The economic consequences of IFRS 16 adoption: the role of gearing restriction in debt covenants

Abstract

PurposeThis study aims to examine the economic consequences of, and managerial behaviour in response to, the introduction of IFRS 16 Leases. It extends the debt covenant hypothesis to explain why firms reduce the use of operating leases with the introduction.Design/methodology/approachThis study develops a model, based on operating leases as an alternative financing source and the determinants of debt policy, to estimate the effects of gearing on operating lease intensity. High gearing is a proxy to probably closer to the violation of, or expected to violate, the gearing restriction in debt covenants given the retrospective capitalisation of operating leases, when IFRS 16 takes effect.FindingsThis study finds that operating lease intensity fell between 2011 (immediately after the first exposure draft leading to IFRS 16) and 2018 (immediately prior to the effective date of IFRS 16). It also finds that gearing affects changes in operating lease intensity over 2011 and 2018, consistent with the debt covenant hypothesis.Research limitations/implicationsThe introduction of IFRS 16 is a natural experiment with unique characteristics (the active lobbying behaviour, ex ante evidence on adverse economic consequences, a prolonged standard-setting period, etc.) valuable for accounting research.Practical implicationsA showcase about the relevance of financial reporting for contracting interests of firms and managers and a good reference for accounting standard setters in considering and managing the economic consequences of proposed accounting standards.Originality/valueThis study adds to the limited research on the consequences of accounting standards and documents the ex-post impact on firm leverage ratios and the behavioural aspects of reporting entities.