Capitalisation of Operating Leases and Credit Ratings

Journal of Applied Research in Accounting and Finance (JARAF), Vol. 8, No. 1, 2013

23 Pages Posted: 10 Jun 2013

See all articles by Brett Cotten

Brett Cotten

Columbus State University - D. Abbott Turner College of Business

Douglas K. Schneider

East Carolina University

Mark G. McCarthy

East Carolina University

Date Written: June 9, 2013

Abstract

The Financial Accounting Standards Board (FASB) and International Accounting Standards Board (IASB) will re-expose in the first half of 2013 a revised joint proposal for a new lease accounting standard (FASB 2012). The proposed standard requires lessees to record operating leases as debt, making it more difficult for lessees to avoid liability recognition. We examine whether or not the debt impact of operating leases is reflected in bond ratings. Using the methodology of Damodaran (2009), we compare firms’ actual credit ratings with synthetic ratings calculated using both reported financial statement data and financial statement data that has been adjusted to reflect the debt treatment of operating leases. We find that when operating leases are treated as debt, coverage ratios and synthetic ratings are significantly lower than those created under current accounting rules. In addition, we find that the actual ratings are significantly lower than unadjusted synthetic ratings, while synthetic ratings calculated using adjusted data approximate the actual ratings. This suggests that the debt impact of operating leases is important to ratings agencies and that the agencies incorporate available information into their ratings. However, information available under current accounting rules is incomplete. Given the importance of lease information and the incompleteness of the data available under current accounting rules, we suggest ratings may become more accurate under the proposed standard.

Keywords: financial reporting

JEL Classification: M40, M41

Suggested Citation

Cotten, Brett and Schneider, Douglas K. and McCarthy, Mark G., Capitalisation of Operating Leases and Credit Ratings (June 9, 2013). Journal of Applied Research in Accounting and Finance (JARAF), Vol. 8, No. 1, 2013. Available at SSRN: https://ssrn.com/abstract=2276766

Brett Cotten (Contact Author)

Columbus State University - D. Abbott Turner College of Business ( email )

Columbus, GA 31907-5645
United States

Douglas K. Schneider

East Carolina University ( email )

Greenville, NC 27858
United States

Mark G. McCarthy

East Carolina University ( email )

Greenville, NC 27858
United States

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