Abstract
What incentives do managers face that might give rise to inefficient investments in leases? If managers make inefficient investments in leases, what economic consequences arise for those managers and their firms? We develop a model of expected investments in leased assets and use the residuals from the model as proxies for inefficient investments. We find that, in contrast to investments in capital expenditures, leasing appears to be a mechanism through which managers can seemingly over-invest, even among firms with high quality financial reporting and negative free cash flows. Examining economic consequences, we predict and find that unexpected investments in leased assets trigger increasing future sales growth but declining future earnings growth for as long as three years ahead. We also find a negative relation with contemporaneous stock returns, suggesting investors view unexpected investments in leases as value destructive. Finally, despite negative returns consequences, we find that unexpected investments in leases are associated with higher CEO compensation driven primarily by future sales growth. Our study suggests that compensation contracts that reward growth may give managers’ incentives to drive sales growth with larger-than-expected investments in leased assets, which lead to slower future earnings growth and negative share price consequences for investors. Our results should inform managers and board members, investors, and researchers interested in investment efficiency, corporate governance, and leases.
Highlights
In this study, we examine managers’ decisions to lease assets and the subsequent economic consequences
We find that unexpected investments in leases relate to faster future sales growth, but slower future earnings growth
The investment efficiency literature suggests that both under- and over-investment in capital expenditures (CapEx) are less pervasive among firms with free cash flows constraints (Jensen 1986; Lang et al 1991; Richardson 2006; and others) and higher quality financial reporting, which enables more effective monitoring
Summary
We examine managers’ decisions to lease assets and the subsequent economic consequences. We find that managers’ unexpected investments in off-balance sheet leases are diminishing across firms in the quality of financial reporting, but that the relation is considerably weaker than it is for CapEx. Overall, our results suggest that, in contrast with CapEx, managers’ propensity to invest in leased assets can arise even among firms with higher quality financial reporting and negative free cash flows. We contribute novel evidence on the consequences of unexpected investments in off-balance sheet leases for future revenue growth, future earnings growth, stock returns, and compensation For researchers in this area, our approach contributes a series of tests on the economic consequences of investment inefficiency that researchers can use to assess the identification of unexpected investment in a variety of contexts. Our approach can be extended by researchers interested in examining the consequences of other decisions by managers’ that are not fully recognized on balance sheets (e.g., equity affiliates, certain types of R&D joint ventures, stock-based compensation, and others)
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