyze the relationship between the dependent and the independent variables, and the p-value associated with the regressor coefficients suggests whether the variable is statistically significant (Meaning that there is a significantly different from zero effect of the dependent variable on the independent variables). Nevertheless, there might be some cases in which the independent variables are highly correlated each other, and entering them simultaneously in the regression model, regardless of their significance, might generate a risk—due to the multicollinearity—that some variables turn out to be not significant, when in reality they are significant if taken into consideration individually. This happens because their significance is “absorbed” by another collinear variable. Therefore, in order to avoid multicollinearity problems, it has been used a selection method called stepwise model that takes into consideration, progressively, all and only the statistically significant variables. More precisely, this model is based on the progressive introduction of the variables for which the significance ( p-value) is below a predetermined level, with the possible removal of one or more of the independent variables previously entered, in case the p-value exceeds the significance level during subsequent entries. Statistical studies (Breaux 1968; Smith 2018) proposed choosing the explanatory variables for a multiple regression model from a group of candidate variables by going through a series of automated steps. At every step, the candidate variables are evaluated, one by one, using the t-statistics for the coefficients of the variable being considered. A forward selection rule starts with no explanatory variables and then adds variables, one by one, based on which variable is the most statistically significant, until there are no remaining statistically significant variables. Practically, the model begins with no candidate variables, then selecting the variable that has the highest R-Squared. At each step, the model selects the candidate variable that increases R-squared the most and it stops adding variables when none of the remaining variables are significant. On the contrary, the backward selection model starts with all candidate variables in the model. At each step, the variable that is least

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4 Post-Implementation Analysis of IFRS 16 on Companies’ Financial Structure,. . .

significant is removed, continuing until no insignificant variables remain. The user sets the significance level at which variables can be removed from the model. The stepwise regression model runs for the empirical analysis is a modification of the forward selection, so that after each step in which a variable is added, all other candidate variables in the model are checked to see if their significance has been reduced below the predetermined tolerance level. If a non-significant variable is found, it is removed from the model. Therefore, the stepwise regression model has required two significance levels: one for adding variables and one for removing variables and, the cutoff for adding variables is less than the cutoff for removing variables. In the regression model run to test hypotheses from H1a to H1f, the natural logarithm of the amount of the leased liability (scaled for total sales) resulting in the financial statement post-implementation of the new lease accounting model prescribed by IFRS 16 has been used as dependent variable (lnlease_liabilty). Moreover, as described in Table 4.3, the independent variables are the following: D/E ratio_2018, major_owner, underlying_asset, Tobin’s Q_2018, tax_rate_2018, size, while the control variables used are contract_duration and industry (Table 4.5). The analysis of the correlation matrix shows interesting results with regard to the significant and negative relationship between the company’ s dimension (size) and the variable explaining the ownership structure (major_owner). As expected, as the company size increases the concentration of the ownership on the hand of a major shareholder decreases. In addition, always related to the ownership structure (major_owner) the correlation matrix shows a significant and positive association with the dependent variable, meaning that companies characterized by a closely held ownership structure recorded a greater amount of lease liability following the adoption of the new lease accounting model. This result suggests that more closely held companies have used operating leases more intensively in the years before the mandatory adoption of IFRS16. The correlation matrix shows also a positive and significant relationship between the amount of lease liability and the variable measuring the nature of the underlying asset (underlying_asset) and a positive and significant relationship with the control variable measuring the average duration of the lease contract (contract_duration). Looking at the correlation matrix, it is also interesting to underline the positive and significant relationship between the duration of the lease contract and the nature of the underlying assets (underlying_asset) meaning that the longer is the average duration of the lease contracts the greater is the amount of the right of use recorded in the company’s balance sheet. Finally, the correlation matrix shows a positive and significant association between companies’ growth—measured through Tobin’s Q—and the level of indebtedness (D/E ratio_2018), suggesting that companies presenting greater growth opportunities tend to increase the D/E ratio. The results of the stepwise regression model used to test hypotheses form H1a to H1f are reported in Table 4.6. Contrary to the expectations based on the existing literature (Eisfeldt and Rampini 2009; Mehran et al. 1999; Beatty et al. 2010; Callimaci et al. 2011;

D/E ratio _2018 major_owner underlying_asset Tobin’s Q_2018 tax_rate_2018 Size lnlease_liability contract_duration

D/E ratio_2018 1 0.105 0.098 0.194* 0.047 0.068 0.112 0.006

Table 4.5 Correlation Matrix

1 0.069 0.005 0.021 0.193* 0.189* 0.092

major_owner_2018

1 0.094 0.027 0.058 0.596** 0.300**

lease_intensity

1 0.027 0.045 0.11 0.019

Tobin’s Q_2018

1 0.018 0.012 0.056

tax_rate_2018

1 0.06 0.02

size

1 0.27**

lnlease_liability

1

contract_duration

4.2 The Empirical Analysis on Determinants (Explanatory Variables) of. . . 73

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4 Post-Implementation Analysis of IFRS 16 on Companies’ Financial Structure,. . .

Table 4.6 Stepwise regression model results underlying_asset

Model 1 3.764*** (0.000)

Model 2 3.644*** (0.000) 0.686** (0.001)

Model 3 3.531*** (0.000) 0.633** (0.003) 1.693** (0.010)

Model 4 3.443*** (0.000) 0.632** (0.002) 1.873** (0.004) 0.12** (0.010)

Model 5 3.478*** (0.000) 0.557** (0.007) 1.953** (0.002) 0.13** (0.006) 0.689⚚ (0.07)

0.054 (0.452) 0.148 (0.037) 0.054 (0.452) 0.028 (0.691) 0.1 (0.179) 0.022 (0.763) 0.06 (0.405) 0.1 (0.159) 0.011 (0.883) 0.133 (0.061) 0.225 (0.001) 0.037 (0.607) 0.05 (0.482) 0.198

0.041 (0.558) 0.151 (0.028) 0.05 (0.467) 0.011 (0.873) 0.053 (0.469) 0.038 (0.581) 0.023 (0.754) 0.037 (0.612) 0.028 (0.688) 0.093 (0.185)

0.038 (0.573) 0.172 (0.010) 0.059 (0.385) 0.07 (0.922) 0.054 (0.454) 0.043 (0.520) 0.002 (0.977) 0.056 (0.428) 0.015 (0.883) 0.104 (0.130)

0.021 (0.753)

0.009 (0.891)

0.061 (0.352) 0.009 (0.888) 0.077 (0.278) 0.12 (0.860) 0.014 (0.846) 0.05 (0.470) 0.013 (0.849) 0.122 (0.070)

0.059 (0.367) 0.007 (0.913) 0.094 (0.185) 0 (0.994) 0.016 (0.821) 0.077 (0.272) 0 (0.999)

0.075 (0.282) 0.11 (0.122) 0.177

0.067 (0.323) 0.099 (0.156)

0.06 (0.369) 0.088 (0.196)

0.048 (0.472) 0.071 (0.302)

industry_manufacturing industry_telecommunications major_owner industry_IT Excluded variables: underlying_asset D/E ratio _2018 major_owner Tobin’s Q_2018 tax_rate_2018 contract_duration size industry_consumer goods industry_consumer services industry_healthcare industry_IT industry_manufacturing industry_oil&gas industry_public utilities industry_telecommunication

⚚, *, **, ***, indicate p-value