Eliminating Operating Leases: The Effect on Reported Leverage

Abstract

The International Accounting Standards Board and the Financial Accounting Standards Board are working together to require that the present value of future lease payments for most leases currently classified as operating leases be recorded on lessees’ balance sheets as both an asset and a liability. By requiring that future lease payments be capitalized and reported on the balance sheet, the rule is expected to result in a significant increase in reported leverage for companies with large operating lease obligations. We analyze the 2009 annual reports for companies comprising the S&P 500 Index and find that revising accounting standards to eliminate the use of operating leases will significantly impact the total debt ratios of many companies in the S&P 500, especially members of the wholesale/retail industry. The magnitude of the change in many of these companies’ debt ratios likely would have a significant impact on the perceived risk exposure of suppliers of capital. Depending on the extent that these obligations have not been properly reflected by financial analysts, the requirement to capitalize future obligations under operating leases may result in increased borrowing costs and a decrease in the market value of these companies.