Manipulating the Balance Sheet? Implications of Off-Balance-Sheet Lease Financing

Cornaggia, Kimberly Rodgers; Franzen, Laurel; Simin, Timothy T.

doi:10.2139/ssrn.1680077

Cited by 13 publications

(9 citation statements)

References 36 publications

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“…LEVERAGE FACTOR greater than 1.0 would indicate that firms have more effective financial leverage than implied by the net debt ratio, perhaps because of off-balance-sheet financing such as operating leases, pension liabilities, or structured investment vehicles. Recent research suggests that reported debt levels may understate effective financial leverage (see Bartram (2015), Cornaggia, Franzen, andSimin (2011), andShivdasani andStefanescu (2010)), and thus we might reasonably expect a leverage factor greater than 1. In contrast, LEVERAGE FACTOR less than 1.0 would indicate that firms have less effective financial leverage than implied by the net debt ratio, perhaps because of various financial risk management policies such as cash management, insurance, dynamic capital structure, use of financial derivatives, or so-called alternative risk transfer techniques.…”

Section: Lt Model Empirical Specificationmentioning

confidence: 94%

How Important Is Financial Risk?

Bartram¹,

Brown²,

Waller³

2015

J. Financ. Quant. Anal.

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We explore the determinants of equity price risk of nonfinancial corporations. Operating and asset characteristics are by far the most important determinants of risk. For the median firm, financial risk accounts for only 15% of observed stock price volatility. Furthermore, financial risk has declined over the last 3 decades, indicating that any upward trend in equity volatility was driven entirely by economic risk factors. This explains why financial distress (as opposed to economic distress) was surprisingly uncommon in the nonfinancial sector during the 2007-2009 crisis even as measures of equity volatility reached unprecedented highs.

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Section: Lt Model Empirical Specificationmentioning

confidence: 94%

How Important Is Financial Risk?

Bartram¹,

Brown²,

Waller³

2015

J. Financ. Quant. Anal.

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“…The rationale for the differential treatment is the underlying economics: capital leases are in substance similar to a financed asset acquisition whereas operating leases are economically similar to a rental. Since these rules have been in place, leasing has grown as a source of corporate financing, and operating leases are by far the most common type (SEC, 2005;Cornaggia et al, 2011). Regulators and accounting standard setters believe that the preponderance of operating leases is not a reflection of the economics of leases; rather, it is the result of firms structuring their lease terms to obtain operating lease accounting (Reason, 2005).…”

Section: Introductionmentioning

confidence: 99%

Operating Leases and Credit Assessments

Altamuro

Johnston²,

Pandit

et al. 2012

SSRN Journal

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Operating leases have grown significantly as a source of corporate financing over the last 30 years. Their offbalance sheet treatment, which may in part explain their popularity, raises concern that financial risk may be misjudged and capital misallocated. Prior research evidence on the above issue is mixed. To improve reporting transparency, regulators propose a new accounting concept, right of use, which will add the present value of most leases to the balance sheet. We examine the effect of operating leases on loan pricing by banks, a sophisticated financial statement user. Since leases are a potential debt substitute, we expect them to be important in our setting. With loan spreads as the dependent variable, we test the differential explanatory power and model fit of as-reported financial ratios versus financial ratios adjusted for the capitalization of operating leases. We find that lease-adjusted financial ratios better explain loan spreads, especially for larger lenders. Our results also suggest that retailer leases that are closer in substance to rental agreements than financed asset purchases are less relevant for credit risk assessments. Thus we conclude that banks not only price operating leases, on average, but also make distinctions about which leases should be priced. Second, we explore the role of credit rating agencies and confirm that credit ratings also reflect capitalized operating leases, and find support for an informational role for others' credit assessments. However, unlike banks, rating agencies appear to capitalize all operating leases mechanically. Overall, our results suggest that banks and rating agencies adjust for the off-balance sheet presentation of operating leases and, at least in the case of banks, attempt to do so to reflect the underlying economics of the leases. This evidence lessens concern over the potential negative consequences of existing operating lease accounting and raises concern over proposed accounting that capitalizes all leases regardless of their economic characteristics. Electronic copy available at: http://ssrn.com/abstract=1115924 1 AbstractOperating leases have grown significantly as a source of corporate financing over the last 30 years. Their off-balance sheet treatment, which may in part explain their popularity, raises concern that financial risk may be misjudged and capital misallocated. Prior research evidence on the above issue is mixed. To improve reporting transparency, regulators propose a new accounting concept, right of use, which will add the present value of most leases to the balance sheet. We examine the effect of operating leases on loan pricing by banks, a sophisticated financial statement user. Since leases are a potential debt substitute, we expect them to be important in our setting. With loan spreads as the dependent variable, we test the differential explanatory power and model fit of as-reported financial ratios versus financial ratios adjusted for the capitalization of operating leases. We find that lease-adjusted financial...

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“…10 This is a reasonable assumption, since most legal systems allow for punishment above limited liability (i.e., prison or personal liability) if it is found (perhaps with some probability) that a borrower did not intend to repay in any possible state of the world. 11 Finally, we make parametric restrictions that preclude some trivial and uninteresting cases. Speci…cally, we assume that D > 2, which ensures that no borrower can repay for sure, and D > B > D 2, which ensures that all types of borrowers will default to a di¤erent extent if the project is unsuccessful (so, from the lenders' point of view, they really are di¤erent types).…”

Section: Simplifying Assumptionsmentioning

confidence: 99%

Long-Term Debt and Hidden Borrowing

Bar‐Isaac¹,

Cuñat²

2014

Review of Corporate Finance Studies

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We consider borrowers with the opportunity to raise funds from a competitive banking sector that shares information, as well as from other hidden lenders. The presence of hidden lenders allows borrowers to conceal poor results from their banks and, thus, restricts the contracts that can be obtained from the banking sector. In equilibrium, borrowers obtain funds from both the banking sector and ine¢ cient hidden lenders simultaneously, so that di¤erent types of borrowers cannot be distinguished by banks. This generates cross-subsidies between di¤erent borrowers that are observationally equivalent to the banking sector. We show that the cheaper the cost of hidden borrowing, the lower is welfare and the lower is the variety of funding arrangements in the banking sector. In particular, while high costs of hidden borrowing allow each di¤erent (viable) type of borrower to access di¤erent terms from the banking sector, as the cost of hidden borrowing falls, more and more borrowers face identical terms up to the point where all borrowers who access the banking sector (which may include ine¢ -cient ones) face identical terms. We generalize the model to allow for partially-hidden lenders and obtain qualitatively similar results.

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Manipulating the Balance Sheet? Implications of Off-Balance-Sheet Lease Financing

Cited by 13 publications

References 36 publications

How Important Is Financial Risk?

How Important Is Financial Risk?

Operating Leases and Credit Assessments

Long-Term Debt and Hidden Borrowing

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