the impact of constructive operating lease capitalisation...

iind Business Restarch, Vol. 28. No. 4. pp. 233-254, Autumn Issue 233

The impact of constructive operating leasecapitalisation on key accounting ratiosVivien Beattie, Keith Edwards and Alan Goodacre*

Abstract—Current UK lease accounting regulation does not require operating leases to be capitalised in the accountsof lessees, although this is hkely to change with the publication of FRS 5. This study conducts a prospective analysisof the effects of such a change. The potential magnitude of the impact of lease capitalisation upon individual users'decisions, market valuations, company cash flows, and managers' behaviour can be indicated by the effect on keyaccounting ratios, which are employed in decision-making and in financial contracts. The capitalised value ofoperating leases is estimated using a method similar to that suggested by Imhoff. Lipe and Wright (1991). adaptedfor the UK accounting and tax environment, and developed to incorporate company-specific assumptions. Resultsfor 1994 for a random sample of 300 listed UK companies show that, on average, the unrecorded long-term liabilityrepresented 39% of reported long-term debt, while the unrecorded asset represented 6% of total assets. Capitalisationhad a significant impact (at the 1% level) on six of the nine selected ratios (profit margin, return on assets, assetturnover, and three measures of gearing). Moreover, the Spearman rank correlation between each ratio before andafter capitalisation revealed that the ranking of companies changed markedly for gearing measures in particular.There were significant inter-industry variations, with the services sector experiencing the greatest impact. An analysisof the impact of capitalisation over the five-year period from 1990 to 1994 showed that capitalisation had thegreatest impact during the trough of the recession. Results were shown to be robust with respect to key assumptionsof the capitalisation method. These findings contribute to the assessment of the economic consequences of a policychange requiring operating lease capitalisation. Significant changes in the magnitude of key accounting ratios anda major shift in company performance rankings suggest that interested parties' decisions and company cash flowsare likely to be afTected.

1. Introduction

The use of leasing as a form of asset financing hasbeen growing worldwide during the past twentyyears. In the UK, leasing represented 15.8% of thetotal investment in equipment by 1994 (Financeand Leasing Association, 1994). Although pub-lished information does not permit the calculationof a comprehensive lease ratio (capitalised value ofleased assets to total assets), a crude indication ofthe overall significance of leasing across asset cate-gories can be obtained from the ratio of the annuallease payment commitment to total assets. Ananalysis of data extracted from the Extel CompanyAnalysis database for the population of UK listedcompanies (n = 2,288) shows this 'annual' leaseratio to be 0.76% in 1994. Moreover, the figures

*The authors are. respectively, professor, former researchstudent, and senior lecturer at the University of Stirling. Corre-spondence should be addressed to Dr. Alan Goodacre. De-partment of Accounting, Finance and Law, University of Stir-ling. Stirling. UK, FK9 4LA. Tel. 0044-1786 467291; Fax0044-1786 467308; e-mail [email protected]. The fi-nancial support of the Research Board of the Institute of Char-tered Accountants in England and Wales is gratefully acknowl-edged. The authors also wish to thank two anonymousreviewers for their extremely helpful comments on an earlierdraft of this paper, which was first submitted in June 1997; thefinal version was accepted in May 1998.

for operating and finance leases are 0.74% and0.04%, respectively, indicating that the annual op-erating lease commitments are 18 times that of fi-nance leases.

Prior to 1984. UK leasing growth could be at-tributed to two main factors. First, the availabilityof 100% first year allowances meant that lesseeswith insufficient profits to utilise this allowancethrough asset purchase could instead lease the as-set and pay rentals which reflected the tax savingmade by the lessor. Second, the off-balance sheetnature of lease transactions was attractive sincegearing levels are not adversely affected. The Fi-nance Act 1984 provided for the gradual removalof first year allowances, and SSAP 21 required thecapitalisation of finance leases by lessees from1987. Despite these events, leasing in the UK hasnot declined, the level remaining approximatelyconstant since 1984 (Finance and Leasing Associa-tion, various years). In particular, this may be dueto the design of lease contracts which avoid beingclassified as finance leases. However, there areclearly also other significant advantages (of both ageneral and a company-specific nature) fromleasing.

The US was the first country to adopt a leaseaccounting standard, SFAS 13 (FASB, 1976).Prior to this, most lease payments were simply

234 ACCOUNTING AND BUSINESS RESEARCH

charged to the profit and loss account as incurred.Leases were classified into two types, those whichtransfer to the lessee substantially all the risks andrewards of ownership (known as capital or financeleases) and those which do not (known as oper-ating leases). SFAS 13 required capital leases to becapitalised, i.e. a liability is created in the lessee'sbalance sheet reflecting the lessee's future obliga-tions under the lease, and a corresponding asset iscreated reflecting the lessee's rights in the asset.The concepts and definitions of lease accountingintroduced by SFAS 13 were substantially adoptedby many countries (including the UK, Canada,Australia, and New Zealand) and the IASC, al-though the US standard is the most prescriptive.In the UK, the growth in leasing from the mid-1970s and the collapse of Courtline were contribu-tory factors in the move towards lease regulation.SSAP 21 Accounting for leases and hire purchasecontracts was introduced in 1984 and its full lesseeprovisions were effective from 1987 (ASC, 1984).

Standard-setters in the UK, US, Australia, andNew Zealand, together with the IASC, have re-cently published a discussion paper: Accounting forleases: a new approach, which proposes that allleases be capitalised (McGregor, 1996). It is likelythat a new UK lease accounting standard will soonbe introduced based upon this proposal, since thiswould resolve the current conflict which exists be-tween SSAP 21 and FRS 5 Reporting the substanceof transactions (ASB, 1994). FRS 5 (para. 4) de-fines liabihties as 'an entity's obligations to trans-fer economic benefits as a result of past transac-tions or events', from which it appears to followthat all ongoing lease contracts give rise to liabil-ities and should, therefore, be reflected in the bal-ance sheet. In recognition of this conflict, FRS 5states that the standard that contains the morespecific provisions relating to a transaction shouldbe applied; in the case of leases, this is in generalSSAP 21.

Given the economic significance of leasing, achange in lease regulation which requires the cap-italisation of operating leases is likely to have asignificant impact on the accounting numbers ofmany companies. This could impact, in turn, upona wide variety of individual users' decisions (e.g.credit rating, loan assessment, risk evaluation), ag-gregate investor decisions (i.e. share prices), com-pany cash flows (via contracts based on account-ing numbers which apply 'rolling' GAAP), andmanagers' behaviour (i.e. financing decisions andearnings management). See, for example, Taylorand Turiey (1985), Garrod (1989), Citron (1992),and Breton and Taffler (1995) for relevant UKstudies. The impact of such a regulatory changeon the accounting numbers is captured effectivelyby observing the change in key accounting ratios.Financial analysis textbooks in both the UK andthe US indicate that ratios are used widely by in-

vestment analysts and loan officers as decisiontools (Foster, 1986; Bouwman et al., 1987; Cohenet al, 1987; Holmes and Sugden, 1995; and Rees,1995). Moreover, a UK questionnaire survey hasshown that 70% of analysts use financial ratiosextensively in forecasting earnings (Arnold andMoizer, 1984), while a US survey found that gear-ing was crucial to loan officers' lending decisions(Gibson, 1983).

Thus, the principal objective of this paper is toprovide evidence which will assist in assessing theeconomic consequences of a change in the regu-lation of lease accounting, by estimating the im-pact on key accounting ratios of the requirementto capitalise all non-cancellable operating leases bylessee companies. This paper, therefore, representspolicy-relevant, ex ante research in support of thestandard-setting process of the type advocated bySchipper (1994). To achieve this objective, acomprehensive database of operating leaseinformation is created from published corporateannual reports, and operating leases are capitali-sed using an amended version of the method pro-posed by Imhoff, Lipe and Wright (1991) (here-after ILW).

The remainder of this paper is structured as fol-lows. Section two provides a summary of the ac-counting regulation salient to leases, reviews theexisting evidence concerning the impact of leasecapitalisation on accounting ratios, and the ILWcapitalisation procedure. The third section de-scribes the methods used. Results are presentedand discussed in section four. The final sectionsummarises and concludes the paper.

2. Literature review

2.1. Lease regulationIn general, the trend in lease accounting regu-

lation has been from the footnote disclosure of ob-ligations to the capitalisation of these obligations(and the related asset) in the balance sheet. Asummary of the regulatory pronouncements in theUK and elsewhere which have affected lease ac-counting in the UK is given in Figure 1. This fig-ure shows that the classification rules for financeleases are more stringent under SFAS 13 thanSSAP 21. It is therefore to be expected that, ceterisparibus, operating leases will represent a largerproportion of leases in the UK than in the US,since preparers of accounts may prefer leases to beclassified as operating due to the more favourableeffect on gearing ratios, in particular. Any furtherregulatory change requiring the capitalisation ofoperating leases will, consequently, have a greaterimpact upon the accounting numbers and key ac-counting ratios in the UK.

A recent analysis of UK financial reportingpractice with respect to leases shows that consider-able variation exists, particularly in disclosure lev-

AUTUMN 1998 235

Figure 1Chronology and content of regulatory pronouncements affecting lease accounting in the UK

US

ASR 147 (SEC, 1973)

Required footnote disclosures in iO-K reports.

Opinion 13 (APB, 1973)Suggested the disclosure of the present value of gross minimum rental commitments.

SFAS 13 (FASB, 1976)Effective for leases entered into on or after I January 1977. Capital lease defined as one under which any ofthe following four conditions is met:• the present value at the beginning of the lease term of the payments not representing executory costs paid

by the lessor equals or exceeds 90% of the fair value of the leased asset;• the lease transfers ownership of the asset to the lessee by the end of the lease term;• the lease contains a bargain purchase price (i.e., an option to buy);• the lease is equal to 75% or more of the estimated economic life of the leased asset.Leases which do not satisfy any of these conditions are classed as operating leases.Required the capitalisation of capital leases by lessee with operating lease payments reported as a profit andloss account charge, and disclosure of total minimum future payments under operating leases with remainingterms of more than one year (reported separately for each of the next five years and combined thereafter),

UK

ED29(ASC, 1981)Proposed the capitalisation of finance leases by lessors.

SSAP 21 (ASC, 1984)Effective for lessors for accounting periods beginning on or after 1 July 1984; full provisions effective forlessees for accounting periods beginning on or after 1 July 1987, with disclosure requirements effective foraccounting periods beginning on or after I July 1984. Finance lease defined as one which in substance passesover to the lessee substantially all the risks and rewards of ownership. A present value test is provided to aidclassification: a lease is presumed to be a finance lease if the present value at the beginning of the lease termof the minimum tease payments, discounted at the interest rate implicit in the lease, amounts to substantiallyall (normally 90% or more) of the fair value of the leased asset (the '90% test').Other leases are classed as operating leases.Required the capitalisation of finance leases by lessees, with operating lease payments charged to the profitand loss account on a straight line basis over the lease term (analysed between hire of plant and machineryand other operating leases). Also required the disclosure of next year's minimum future payments underoperating leases, analysed according to the period in which the annual commitment expires (those expiringnext year, within the second to fifth year inclusive, and over five years from the balance sheet date), furtheranalysed between land and buildings and other operating leases.

TR664(ICAEW, 1987)Encourages the consideration of aspects of the lease other than the 90% test in classifying leases.

FRS 5 (ASB, 1994)Requires the consideration of all aspects of transactions in determining the appropriate accounting treatment,and so would appear to require recognition of assets and liabilities to the extent that risks and rewards havebeen transferred. The apparent conflict between SSAP 21 and FRS 5 is resolved by an explanation that thestandard containing the more specific provisions should be applied and that, in general, these are contained inSSAP 21.

International

IAS 17 (IASC, 1982)Effective for accounting periods beginning on or after 1 January 1984. This standard is general in approachand its disclosure requirements are less detailed than for either SFAS 13 or SSAP 21. Compliance with SSAP21 ensures compliance with IAS 17 in ail material respects.


els (Loveday, 1995). First, some companies chargeoperating lease rentals to the profit and loss ac-count as incurred, contrary to SSAP 21, while oth-ers do not state the basis used. Second, the oper-ating lease rental asset categories stipulated bySSAP 21 are not always followed. Third, manycompanies do not disclose either the method usedto allocate finance lease rentals between capitaland interest or the basis on which leased assets aredepreciated. Finally, in response to FRS 5, fiveFTSE 100 companies have chosen to reclassify op-erating leases as finance leases (Company Report-ing. 1995).

2.2. The impact of lease capitalisation onaccounting ratios

The first published study of the impact of leasecapitahsation on accounting ratios was conductedby Nelson (1963). who examined the effect of leasecapitalisation on the debt-equity ratio of elevenUS companies. He found a significant change inthe rankings of the companies after capitalisationcompared to before capitalisation. Fifteen ratioswere calculated for each company, and in 56% ofcases a change in rank of two or more places oc-curred. Ashton (1985) extended Nelson's study ina UK context, recognising that the impact of leasecapitalisation will affect five accounting numbers:interest charges, depreciation, fixed assets,accumulated depreciation, and debt. The resultingimpact on key ratios will depend upon therelationship between the capital element in thelease rentals (which rises over time) and the de-preciation charged on the leased asset. This de-pends, in turn, upon the asset's estimated life, theprimary lease term, and the method ofdepreciation.

Ashton identified two scenarios. First, where theprimary lease term is sufficiently shorter than theestimated life of the asset, he argued that depre-ciation would generally be less than the capital re-payment element of the lease rentals, and so re-ported profits and capital employed would initiallyrise. However, this will only occur if depreciationis based on the estimated life of the asset. If, asSSAP 21 requires for finance leases, it is based onthe shorter of the asset life and the lease period,then depreciation will generally exceed the capitalrepayment element of the lease rentals, and re-ported profits will initially fall. This also appliesfor Ashton's second scenario, where the primarylease term equals the asset life (1985: 233-234).

Ashton (1985) estimated the effect o^ financelease capitalisation on six ratios for 23 companies.He found only the individual reported results forthe gearing ratio to be affected significantly. AllSpearman rank correlations between pre- andpost-capitalisation ratios were greater than orequal to 0.90, from which he concluded that inter-

firm comparisons of performance would not be af-fected significantly by capitalisation. He cautioned,however, that his sample was small and potentiallyunrepresentative.

More recently, in a pioneering study, ILW(1991) developed a method for the constructivecapitalisation of operating leases, used to estimatethe impact of operating lease capitalisation on tworatios (return on assets and debt to equity) for 14US companies (seven matched industry pairs, se-lected to represent high and low operating leaseuse). They find material differences in the ratiosfor both 'high' and 'low' lessees, concluding thatoperating lease capitalisation can materially affectinter-firm comparisons of key financial statementratios. (Subsequent to the completion of thisstudy. ILW published a paper which explored theincome effects (Imhoff, Lipe and Wright. 1997).)

The key features of these three studies, each ofwhich is based on a small, non-random sample, aresummarised in Table 1. The impact of operatinglease capitalisation does appear to alter key ratiossignificantly in the US, although the impact onranking was not explored explicitly. The impact ofoperating lease capitalisation has, to date, notbeen explored in the UK setting.

2.3. ILW capitalisation procedureThe basis of the procedure developed by ILW

(1991) for the US reporting environment is theschedule of minimum total future operating leasepayments disclosed by US companies in a note tothe financial statements. The total commitment isanalysed by time period (amounts payable in eachof the next five years and after five years). In thispaper, ILW focus on the balance sheet effects ofoperating lease capitalisation, assuming that theincome statement effects are negligible.

The accuracy of the procedure is limited by theavailability of public domain data. Thus, basedupon a detailed examination of only one company(McDonalds Corporation), ILW develop the fol-lowing six uniform assumptions for generalapplication. Estimation of the present value of theunrecorded lease liability depends critically uponassumptions regarding the appropriate interestrate and the average remaining life of leases wherethis life exceeds five years. First, ILW assume thatthe appropriate interest rate is 10% for each com-pany. This is conservative, since the historical in-terest rate on McDonalds' secured long-term debt,based on the 1988 debt footnote is 9%. Second,ILW assume that the average remaining hfe of theoperating leases is 15 years since, in McDonaldscase, this figure produces a smoothly decreasingschedule of minimum future cash flows as at 1988,which is the typical pattern. Third, the assumptionof year-end cash flows provides a further built-inconservative bias.

AUTUMN 1998 237

Table 1Summary

Study

Nelson(1963)

Ashton(1985)

Imhoff,Lipe andWright(1991)

of empirical studies of the impact

Country Sample size andtype

US 11 companies

UK 23 companies from300 in the Surveyof PublishedAccounts 1983/84which gavesufficientinformation toisolate effect offinance leasecapitalisation

US Seven pairs ofcompanies fromdifferent industries.matched on sizebut with differentoperating lease use

of lease capitalisation

Ratios examined

15 ratios, includingdebt/equity

Return onshareholders' funds;return on capitalemployed; profitmargin; assetturnover; interestcover; gearing

Return on assets(ROA); debt/equity(D/E)

on accounting ratios

Findings

Some ratios quitesubstantially affected.producing markedlydifferent companyrankings

Difference betweenpre- and post-capitalisation ratiossignificantly differentfor only gearing(significance level notreported); Spearmanrank correlationbetween prc- and post-capitalisation ratioslowest for gearing at0.90, which is still'high'

Average decrease inROA;- 'high' lessees 34%- 'low" lessees 10%Average increase in D/E:- 'high' lessees 191%- 'low' lessees 47%

Conclusions

Inter-firmcomparisons ofsome ratiosinaccurate andmisleading withoutlease capitalisation

Inter-firmcomparisons ofperformance notsignificantlyaffected by financelease capitalisation

Operating leasecapitalisation canmaterially affectinter-firmcomparisons of keyfinancial ratios

Estimation of the present value of the unre-corded lease asset requires further assumptions tobe made regarding the weighted average total leaselife and the depreciation method that would beused. Figure 2 demonstrates that the relationshipbetween asset value and lease liability depends onthe proportion of the lease which has expired. Themodel assumes that (i) straight line depreciation isused for all assets, (ii) the capitalised asset and thecapitalised liability both equal 100% of the presentvalue of the future lease payments at the beginningof the lease, and (iii) the capitalised asset and thecapitalised liability both equal zero at the end ofthe lease. ILW also implicitly assume a standard,simple, lease payment profile with no initial costs,nor reverse premiums, and no contingent rentalpayments.

The ratio of asset to liability (asset proportion)can be expressed as;

PV^ RLT L

(1)

where:PV^ = present value of unrecorded asset,PVL = present value of unrecorded liability,RL = remaining lease life,TL = total lease life, andPVAF ,_ „ = present value annuity factor for £1

at r% for n years.ILW calculate the asset proportion for 105 dif-

ferent combinations of the three variables: totallease life (years) = 10. 15, 20, 25, and 30; interestrate = 8%, 10% and 12%; and total lease life ex-pired (%) = 20, 30, 40, 50, 60, 70, and 80. Theyshow that the asset proportion lies between 60%


Figure 2Relation between the unrecorded operating lease asset and unrecorded operating lease liahility

PV of Operatinglease asset at

inoqptian PV, PVL: book \due of theunicoGidBd debt on theqxxating lease aset: theunpaid pnnt^al aa thedebt

PVAi'netbookvaliK'oftheunreocidBd opoating leaseaset: cost less accunulatodstraigh-line depredatiaa

time

Start of lease

Source: Based on Figure 1 in Imhoff. Lipe and Wright (1991: 57)

Bid of leaseor Old of

asserts life

and 80% in 51 (49%) cases. Based on this, theirfourth assumption is that an appropriate approx-imation for the asset proportion is 70%.

The income statement effect of operating leasecapitalisation is shown in Figure 3, which com-pares the annual profit and loss charge under bothaccounting treatments over the lease/asset life. Inthe early stages of a lease's life, the profit and lossaccount charge under capitalisation (i.e., depreci-ation plus interest) exceeds the charge under non-capitalisation (i.e., lease rental, OLR). The differ-ence gradually declines, then reverses. ILW assumethat a stable lease portfolio exists (i.e., on average,50% of lease life remains) and that this averageremaining age approximates to the point of indif-ference between the impact of capitalisation andnon-capitalisation on the profit and loss account.This justifies ILW's fifth assumption that the effecton the current period's net income is zero; it is alsoconsistent with the 70% asset/liability relationship.

The difference between asset value and liabilityreflects the accumulated effect of the profit reduc-tions in the early years of leases and equates to areduction in equity. However, the reduction in

profit also implies a reduced tax charge'. ILW cap-ture the tax consequences of capitalisation in theirsixth assumption: that the combined effective taxrate is 40% which approximates to McDonalds'actual effective tax rate in 1988 of 38.3%. The ex-cess of the unrecorded lease liability over the un-recorded lease asset is taxed at this rate to reflectthe effect on (deferred) tax.

3. Methods3.1. Sample selection

A large, randomly selected sample of 300 listedindustrial and commercial companies was selectedfor analysis. Financial companies were excluded asour analysis of the Extel Company Analysis da-tabase showed this sector to employ minimal leas-ing. In addition, many financial companies arelikely to be substantial lessors; the impact of re-

' The lax paymenl will not be aflected as the tax rules cur-rently allow full deductibility of operating lease rentals, but thecharge will be adjusted by a transfer from deferred tax inaccordance with the accruals/matching principle.

AUTUMN 1998 239

Figure 3Effect of capitalisation on profit

£180Depreciation + interest

£160 + ^

£140 +loss

charge £120 -

£010 11 12 13 14 15

Year

Source: Based on Figure 2 in Imhoff, Lipe and Wright (1991: 59)

Illustration is based on an asset value of £I.O(K) leased over 15 years with an implicit interest of 10% perannum. This gives an annual operating lease rental expense (OLR) of £131.47. If the asset is capitalised, thestraight-line depreciation charge will be £66.67 per annum. In year 1, the interest element of the OLR will be£100. Thus, if capitalised, the operating profit (EBIT) will increase by £64.80 (+£13I.47-£66.67) but profitbefore tax will fall by £35.20 (+£I3I.47-£66.67-£100). If the effective tax rate was 30%, say, then the taxcharge will be £10.56 lower (30% of 35.20) and the profit after tax will reduce by £24.64 (-£35.20+£10.56).

It is assumed that (i) the primary lease period is less than or equal to the useful life of the asset, and (ii)straight-line depreciation is based on the shorter of the primary lease period and the useful life (consistentwith the SSAP 21 required treatment for finance leased assets).

porting changes on lessors is outside the scope ofthe present study. The UKQI list current in 1995(the year in which the sampling was undertaken)was used as the initial sampling frame. ThisDatastream hsting of approximately 1,300 com-panies contains all the tJK industrial and com-mercial companies for which Datastream has ac-counting information. A particular method-ological problem in studies concerning perform-ance is 'survivorship bias', which refers to the useof samples which are biased towards long-surviv-ing companies (see. for example. Brown et al.,[1992], for a review of this problem).

To overcome this problem, the 1995 UKQI listwas augmented by a group of approximately 250'dead' companies (failed, taken over, or gone pri-vate), identified from a comparison of the Times1.000 1981/82 top UK companies (no historicUKQI list being available) with the 1995 UKQIhst. T'he year 1981 was selected for comparisonpurposes because it is the year in which ED 29 waspublished, and some of our analysis thereforecovers the 14 year period 1981 to 1994. The finalsample of 300 companies comprised 53 'dead'companies, 122 'new' companies, and 125 com-panies which had existed from 1981 to 1994.


3.2. Data collection and sample representativenesschecks

Information to enable key pre-operating leasecapitalisation ratios and the effective tax rate ofeach company to be calculated was extracted fromDatastream. Eleven profit and loss and balancesheet items and industry group membership werecollected (see Table 2, panel A). Leasing data tosupport the operating lease capitalisation pro-cedure is contained in the notes to the accounts(not available in Datastream); this was extractedmanually from company microfiches. The detailedinformation collected is shown in Table 2, panelB.

At this point, sample representativeness checkswere performed, based on total assets (item 392)and share capital and reserves (item 307). Thisshowed that the company size distribution and in-dustry sector distribution of the sample approxi-mated closely to that of the population, indicatingthat the sample adequately represented thepopulation.^

3.3. Modification of ILW capitalisation procedureThe ILW procedure was adapted to take into

account the different operating lease disclosure re-quirements in the UK. In addition, to assess the

^ The mean total assets for the sample is 115% of the popu-lation mean total assets, while the mean share capital and re-serves for the sample is 127% of the population share capitaland reserves. The size distribution of the sample companies wasalso positively skewed (coefficient. = 8.3), consistent with ob-served population skewness.

appropriateness of ILW's assumptions for the UKenvironment, we first undertook a preliminaryanalysis regarding operating lease lives. This failedto produce reasonable and consistent results, dueto the considerable variation in leasing patternswithin our sample companies. The pattern of op-erating lease commitments over the period 1985through 1994 was analysed for a small sub-sampleof companies. This identified some companies withcommitments predominantly in the ' > five years'category, some predominantly spread over the two' < five years' categories, and some spread over allthree expiry categories. Thus, some companiestake on only short- to medium-term leases, somemainly long-term leases, and some the whole rangeof lease durations.

ILW's assumption of uniform total and remain-ing lease lives is unable to capture such diversity.In particular, calculation of the impact of capital-isation on the profit and loss account (not investi-gated by ILW) would be severely distorted. Forexample, imagine a company which takes on onlymedium-term leases of, say, five years. In a steady-state, the average remaining life for the company'sleases would be approximately three years. ILWsuggested a uniform assumption of 15-year re-maining lease life. If this were applied to such acompany, the depreciation charge in the P&L ac-count upon capitalisation of the operating leaseswould be one-fifteenth of the asset value (assumingstraight-line method) rather than one-third andwould give a large understatement of the effect onoperating and pre-tax profit.

Table 2Data collected for each year from 1981 to 1994 inclusive for 300 sample companies

Panel A: Datastream

Item description

SalesTotal interest chargesPre-tax profit — adjustedTotal tax charge — adjustedTotal share capital and reservesBorrowings due within one yearTotal loan capitalTotal capital employedTotal cash and cash equivalentsTotal current liabilitiesTotal assetsIndustry group

Panel B: Company microficheProfit and loss account charge for operating lease rental, splitand other, where given.Note to the accounts giving operating lease commitments dueand lease expiry category.

Datastream code

104153157172307309321322375389392Level 3

into plant and equipment, land & buildings.

within the next year, split into asset category

AUTUMN 1998 241

We therefore developed ILW's method to incor-porate company-specific assumptions in respect ofthe remaining lease life, the asset proportion, andthe effective tax rate. We also distinguish in ouranalysis between asset categories and lease expirycategories, performing separate calculations of re-maining lease life and asset proportion for each.Our capitalisation procedure is now described indetail.

The operating lease information disclosed byUK companies in a note to the financial state-ments is a schedule of next year's operating leasepayments (compared to the minimum total futurepayments disclosed by US companies). This figureis analysed by asset category (i.e., 'land and build-ings' and 'other') and by lease expiry date (i.e..

leases expiring within one year, between one andfive years, and after five years). Although generallyless complete than US disclosures, UK disclosuresdo have the advantage of giving a more reliablepicture of the company's pattern of remaininglease lives. Figure 4 provides an illustration of UKdisclosure in respect of the 'land and buildings'category (Panel B) and of US disclosure (Panel A),reported voluntarily in this case by the company.

We first used 13 cases of such combined US andUK disclosure by UK companies to develop baseestimates of remaining and total lease lives appro-priate to the UK setting. These cases were con-tained in the accounts of seven companies between1987 and 1995, and were taken from 20F formsand from voluntary disclosures identified during

Figure 4niustration of calculation of remaining lease life estimate for company disclosing both minimum total futureoperating tease payments and next year's commitment

Company Name: NFC picAsset category: Land and buildingsYear-end: 30 September 1995All monetary values in £m

Panel A

Panel B

Amounts payable inyears

<\US>5

Total commitment

Leases expiring inyears

>5Total

Minimum total futureoperating lease payment ( TCFj

Next year'soperating lease commitment (CFl)

17.924.718.6

Since the total lease liability beyond year five (TCF-,j = £290m) can only relate to leases expiring beyond yearfive, and assuming that next year's commitment for leases expiring after five years (CFl3 = £18.6m) is constantover the remaining life of the leases, then the £290m represents 15.6 years payments after year five, giving atotal remaining life of 20.6 years (on average), i.e.,

290.0+ 5 = - r ^ - p + 5 = 20.6 years

18.6- CFL

The total liability between years one and five (TCF|^,^, = £162.6m) relates to leases expiring beyond year five,as well as those expiring within the one to five year period. Assuming four years of the constant annualpayment of £18.6m relating to the former leaves £88.2m relating to the latter. This equates to 3.6 years ofconstant £24.7m (CFlj) after the first year giving an average remaining life of 4.6 years for this category, i.e..

CFl,162.6-(4xl8.6) . , _

~ T7Z, + 1 = 4.624.7

years

The remaining life for the ' < 1 year' expiry category is assumed to be one year exactly, consistent with thegeneral assumption of year end cash flows, i.e.:

RL, = 1


data collection.' Figure 4 also provides an illus-tration of the base estimate calculations for one ofthe thirteen cases.

For each asset category, the total next year's op-erating lease payments can be expressed as:

E CFl.c=l

(2)

where e = lease expiry category (e = 1 (withinone year), 2 (between one and five years), and 3(after five years)). This describes the total of£61.2m in panel B of Figure 4.

The additional US-style disclosures permittedthe remaining lease life of each lease expiry cate-gory to be estimated as follows:

(3)CFl ,

where RL . = the remaining lease life of assets inlease expiry category e,

TCF, = minimum total future operating leasecash flows payable in period t, and

CFl^ = next year's operating lease cash flowsfor assets in lease expiry category e.

The first term in equation 3 represents an esti-mate of the number of years' payments includedin TCF, assuming that the next year's payment(CFl) is, on average, constant throughout the lifeof the lease. In the example in Figure 4, RL^ iscalculated to be 20.6 years. Similarly,

(4)CFl ,

In the example in Figure 4, RL; is calculated tobe 4.6 years. Note that RL, is taken to be one year,assuming year-end cash flows.

Remaining life estimates for each of the thirteenidentified cases were averaged to give base esti-mates (RL^yj ) for application to the whole sample.These cases were also used to subjectively estimatesuitable corresponding base total lease lives(Tl^^j^), based on the remaining lease life and theobservation that the lease portfolio of our com-panies was generally quite young. These estimatedlease lives are shown in Table 3.'*^ As discussed

' The 'Form 20-F' report to the SEC is required by com-panies that sponsor an ADR (American Depository Receipt)which is traded on one of the national stock exchanges such asthe NYSE. the AMEX or NASDAQ. It contains additionaldisclosures not required by UK regulations. Other companiesvoluntarily disclosed minimum total future operating leasepayments.

Further support for the use of a 25-year total lease life forland and buildings was provided by the disclosure of lease con-tract details relating to 29 separate properties valued over £lmin the 1996 Report of Legal & General Investment Manage-ment Property Fund Portfolio. The median total lease life was25 years, accounting for 62% of the individual leases.

^ These base estimates for the " < ! year' and '1 to 5 years'categories (assumed to be I and 5 years, respectively) ignore

above, for the purpose of assessing the 'asset pro-portion', these estimates were rejected as validcommon assumptions for all companies, and wererefined by weighting each base lease hfe by theindividual company's cumulative historic (from1981 to 1994, inclusive) volume of leases In thelease expiry category. This refinement seeks to es-timate an overall weighted average life which re-flects each particular company's lease profile: whilenot rigorously determined, this adjusts in an ap-propriate direction. Use of the cumulative historicvolume of leases in each lease expiry categorymight be expected to give a more reliable indica-tion of the average proportion of lease life expiredthan the use of data from a single year.*"

The weight for lease expiry category e (wj isgiven by:

1994

e = l t = 198t

and the weighted average remaining life for com-pany i (RL,) is:

-base, e

RLj- (5)

Similarly, the weighted average total life for com-pany i (TL,) is:

TL:= y w, TLb,^e (6)e = I

the liability which relates to longer expiry categories. To illus-trate, consider the next year's commitment for leases expiringin less than I year. This could relate entirely to the final year'spayment due on a 25 year lease, or entirety to 1 year leases,with the most likely scenario somewhere between these ex-tremes. The weighting of base estimates reflects this variation.For example, if the first extreme scenario were true, then the•> 5 years' category would almost certainly represent the ma-jor category historically, and so the weighted average remaininglife would be weighted appropriately towards 25 years.

^ An alternative approach, suggested by one of the referees,is to use the particular year's reported operating lease commit-ment to estimate the weighted average total life of leased assets.This has the advantage of refiecting any changes in lease profileand is also consistent with the calculation of PV^. However, itdoes not allow the historical pattern of one-year commitmentsto be reflected in the ratio of asset to liability. This alternativeapproach was tested on the full sample of companies for 1994.For individual companies there were changes to the asset pro-portion and to depreciation, and therefore also to the effect onannual profit and loss and related ratios. The overall impacton mean ratios (as reported in Table 7) was very small. Oneratio (return on equity) showed increased variability and, as aresult, the slightly higher post-capitalisation ratio of 8.37% wasstatistically insignificant (it is reported as significant at the 5%level in Table 7). Similarly, the maximum impact on rank cor-relations (as reported in Table 9) of 0.001 was minimal. In viewof these findings, only the results based on the historicalweighted average total life are reported.

AUTUMN 1998 243

Table 3Base estimates of remaining and total lease lives calculated from Form 20F and voluntary disclosures

Remaining leaselife

Lease expirycategory (years)

Less than oneOne to fiveMore than five

Land dbuildings

13

Other

131

Total lease life

Land &buildings

I5

Other

15

In contrast to ILW's procedure, which assumesthat the weighted average remaining and totallease lives are constant across companies, our pro-cedure establishes company-specific estimateswhich are assumed merely to remain stable for agiven company over time.^

We selected a short-term borrowing rate, thethree-month London deposit rate, as a suitablediscount rate to use to discount the estimated fu-ture lease payments. This rate is similar to the Fi-nance House Base Rate, used by members of theFinance and Leasing Association. The meanmonthly rate (extracted from Datastream) for 1981to 1994 was 10.8% and for the most recent busi-ness cycle (1988 to 1994) was 10.3%. We selected10.3% as the most suitable discount rate, since thestudy covers 1990 to 1994, rounded to 10%.

Although the capitalisation of operating leaseswould not affect the amount of tax payable undercurrent tax law, the amounts of tax charged to thecurrent period and deferred to future periods areaffected. An effective tax rate has to be calculatedto incorporate this eiTect. Since this rate can varyconsiderably over time, the average effective taxrate for each company was calculated over theperiod 1981 to 1994.

These company-specific remaining and totallease life estimates, and effective tax rate estimates,were then used to perform the constructive capi-talisation of operating leases using the proceduresof ILW (1991). The present value of the unre-corded liability (PV^ for company i is calculatedas:

^ Twenty-four companies did not disclose the split betweenasset categories, which afiects the calculation of remaining andtotal lease lives for the 'more than five years" lease expiry cat-egory. To provide an estimate of the likely split for these com-panies, we calculated the mean split within each of the fiveindustry groups using data from the remainder of the sample,cumulated over the period 1981 to 1994. The relevant meanindustry split was then imputed in the place of the missingvalues.

* The data was winsorised; a technique to reduce the impactof serious outliers and non-normality, i.e., extreme observa-tions (less than 0"/) or more than 50%) were reset to 0% and50%, respectively (Foster. 1986: 103).

The corresponding present value of the unre-corded asset for company i is:

(8)

where PVAF^^ represents the present value of anannuity of £1 for n periods at interest rate r%, PVLand PV^ are calculated separately for both assetcategories (i.e. for 'land and buildings' and 'other')and summed to give total unrecorded liabilitiesand assets. An illustration of this calculation forone company is given in Table 4.

3.4. Impact of capitalisation on key accountingratios

To facilitate comparison with previous studies,nine performance and gearing ratios were investi-gated, comprising the six ratios used by Ashton(1985). the two used by ILW (1991), and an ad-ditional gearing ratio (a variant used extensively incorporate annual reports).'" Due to their assump-tion that operating lease capitalisation is income-neutral, ILW originally examined only return onassets and gearing ratios. Their subsequent paper(ILW, 1997) relaxes this assumption. The defini-tions of the nine ratios examined, and the corre-

^ Alternative approaches, involving three different assump-tions, were also tried independently. First, operating leaserental was taken as the reported operating lease rental expense,rather than next year's operating lease commitment. Second,the operating lease liability for each asset category was esti-mated based on the overall average remaining life, rather thanconsidering expiry categories individually. This allows the his-toric lease obligation profile to be reflected in both asset andliability estimates. Third, the P V ^ / P V L proportion was esti-mated for each expiry category, rather than using the overallaverage remaining and total lease lives. The results reportedhere are robust with respect to these alternatives.

"* Many company managers seem to favour the net debt toequity ratio measure of gearing, claiming that the deduction ofcasb (and often also short-term investments) gives a fairer pic-ture of the debt exposure facing the company. The definitionadopted here included short-term borrowings within debt.


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AUTUMN 1998 245

sponding Datastream item codes, are given in Ta-ble 5, panel A, columns 2 and 3. The impact ofoperating lease capitalisation on the constituentaccounting numbers is shown in Table 5, panel B.

To calculate post-capitalisation earnings beforeinterest and tax (EBIT), the annual operating leaserental is added back and annual straight line de-preciation of the capitalised asset is deducted frompre-capitalisation EBIT. To calculate post-capital-isation profit after interest and tax (PAIT), pre-capitalisation PAIT is adjusted by the net-of-taxeffect of adding back annual operating lease rentaland deducting both annual straight line deprecia-tion of the capitalised asset and annual lease in-terest expense. The expected direction of change ineach ratio following operating lease capitalisationis given in the final column of Table 5, panel A.

4. Results

4.1. Impact in 1994This analysis is based on 232 of the 247 'new'

and 'continuing' companies, Eive companies wereeliminated from the sample at the data collectionstage, because their accounts had not been up-dated on Datastream. A further 10 companies wereexcluded due to outlying observations (negativeequity or capital employed before or after capital-isation) which would have distorted the samplemeans severely. Table 6 provides a summary of theestimated mean capitalised value of operating leaseassets and liabilities for 1994. Overall, the meantotal liability in respect of operating leases was£51m, of which £8m would be classified on thebalance sheet as short-term (i,e., due within oneyear) and £43m as long-term (i.e., due after morethan one year)."

On average, the latter represented 39% oflong-term debt before capitalisation. Wide varia-tion was observed across the five sectors, rangingfrom a mean long-term liability of just £6m (3%of long-term debt) for mineral extraction, to £88m(69% of long-term debt) for the services sector.Capitalised operating lease asset values rangedfrom a mean of £5m for mineral extraction to£80m for services, with an overall mean of £40m,representing 0.8%, 13%, and 6% of pre-capitalis-

" Of Ihe sample, 16% had no operating leases; the equivalentfigures based on only those companies with operating leasesrise to, approximately, £6lm (total), £10ni (short-term), and£5Im (long-term).

ation total assets, respectively,'- Thus, operatingleases represent a major source of long-termdebt-type financing in the UK. Under current ac-counting regulations, approximately 39% of long-term liabilities do not appear on the balance sheet,with total assets being understated by approxi-mately 6%,

The magnitude and statistical significance of thechanges in the nine selected ratios following op-erating lease capitalisation is shown in Table 7.Statistical significance was examined using boththe paired t-test and the Wilcoxon test, which testfor differences between the pre- and post-capital-isation ratios, based on absolute values and rankdifference values, respectively. Only t-test resultsare reported here; the corresponding non-para-metric test (the Wilcoxon signed ranks test ofchange in medians) consistently produced resultsof greater significance." Two-tailed tests were usedthroughout, despite the existence of uni-directionalexpectations (which were confirmed) for six of theratios; thus the reported significance levels forthese ratios are conservative. For the sample as awhole, a significant impact at the 1% level was ob-served for six of the ratios (profit margin, returnon assets, asset turnover, and the three gearingmeasures), with a further one ratio significant atthe 5% level (return on equity). Return on capitalemployed and interest cover were not significantlyaffected. Of the three gearing measures, thepercentage change in the net debt to equity ratio(260%) is particularly striking. Since this gearingmeasure produces a lower figure pre-capitalisationthan the ILW total debt to equity ratio, the capi-talised lease liability has a greater proportionateimpact.

The pattern of results across industry groups isalso reported in Table 7, although these resultsmust be compared with caution since the numberof companies in each group varies considerably,with the mineral extraction and utilities groups be-ing very small in size. The effect of operating leasecapitalisation on profit margin, asset turnover, andthe three gearing measures is significant at the 1%level for three industry groups—consumer goods,general industrial, and services. The only signifi-cant results for these five ratios in the remainingtwo industry groups are profit margin (significant

' - The median capitalised value of operating lease liabilitieswas only £4. lm, compared to the mean of £51m. However, therelative magnitude of this figure must be assessed in the contextof the positively skewed nature of the distributions of companysize and capitalised operating lease assets and liabilities. Thelong-term element of the median total liability was £3.2m,which represents 140% of the median long-term debt beforecapitalisation. The median value of capitalised operating leaseassets was £3.3m compared to the mean of £40m. This repre-sents 5.4% of median total assets before capitalisation.

'^ The use of a non-parametric test takes into account thenon-normal distribution of many ratios (Barnes, 1987).


Table 5Definition of key ratios and the impact of operating lease capitalisation on constituent accounting numbers

Panel A: Definitions of key ratios

Ratio DefinitionDatastreamdefinition

157+153104

157-172307

157-172392

157+153322

104322

157+153153

321322

321+389307

321+309-375

Expectedimpact of

capitalisation

+

+or-

+or-

-

+or-

+

+

Profit margin

Return on equity

Return on assets

Return on capitalemployed

Asset turnover

Interest cover

Earnings before interest & tax (EBIT)Sales

Profit after interest & tax (PAIT)Equity (E , , J

Profit after interest & taxTotal assets (TA)

Earnings before interest & taxCapital employed (CE)

Sales

Gearing

Capital employed

Earnings before interest & taxInterest (I)

Long-term debt (LTD)Capital employed

Total debt (D)Equity (E,, w)

Total borrowing less cash & cash equivalents (TB)Equity (E,Lw) 307

Panel B: Impact of operating lease capitalisation on constituent accounting numbers

-EBITp^+OLR-depn= PAITp«+( 1 - T)(OLR - depn - int)

-Aihian. port

int = [ix(PVL+OLR)]/(l+i)

-iLW, posl

whereOLR = annual operating lease rental (for consistency with asset and liability estimates, this was

taken as next year's operating lease commitment, as specified in the notes to theaccounts, rather than the current year reported operating lease rental);

= annual straight line depreciation of capitalised asset;= effective tax rate;= annual lease interest expense;^ rate of interest implicit in lease; and

depnTintithe subscripts 'pre' and 'post' signify values before and after operating lease capitalisation, respectively.T(PV, — PVA) = reduction in deferred tax due to operating lease capitalisation

= short-term portion of lease liability

AUTUMN 1998 247

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AUTUMN 1998 249

Table 8Comparison with results of previous studies

Nature of sample

CountryType of lease capitalised

Ratio

Profit marginReturn on equityReturn on assetsReturn on capitalemployedAsset turnoverInterest coverGearingA,t,, ^GearingiiwGearing,,,, j . ^ , ,„ ^«i,y

Notes: 1. From Table 7

Ashton (1985)n = 23; non-random;1983/84 accounts

UKFinance

Study

ILW (1991)n = 14; non-random;1988 accounts

USOperating

Present study^n = 232; random;1994 accounts

UKOperating

Percentage change in ratio following capitalisation and statistical significance^

1.02^^2.85^sNA

0.24 -

-0.77'^^2.74^^

20.11^ 'NANA

final column.2. NA= ratio not included in study; NS = notpaired t-test (***3. Ashton(1985:must be positive4. Derived from

= significant at 1% level; **^236) reports a 'decline' in the

figures reported in ILW (1991

NANA

-22.00^NA

NANANA

119.00^NA

12.1***4.8**

-10.8***-0.6

-12.5***-25.9

92.8***48.7***

260.0***

significant; S = significant; significance of two-tailedsignificant at 5% level; *gearing ratio of (20.11),

: 61); no statistical tests

= significant at 10% level).in fact the direction of change

of significance were performed.

at 10% for utilities) and Ashton's gearing measure(significant at 10% for mineral extraction). Returnon assets is significant at the 1% level for generalindustrial and services and at the 10% level forconsumer goods. Return on equity is significantfor only the services sector (at the 5% level), a re-sult which drives the 5% significance for the sam-ple as a whole. Interest cover, while insignificantacross the whole sample, is significant for the con-sumer goods and genera] industrial sectors (at the5% and 10% levels, respectively). Finally, returnon capital employed is not significant for any sec-tor (or for the whole sample).

It is noticeable that, based on constructive re-sults, operating lease capitalisation impacts on theservices sector most acutely. The effect on all threegearing measures was markedly in excess of thatin any other sector, as was the effect on profit mar-gin, return on assets, and asset turnover. This canbe explained by the greater reliance on operatingleases by this sector. In 1994, the total next year'soperating lease commitments of the sample com-panies alive in that year was £2,208m. Service sec-tor companies, which account for 37% of this setby number, account for 69% of the total commit-ment. This equates to a mean value of £16.9m perservices company, the corresponding means for theother four sectors being, in descending order,

£15.4m (utilities), £5.8m (consumer goods), £3.1m(general industrial) and £l. lm (mineral extra-ction).

Our findings with respect to the total samplecontrast sharply with those of Ashton (1985), whofound only the gearing ratio (out of the six ratioswhich he examined) to be affected significantly.(Unfortunately, Ashton does not state whetherone- or two-tailed tests were used or the cut-offlevel of significance adopted.) It is likely that thelow percentage change in ratios found by Ashton(and their lack of significance) is attributablepartly to his exclusive focus on finance leases andhis small sample size. Further, his sample consistedentirely of companies which adopted the lease ac-counting standard at the exposure draft (ED29)stage. It is likely that the expected impact of thechange in regulation on early adopters was small.Our findings are, however, less strong than thoseof ILW, who do consider operating leases. ILW'sresults imply a 22% decline in return on assets fortheir sample of 14 companies and a 119% increasein gearing (statistical significance is not con-sidered). The comparable figures in the presentstudy are - 11% and +49%, respectively. This issurprising, given the greater stringency of US leaseaccounting regulation which leads us to expect,ceteris paribus, operating lease capitalisation to


Table 9Rank correlation of pre- and post-operating lease

Ratio'

Profit marginReturn on equityReturn on assetsReturn on capital employedAsset turnoverInterest cover^GearingAshionGearing, LWGearing^,, , , , , „ , , , , ,

Consumergoods

(n^33)

0.9880.9970.9560.9990.9870.8090.7010.9500.837

Notes: 1. See Table 5 for definitions.

capitalisation

Generalindustrial(n = I0OJ

0.9850.9980.9920,9970.9780.9450,7710,9250,927

2. Excludes nine companies with no interest expense

ratios for 1994

Industry

Mineralextraction

(n=7)

1.0000.9641.0001.0001.0001.0001,0000,9641.000

Services(n = 81)

0,9030,9880.9330,9820,8900.7320.4180.7100.534

)re-capita!isation.

Utilities(n = ll)

1,0001.0000,9361,0001,0000.7820.6360.9630.864

Total(n = 232)

0,9530.9960,9660,9920.9340.8260.6380.8570.738

Table 10Magnitude and statistical significance of changes in mean ratios following operating lease capitalisation for 1990to 1994

Mean difference between pre- and post-capitalisation ratios(significance)'

Ratio^

Profit marginReturn on equityReturn on assetsReturn on capitalemployedAsset turnoverInterest coverGearingA,h,nnGearingiLwGearingn,,d,b,,,^^,,^

J990

0.93=-2.08- 0 , 5 P-0.76"

-0,35"-17.53'-

0.12'1.06-0.94-

1991

1.10»-11.97-0.26

0.69

-0.37"-19.88^

0.13^1.180.90"

1992

1.23'-1,22--0.38"

0.40

-0.39"-23.10^

0.14'0,88^0.79"

1993

1.24'-4.46-0.45"

0.23

-0.34--18.96"

0.13'0.70-0.61-

1994(from Table 7)

0.38"-0.48"-0.09

-0.34"-4 .12

0.13'0.58'0.52'

Range o\er period^

0.93,,, to 1.24,,-11.97,1 to 0.38,4-0,51,0 to -0.26,,-0.76,0 to 0.69,,

-0.39, , to -0 .34« , .-23.10,3 to -4.12,4

0.12^ to 0.14,;0.59^ to 1,18,,

0.52,4 to 0.94«,

Notes: 1. See Table 5 for definitions,2. Significance of two-tailed paired t-test (' = significant at 1% level; ''=significant at 5% level;' = significant at 10% level).3. Subscripts indicate year(s} in which observation occurred.

have a greater impact upoti accoutititig ratios inthe UK.

However, ILW's sampling procedures differedfrom those adopted here in two key respects.ILW's sample comprises ati equal number of'high'lessees and 'low' lessees. Six of the matched pairswere retailers while the seventh was from the trans-port sector. Thus, all selected companies fallwithin the services sector {as defined in the presentstudy). Moreover, their sample includes only com-

panies which had operating leases (16% of thesample in the present study had no operatingleases). Each of these differences can be expectedto result in larger changes than under randomsampling. Table 8 provides a summary of thepoints of comparison between the Ashtoti (1985),ILW (1991), atid the present study.

Arguably, in some decision contexts, the impactof operating leases capitalisation on the absolutemagnitude of ratios is of limited relevance; what

AUTUMN 1998 251

Table 11Rank correlatioo of pre- and post-operating lease capitalisation ratios for 1990 to 1994

Ratio'

Profit marginReturn on equityReturn on assets

1990

0.9740.9960.972

Return on capital employed 0.987Asset turnoverInterest coverGearing^shionGearing,, wGearing,,, j,bM,,=qu,,y

0.9470.9010.7080.8920.806

Notes: 1. See Table 5 for definitions.2. Subscripts indicate year(s) in

J991

0.9660.9920.9750.9880.9320.9250.7130.8800.788

which

1992

0.9630.9920.9770.9920.9230.9180.6250.8390.752

1993

0.9540.9920.9690.9920.9240.8800.6030.8100.682

1994(from Table 9)

0.9530.9960.9660.9920.9340.8260.6380.8570.738

observation occurred

Range over periocP

0.953« to 0.974^0.992g,wy,to 0.996>«, 40.966^4 to 0.977,,0.987^ to 0.992,,,.^0.923,,, to 0.947^0.826^ to 0.925,,0.603,,, to 0.713,,0.810.,, to 0.892,1,0.682s3 to 0.806^

really matters is whether the position of companiesrelative to each other (i.e., company rankings) isaffected {Foster, 1986: 150-151).'^ The Spearmatirank correlation coefficients between the pre- andpost-capitalisation ratios are reported in Table 9.Across the sample as a whole, the four lowest cor-relations relate to gearing (interest cover plus thethree debt/equity measures), the lowest being 0.638for Ashton's (1985) definition of gearing.''' Thus,gearing ratio correlations can be described as only'moderate'.'^

Turning to industry groups, the rank correla-tions for the services sector were, not surprisingly,the lowest amotig the five sectors, for all nine ra-tios, the margin of differetice being greatest for thethree gearing measures. This finding can be ex-plained by both the overall magtiitude of leasingundertaken by companies in this sector and thegreat variation in leasing levels (the sector includesretailers, hotels, media agencies, and vehicledistributors).

4.2. Inter-temporal stabilityTo assess the stability of our fitidings over time,

we repeated the above analysis for the four years1990 to 1993, inclusive. This period was selectedbecause, in combination with 1994, it encompassesthe latest recession and subsequent recovery. The

'** For example, in a loan appraisal, key ratios may be judgedagainst benchmark measures, thus the absolute value of theratio is relevant, whereas for investors and investment analysts,relative performance measures are of primary relevance.

'^ Ashton himself reported a rank correlation of 0.90 for thisratio (1985: 237). Possible reasons for the greater impact ob-served in the present study, discussed in the present paper, re-late to the sample and lease type studied.

'^ Pearson product-moment correlation coefficients (not re-ported here) were substantially lower than the rank correlationsfor the four gearing-related measures and generally marginallyhigher for the other ratios.

results for the combined industry groups for theperiod 1990 to 1994 are shown in Tables 10 and11. The impact of operating lease capitalisation onthe magnitude of the nine ratios, and consequentcompany rankings, is generally very stable overtime. Close inspection does, however, reveal thatthe largest mean differences, and the lowest rankcorrelations, between pre- and post-capitalisatiotiratios occurred in the early part of the period. Thelargest difference was in 1990 for three ratios andin 1991 for a further two ratios, while the lowestcorrelations were in 1990 for five ratios and iti1991 for a further two ratios. It would appear thatoperating lease capitalisation had the greatest im-pact during the trough of the recession, when cor-porate performance was generally poor and gear-ing (including operating leasing) was high.

4.3. Sensitivity analysisThe sensitivity of the results to key assumptions

made (especially the interest rate and estimatedlease lives), was investigated using the data for1994. First, the base assumptioti of a 10% interestrate was varied by ±2%. The impact upoti themagnitude of the nine ratios, and consequent com-pany rankings, is summarised in Table 12, col-umns 2-5. There is clearly very little change in theresults. Significance levels remain unaffected (withthe exception of return on capital employed, whichbecomes significant at the 5% level at the 8% iti-terest rate) and the maximum absolute change inrank correlatioti coefficients is only 0.019 (the cor-relation coefficient for Ashton's measure of gear-ing falls from 0.638 (at 10% ititerest rate) to 0.619(at the 8% interest rate)).

Second, we replaced the base estimates for re-maining and total lease lives with two sets of moreextreme estimates. One set generally places theleases at a much earlier stage of a shorter total life,


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while the other generally places the leases at amuch later stage of a longer total life. The impactof these alternative scenarios is summarised inTable 12, columns 6-9. The mean change in returnon assets, return on capital employed, return onequity, ILWs measure of gearing, and net debt toequity is marked, especially under the later stagesof a longer lease life scenario. However, signifi-cance levels remain unaffected (with the exceptionof return on equity and return on capital em-ployed, which both increase in significance undereach of the alternative scenarios). Supplementaryanalysis indicated the presence of a few extremeobservations which were unduly influencing thecalculated mean change in selected ratios. Onlyone ratio showed a maximum absolute change inrank correlation coefficient in excess of 0.05, andthis was return on equity, which fell from 0.996for the best estimate to 0.938 under the secondalternative scenario. This sensitivity analysis sug-gests that the general results of this study are ro-bust with respect to the key assumptions incor-porated in the operating lease capitalisationprocedure.

5. Summary and conclusions

Under current international lease accounting reg-ulation, leases classified as operating leases do nothave to be shown in the balance sheet. FollowingFRS 5, this situation is likely to change in the UK.This study reports the first large-scale analysis ofthe impact which the constructive capitalisation ofoperating leases has on nine key financial ratiosused by investment analysts and other users, andalso used in financial contracts.

The method of constructive capitalisationdeveloped by ILW (1991) is refined to reflect moreaccurately individual companies' leasing profiles.Company-specific estimates of remaining and totallease lives, and effective tax rate, are incorporated,and the method distinguishes between asset cate-gories. Application of this method to a randomlyselected sample of 232 UK listed companies for1994 demonstrated that operating leases representa major source of long-term financing.

On average, the unrecorded long-term liabilityrepresented 39% of reported long-term debt, whilethe unrecorded asset was 6% of total assets. Cap-italisation was shown to have a significant impact(at the 1% level) on the profit margin, return onassets, asset turnover, and the three measures ofgearing. The rank correlation between pre- andpost-capitalisation ratios revealed that companyrankings changed markedly for gearing measures.Inter-industry analysis showed that the magnitudeof ratio changes and the associated correlation ofcompany rankings produced by operating leasecapitalisation was greatest in the services sector,which has the highest value of operating leasing

per company and represents diverse companyactivities.

The capitalisation procedure used is limited bythe availability of public domain data and doesinvolve elements of subjectivity. However, findingswere shown to be relatively stable across the five-year period from 1990 to 1994, although the mag-nitude of the impact of capitalisation appeared tobe linked to the stage in the economic cycle. Find-ings were also shown to be robust with respect tothe key assumptions of the capitalisation methodused.

The potential economic consequences of achange in lease accounting regulation are exten-sive. Prior empirical studies indicate that a widevariety of individual users' decisions, market val-uations, company cash flows, and managers' be-haviour may all be affected by such a change. Thispaper provides systematic evidence of the magni-tude of the impact of operating lease capitalisationon key financial issues. This can be expected toassist policy-makers in assessing the likely eco-nomic consequences of a change in leaseregulation.

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