Discuss the impact of capitalizing operating leases on value relevance.

Lease can be defined as a contractual agreement between lessor and lessee that transfers the
right to use of asset to lessee from lessor, but the ownership remains to lessor for a certain period. In
the return, lessee submits lease payments to lessor[ CITATION Fre08 \l 1033 ]. Lease accounting is
very complicated, because there are many different types of assets that can be leased[ CITATION
Fre08 \l 1033 ].

Based on the outdated Australian Accounting Standard Board (AASB 117), the differences
between finance and operating leases is made with the treatment of both being quite
different[CITATION XuW17 \p 35 \l 1033 ]. As for finance lease, the leased asset and liability are
recognized, while operating leases are not recognized in balance sheet or statement of financial
position as it will only reflect in the lessee’s statement of profit or loss[ CITATION Mik16 \l 1033 ].
So, this provides flexibility to companies for using operating leases to undertake fixed cost capital
expenditures[CITATION XuW17 \p 34 \l 1033 ]. This gives an unfair representation of a company’s
financial position, as the balance sheets do not reflect operating leases[CITATION XuW17 \p 34 \l
1033 ].

In 2010, the recommendation of the ‘right of use’ concept was proposed by the International
Accounting Standard Board (IASB) in Exposure Draft 1 (ED1) and Exposure Draft 2 (ED2) in May
2013[CITATION XuW17 \p 35 \l 1033 ]. In 2016 February, Australia was adopted IFRS 16 and
AASB 16[CITATION XuW17 \p 35 \l 1033 ]. Both IFRS 16 and AASB 16 will be applicable to
annual reporting periods beginning on or after 1 January 2019[CITATION XuW17 \p 35 \l 1033 ].
The difference between AASB 117 and AASB 16 is the amounts currently classified as operating
leases and not recognized on balance sheet will now be recognized as an asset[CITATION XuW17 \p
35 \l 1033 ].

Based on the research by Xu, Davidson and Cheong (2017), they used two model which are
residual income and returns-earnings model to examine the value relevance of operating lease
capitalization. In order to test value relevance by using residual income models, they used seven
variables. The test results in Model 1 show that the market value of equity is affected by both the
book value of equity and abnormal earnings. Therefore, the book value of equity and abnormal
earnings are value relevant with market value.
 In Model 2, it examines the association between total abnormal earnings and the abnormal
earnings only driven by capitalizing operating leases. The positive coefficient is documented with
significance at the 5 percent level. These findings provide evidence that abnormal earnings driven
by capitalizing operating leases are a part of total abnormal earnings. So, under AASB 16
capitalizing operating leases is an indispensable source of abnormal earnings.

After that, they do a further testing and the test result show that the abnormal earnings
driven by the capitalized operating leases have an explanatory power on the market value.
Therefore, it provides evidence that abnormal earnings driven by capitalizing operating leases have
different value-relevance from the abnormal earnings under the outdated standard
AASB117[ CITATION Dem12 \l 1033 ]. The new model is formed after the coefficient result in
negative in previous model. According to the new model, the change of net income derived from
capitalizing operating leases does not affect the market value. The change of required return of
equity has a negative influence on the market value. The higher the return expected by the market,
the lower the company’s market value will be.

In summary, the return-earnings models and residual income models are used to test for
value relevance. In the return-earnings models, the findings do not provide persuasive evidence to
support the value relevance of capitalizing operating leases. The explanatory power of earnings
occur from the impact of AASB 16 on market returns is not materially difference from the earnings
under AASB 117. In residual income model, the book value of equity and the comprehensive
earnings contribute to the effects on abnormal earnings. The analysis focusing on abnormal earnings
driven by capitalizing operating leases. The value relevance of capitalizing operating leases mainly
results from the effect on the balance sheet rather than the change of earnings in the income
statement[ CITATION Dem12 \l 1033 ].

In conclusion, the change on book value of equity because of capitalizing operating leases is
value-relevant. However, the changes of earnings do not affect the market value.
Reference Lists

Demper, S 2012, ‘Accounting quality of Leases A comparison in value relevance of the lease
accounting models’, Master Accounting, Auditing and Control thesis, Erasmus School of
Economics, Eramus University Rotterdam, accessed 29/5/2019.

Frecka, T. J., 2008, ‘Ethical Issues in Financial Reporting: Is Intentional Structuring of Lease
Contracts to Avoid Capitalization Unethical?’, Journal of Business Ethics, vol.80, no.1, pp45-59.

Mikkonen, R. S. K., 2016, ‘Value Relevance of Operating Leases – Empirical Evidence from Listed
Companies on Air Transportation Industry’, Master’s Degree thesis, School of Business, Aalto
University, accessed 28/5/2019.

Xu, W, Davidson, R & Cheong, C 2017, ‘Converting Financial Statements: Operating To

Capitalized Leases’, Pacific Accounting Review, vol.29, no.1, pp34-54.