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Journal of Accounting and Economics 8 (1986) 217-237.

North-Holland

ACCOUNTING FOR LEASES BY LESSEES*

Samir EL-GAZZAR
Rutgers Unioersr<y, Newark, NJ 07102, USA

Steve LILIEN and Victor PASTENA


Buruch College of CUNY, New York, NY 10010, USA

Received December 1983, final version received June 1986

This study examines factors that affected managements choices in accounting for leases prior to
the implementation of SFAS No. 13. Empirical evidence indicates that tinancial contracting and
management bonus incentive variables help explain the choice. Empirical results do not support
the political cost hypothesis; rather, tax return considerations also seem to influence manage-
ments lease accounting choice.

1. Introduction

This paper examines factors that affect managements choices in accounting


for leases. Prior research indicates that economic factors influence manage-
ments choice of depreciation methods, pension amortization periods, account-
ing for exploratory costs in the extractive industries, and accounting for
interest costs associated with self-constructed assets. Also, Abdel-Khalik
(1981) focuses on the consequences of lease capitalization. However, prior
research does not attempt to explain managements incentives to choose
particular lease accounting procedures.
This study documents the effects of managements lease accounting choices
on the income statements and balance sheets of their firms prior to the
implementation of SFAS No. 13 and explains managements choices using
political costs, leverage effects, and management compensation variables.
Empirical results indicate that nearly 86% of firms lease accounting choices
can be explained by the proposed model.

*The authors acknowledge the useful comments of Paul Healy, Martin Benis. Eric Noreen,
Joshua Ronen, Ross Watts, and Jerry Zimmerman.
Samir El-Gazzar is also associated with Tanta University in Egypt.
The literature of Positioe Accounting Theor?, is reviewed extensively in Watts and Zimmerman
(1986). An incomplete list of studies on motivations for firms accounting choices includes:
Bowen, Noreen and Lacey (1981), Collins, Dent and Dhaliwal (1981), Hagerman and Zmijewski
(1979). Holthausen (1981), Holthausen and Leftwich (1983). Lilien and Pastena (1982). Leftwich
(1981), Zmijewski and Hagerman (1981) and Watts and Zimmerman (1978).

01654101/86/$3.5001986, Elsevier Science Publishers B.V. (North-Holland)


The second section of this study explains the lease accounting choices
available to management prior to the issuance of SFAS No. 13 and documents
the effects of lessees accounting choices on balance sheets and income
statements. Section 3 explores managerial motivations, while section 4 presents
the empirical models. Section 5 provides results and interpretations of em-
pirical tests of the leasing choice model. Section 6 offers conclusions.

2. Effects of lease capitalization

2. I. The anticipated effects of SFAS No. 13

Reducing managerial flexibility in lease accounting has been a goal of


accounting regulators for over thirty years as evidenced by four APB Opin-
ions, eight FASB statements, and numerous FASB interpretations and techni-
cal bulletins. In spite of the SECs ASR No. 147 and APB Opinions numbered
5, 7, 27 and 31, managers still had considerable discretion in choosing a
method of lease accounting before the adoption of SFAS No. 13 in 1976.
SFAS No. 13 mandated that lessees capitalize many leases that were formerly
operating. This new rule generated widespread criticism by lessees.
Both Abdel-Khalik (1981) and Nakayama, Lilien and Benis (1981) indicate
that the major managerial concern was the balance sheet effect of lease
capitalization. When capitalized, a lease is recorded both as an asset and a
liability. This increases the debt-to-equity ratio and the probability of violating
GAAP-based debt restrictions in lending agreements. Nakayama, Lilien and
Benis report that over 75% of the 176 companies that opposed SFAS No. 13
cited problems with covenant violations or distortions of their debt-to-equity
position as the reason for their opposition.
The FASB responded to managements concerns about covenant violations
by lengthening the SFAS No. 13 implementation period; see FASB (1976,
paragraphs 116 and 119). The longer implementation period allowed many
firms to circumvent the potential effects of SFAS No. 13. Abdel-Khalik (1981)
indicates that some firms renegotiated existing leases and modified the terms
of new leases to avoid the capitalization required by SFAS No. 13.
Mandated capitalization of leases also has the potential to adversely alIect
lessees reported income. Ernst & Ernst (1977) illustrates that reported income
under the operating method is higher early in the lease life because the rental
expense under the operating method is less than the sum of the initial interest
and depreciation expenses under capitalization. Later in the life of any
individual lease, the interest expense on the capitalized lease diminishes so the
income advantage of the operating method also diminishes. However. if
leasing activities continue to grow on a nominal basis, the dollar value of new
leases will be greater than the dollar value of the older leases where the
operating methods income advantages are reversing. Thus, on an aggregate
S. El-Gazrar et al., Lease accountmg 219

basis, the operating methods income advantage will continue if growth in


leasing continues. For virtually all firms, nominal growth in leasing was likely
in the inflationary period prior to 1976.

2.2. The reporting sample

The 600 firms included in the 1977 Accounting Trends & Techniques (ATT)
constitute the sample for this study. Of these firms. 37 are identified as having
capitalized all leases. An additional four firms included in the 1976 ATT
sample, but deleted from the 1977 ATT sample, are identified as having only
capitalized leases and are included in the current study. These 41 firms were
already capitalizing all their leases prior to the adoption of SFAS No. 13 in
November 1976 and consequently are classified as capitalizers by managerial
choice. The capitalizers were not required to make any retroactive restate-
ments to comply with the statement.
ATT for 1977 classified 300 firms as having only operating leases in 1976. A
search of the annual reports of these 300 firms for the years 1977 through 1979
revealed that 113 of these firms subsequently restated their financial state-
ments to comply with the provisions of SFAS No. 13. We classify these 113
lessees as non-capitalizers by managerial choice because the nature of their
leasing arrangements was such that they were forced to capitalize their leases
retroactively when their discretion was narrowed by SFAS No. 13. The 113
non-capitalizers by managerial choice plus the 41 all capitalizers constitute our
reporting sample of 154 firms.

2.3. Capitalizations actual efects

Statement No. 13 mandated capitalization if leases transferred title, con-


tained bargain purchase agreements, extended for more than 75% of the
remaining asset lives, or required payments whose present value exceeded 90%
of the leased propertys fair market value. The FASB required retroactive
restatement of retained earnings and net assets to comply with the provisions
of SFAS No. 13. The impact of the retroactive restatement on financial ratios
and retained earnings highlights the reporting effects of managements leasing
choices.
Panel A of table 1 shows that the leasing choice had a very substantial effect
on lessees balance sheets. For the 113 non-capitalizers. we calculated the
potential increase in the ratio of outstanding debt to equity that would have
occurred if these non-capitalizers had capitalized their operating leases at the
end of 1976. Our measure of the increase in debt of these 113 firms is the
present value of non-capitalized operating leases as reported in lessees 1976
Form 10-K disclosures under Accounting Series Release (ASR) 147. As
reported in table 1, the average potential percentage increase in debt-to-equity
220 S. El-Gazzur et a/., Lease accounting

Table 1
Effects of lease capitalization on lessees debt-to-equity ratios (D/E) and retained earnings

Panel A. Effects ofleasecapitalization on the 1976 D/E ratlo


Percentage increase in D/E ratio

Capitalizersa Non-capitalizersa
Number Number
Increase of firms Percent of firms Percent

1% to 9.9% 34 R3 46 41
10% to 19.9% 7 17 32 2x
20% to 49.9% 0 0 15 13
50% to 99.9% 0 0 13 12
over 100% 0 0 7 6
-
Total 41 100 113 100
Mean and (median) percentages for capitalizers 4.6% (3.7%)
Mean and (median) percentages for non-capitalizers 31.2% (23.5%)

Panel B. Effects of lease capitaliratlon on retained earmngs (RE) of non-capltaluersh


Number of
Reduction in RE firms Percent

Less than 3% 73 65
3% to 10% 15 13
10.1% to 19.9% 2 2
20% or more 8 7
Not disclosed 15 13
-
Total 113 100
Mean percentage for 113 non-capitalizers 6.0%
Median percentage for 113 non-capitalizers 2.3%

The capitalizers are the 41 lessees that AT&T for 1975 or 1976 identified as capitalizing all of
their leases. The non-capitalizers are the 113 lessees that AT&T for 1976 identified as not
capitalizing any leases. Subsequently, these 113 non-capitalizers had to capitalize their leases to
comply with SFAS No. 13. The increases in the D/E ratio for non-capitalizers reflect the ASR
No. 147 disclosures on lessees 1976 Form 10.KS.
Note that non-capitalizers adopted SFAS No. 13 and capitalized the appropriate leases in
either 1977, 197X. or 1979. The potential negative effects of lease capitalization on RE are
understated in this table because some lessees renegotiated leases prior to their adoption of SFAS
No. 13.

ratio (D/E) for the non-capitalizing lessees is 31.2%. For these non-capital-
izers, the effect of lease capitalization was substantial and may have had
potential for causing violation of lending covenants and other contracts.
Panel A of table 1 also indicates that on average the leasing choice prior to
SFAS No. 13 had an effect on the debt-to-equity ratio of the 41 capitalizers by
choice. The average D/E of capitalizers increased by 4.6% as a result of lease
capitalization. This increase in the capitalizers D/E is obtained by dividing
capitalized lease debt for 1976 by equity for 1976. While this debt-to-equity
S. El-Guzzur et al., Lease accoumng 221

effect is low for the capitalizer group as compared to the non-capitalizer group,
even a 4.6% increase in debt has potential for affecting covenants and financial
contracts. In fact, leasing debt constituted almost half of the total liabilities of
capitalizers.
Panal B of table 1 shows the actual retroactive adjustment to retained
earnings when non-capitalizing lessees adopted SFAS No. 13. The effect on
retained earnings was generally negative and typically less than 10%. The
average decrease in retained earnings was 6%. These results may be under-
stated because management had an extended opportunity to restructure leases
to circumvent the SFAS No. 13 guidelines before SFAS No. 13 was finally
adopted.

3. Motivations for choice of leasing methods

The literature provides three explanations for cross-sectional differences in


accounting choices: debt covenant constraints, compensation plans based on
income, and political costs.

3.1. Debt covenant constraints

Smith and Warner (1979) point out that debt agreements contain covenants
that restrict dividend payments, issuance of additional debt, reacquisition of
common stock, production and investment activities, and payout options.
Often, these covenant restrictions use accounting numbers that are defined in
terms of generally accepted accounting principles (GAAP).
While managers ability to control the calculation of accounting-based
covenant restrictions is constrained by GAAP, the availability of alternatives
in selecting and applying accounting methods within GAAP provides managers
with an opportunity to mitigate the constraints imposed by these covenants. A
series of studies, summarized in Watts and Zimmerman (1986) report results
consistent with the hypothesis that managers utilize their discretion under
GAAP to mitigate financial covenant constraints.
As previously reported in table 1, prior to the promulgation of SFAS No.
13, managers lease accounting choice had an effect on reported debt and
retained earnings. If externally reported debt and equity numbers are gener-
ally used for covenant purposes, capitalization may move many operating
lessees closer to covenant default. In fact, Nakayama, Lilien and Benis (1981)
indicate that expected covenant violations resulting from the capitalization of
lease debt was a major managerial motivation for lobbying against SFAS No.
13. However, Leftwich (1983) reports that most private financial covenants
already required the capitalization of leases for covenant purposes so, by
implication, the method of lease accounting used in external reports would not
affect the calculation of debt for covenant purposes.
Given this apparent conflict in prior literature, we sought further evidence
as to whether the lease accounting choice available under GAAP allowed firms

JAE (
to mitigate covenant constraints. We obtained a sample of 11 private cove-
nants of those firms whose debt was heavily affected by SFAS No. 13. The
lenders to these intensive lessees should be cognizant of the impact of leasing
reporting methods on GAAP financial statements; so, the covenants of inten-
sive lessees are more likely to contain special non-GAAP lease accounting
rules.
Our analysis indicates that in all 11 cases managers lease accounting
choices under GAAP influenced the computation of covenant financial restric-
tions. Only one of the 11 covenants, that of Frontier Airlines. requires the
inclusion of the imputed present value of lease payments in the calculation of
debt. Yet even in the case of Frontier, the covenant based debt-to-equity ratio
uses an unmodified GAAP definition of equity.
Frontier could improve its covenant-based D/E ratio by choosing the
operating method to increase income. Specifically, in switching from the
operating method to the capitalization method to comply with SFAS No. 13.
Frontier Airlines had to reduce equity by 13%. This indicates that prior to
SFAS No. 13, Frontier was able to loosen covenant constraints by using the
operating method for financial reporting.
Our analysis of lessees covenants does not confirm the Leftwich (19X3)
statement that most lease agreements insure that lease liabilities are counted
as debt. The divergent conclusions may be due to sample differences. Our
sample uses eleven agreements between bank lenders and intensive lessees.
Leftwich (1983) focuses on lending agreements that were drafted by insurance
companies. While the intensive lessees in the current sample may not be
representative of all U.S. firms, the debt covenants of intensive lessees are
most likely to be customized regarding leases.
Prior research indicates that firms with financial ratios closer to the limits
specified in covenants should be motivated to loosen the covenant constraints.
Kalay (1982) argues firms with higher D/E ratios are more likely to be closer
to covenant constraints, and so, are more likely to have incentives to adopt
accounting methods that ease those financial constraints. Violation of the
constraints imposes costs because it restricts investment and financing policy
and in some cases leads to technical default and triggering debt renegotiation
costs.
Given the evidence from our covenant analysis that managers can mitigate
the effects of covenant constraints by using the operating method for external
reporting, high D/E lessees should be the most motivated to keep lease
liabilities off the books by using the operating method. As in much of the
previous research, we do not test the actual financial constraints within
covenants. Rather, we assume that the D/E ratio is an adequate proxy for
financial covenant constraints.
The effect of capitalization on debt constraints is affected by both the
magnitude of the capitalization effect and the level of D/E subsequent to
capitalization; thus, we employ several variables to measure the effects of
S. El-Gaz:ar et al., Lease uccountmg 223

capitalization on covenants. These variables include the change in D/E ratio


due to capitalization, the D/E ratio, and the industry-adjusted D/E ratio.

3.1.1. The change in leverage hypothesis

When a firms covenants limit its D/E ratio. the creation of additional debt
through lease capitalization will move the firm toward the maximum ratio.
Hence, the effects of lease capitalization on the D/E ratio can proxy for the
extent to which covenants are more likely to limit managements actions.

The Change in Leverage Hypothesis. Those firms who would increase their
D/E ratio the most by lease capitalization ure the most likely to use the operating
method. This implies a positive correlation between the increase in D/E and the
operuting method.

3.12. The leverage hypothesis

Using Kalay (1982). we infer that firms with high D/E ratios are closer to
their debt covenant constraints. These firms are more likely to adopt proce-
dures that increase equity by shifting income from future periods to the
current period. Firms with high D/E ratios can loosen the effects of account-
ing based constraints by choosing the operating method which increases equity
and avoids additional balance sheet debt.

The Leveruge Hypothesis. Those jirms with the highest D/E ratios after
capitulization are the most likely to use the operating method for lease accounting.
This implies a positive correlation between the D/E rutio and the operuting
method.

3.1.3. The industry-adjusted leverage hypothesis

The use of D/E as a surrogate for the extent to which covenants are
binding assumes that the D/E level specified in debt covenants does not vary
across industries. However, both Schwartz and Aronson (1967) and Scott and
Martin (1975) find that firms within an industry have similar financial struc-
tures and the D/E ratio of a firm is associated with industry membership.
Hence, it is likely that the D/E level in a firms debt covenants is a function
of its industry. To allow for that possibility, a firms D/E ratio relative to the
industry average D/E ratio is also used as a surrogate for the extent to which
debt covenants are binding.

The Industry Adjusted Leverage Hypothesis. Firms with the highest industry-
adjusted D/E ratios after capitalization are the most likely to reduce debt by
using the operating method. This implies u positive correlation between the
industry-adjusted D/E and the operating method.
3.2. Incentive plan hypothesis

Research on accounting choice proposes that, ceteris paribus. managers of


firms with bonus plans are more likely to choose accounting procedures that
shift reported earnings from future periods to the current period. Typically,
these plans base the bonus on accounting income relative to returns on book
values of assets or equity. Recent research, such as Healy (1985), indicates the
details of the bonus calculations vary across plans. Managers incentives to
report higher income in a given year vary with these details; thus, this study
considers the effects of such plan details, namely whether income is defined
before or after deducting interest expense.
The definition of income used in incentive contracts determines whether
management can increase its wealth through its lease accounting choice. When
incentive income is calculated after deducting interest expense, the operating
approach will maximize the incentive income of growing firms because the
high interest and depreciation expenses that must be recognized early in the
life of a capital lease are deferred to future periods.
It is not clear how the choice of leasing method will affect the bonus pool of
those non-capitalizers whose incentive plan is based on earnings before
interest. Healy (1985) illustrates that firms with earnings targets based on
invested capital (total assets) typically add back their interest expense in
defining income for incentive plan purposes. If leases are capitalized, the
interest expense is added back to defined income but the earnings target is
increased by a percentage of the capitalized lease. The net effect of capitaliza-
tion on the bonus pool in this case is indeterminate. Accordingly, we hypo-
thesize that firms whose incentive plan income is defined on an after interest
basis will choose the operating method for lease reporting.

The Incentive Plan H_vpothesis. Those jirms with incentive plans based on
income after interest expense are more like!r? to use the operuting approach for
lease accounting. Those firms without income-based incentive plans or incentire
plans based on income before interest expense ure more like!v to capitalize leases.
This implies a positive correlation between the operating method and income-bused
compensation plans.

3.3. The political cost hypotheses

This paper uses two measures of political costs: (1) size, which is the
measure used in prior research, and (2) the effective tax rate, which is an
alternate measure of political costs, adopted from Zimmerman (1983). The
paper also tests an alternative hypothesis that views the effective tax as a
surrogate for the tax incentives of capitalizers and reporting incentives of
operating lessees.
S. El-Gazzur et ul., Lease uccounring 225

3.3. I. Size as a surrogate for political costs


Many prior studies have used size as a measure of political costs. These
studies have argued that large firms are more likely to suffer excess regulation
and/or high taxes. When these large firms report higher income, their earnings
reports are more likely to be noticed by regulators and others who may desire
to reallocate resources away from these large firms. Under these cir-
cumstances, large firms have greater motivation to choose accounting methods,
such as lease capitalization, that lower current-period income. Size as a
surrogate for political cost hypothesis is stated as follows:

The Size Hypothesis. Large lessees are more like& to report lower earnings by
capitalizing leases; thus, sales are negative@ correlated with the operating
method.

3.3.2. The tax rate as a surrogate for political cost

Holthausen and Leftwich (1983) indicate that size is a very imperfect


surrogate for political costs. An alternate political cost measure is the effective
tax rate. Effective tax rates are a surrogate for political costs to the extent that
taxes are not systematically offset by non-tax components such as antitrust
suits, regulation, government subsidies and contracts, import quotas and
tariffs. Zimmerman (1983) concludes that the ability of the effective tax rate to
surrogate for political costs varies across different time periods and industry
groupings.
Firms with the highest political costs will be the most motivated to lower
their political visibility by minimizing income. We hypothesize that firms with
high political costs in the form of high effective tax rates are more likely to
choose income-reducing options, such as capitalizing leases.

The Tax-Based Political Hypothesis. Firms with high efSective tax rates are
more likely to reduce their political costs by using lease capitalization to reduce
income. Thus, the effective tax rate will be negatively correlated with the
operating approach.

3.3.3. Tax rate as a surrogate for tax and reporting incentives

Independent of the political cost hypothesis, the interaction of economic


and reporting incentives also predicts negative correlation between the effec-
tive tax rate and operating approach. Leasing can be advantageous for tax
purposes because it provides a mechanism for shifting the inves:ment tax
226 S. El-Guzzar et al., Leuw uccounting

credit (ITC) and depreciation entitlements. 2 Ideally, these tax entitlements will
be shifted from users unable to take full advantage of the credit and deprecia-
tion deduction to the party who can most benefit from these items. Parties to
contracts will write those contracts to maximize the present value of cash flows
to the contracting parties, ceteris paribus. Arranging contracts so that the
highest-tax-rate firm has maximum tax deductions early in the life of the
contract is a means of maximizing the combined net present value of the tax
benefits available to the lessor and lessee.

Economic and reporting incentives of high-tax-rute lessees. High-tax-rate lessees


can obtain full tax benefits by participating in leasing agreements that pass tax
benefits to the lessee. A potential lessee might also purchase assets outright
(rather than lease) as an alternate method to insure retention of full tax
benefits. Thus, ceteris paribus, we expect high-tax-rate firms to lease less than
low-tax-rate firms.
However, some high-tax-rate firms may lease assets because of other ad-
vantages of leasing. If high-tax-rate firms choose to lease, the selection of a
method for financial reporting is likely to be affected by the lessees desire to
influence the tax interpretation of lease contracts. The use of lease capitaliza-
tion for reporting may facilitate retention of the ITC and depreciation on the
tax return because tax rules allow the,lessor to transfer the ITC and accel-
erated depreciation to the lessee, provided that the lessee demonstrates material
equity in the property.
Mellman and Bernstein (1966) report substantial conformity between tax
and book accounting by lessees in the pre-SFAS No. 13 period. Apparently, a
high-tax-rate lessors claim of material equity on the tax return could be
enhanced by showing ownership for reporting purposes. This leads to a
positive correlation between the tax rate and capitalization. It implies a
negative correlation between the operating method and the effective tax rate.

The tax and reporting incentives of low-tax lessees. In addition to the financ-
ing benefits, leasing rather than purchasing allows a low-tax-rate lessee to
obtain benefits from tax entitlements that would be underutilized otherwise. If
the lease contract passes tax benefits to the lessor, the low-tax-rate lessee can
share the cash savings from tax benefits by obtaining lower lease rentals. The
ability to share otherwise lost tax benefits is a strong motivator for low-tax-rate

Clearly, the ability to transfer the ITC to the high-tax-rate firm is valuable if one party to the
lease contract is in a tax-loss-carryforward position, In fact, 19 sample lessees disclosed tax-carry
forward positions in their financial statements during the 1970s. It is probable that other sample
lessees were close to a loss-carryforward position, so they would not have fully utilized the ITC.
Also, Schall and Sundem (1982) demonstrate that (under the most likely conditions) even if both
parties to the lease contract can reduce taxes by using the ITC, total tax benetits to both firms are
maximized when the high-tax-rate firm uses the ITC. In fact, Schall and Sundem (1982) argue that
this ability to transfer the ITC to the high-tax-rate firm provides a greater tax subsidy at the
margin to asset leasing than to asset sales to users.
S. El-Gazzur et cd., Leme uccounting 221

firms to lease so we expect that low-tax firms will be more intensive lessees as
compared to high-tax-rate firms.
Comparatively, low-tax lessees do not have tax incentives to obtain tax
entitlements, so they do not need to demonstrate material equity in the leased
property. Accordingly, there are no tax incentives for low-tax-rate lessees to
capitalize leases on their financial statements. On the other hand, low-tax
lessees are likely to be the most intensive lessees so they experience the highest
increases in debt and decreases in income if forced to capitalize. This reporting
scenario leads to a positive correlation between the operating method and
leasing intensity and also implies a negative correlation between the operating
method and the lessees tax rate.

The Tax Savings/Reporting Incentives Hypothesis. A low effective tax rate


surrogates for reporting incentives to use the operating method. A high effective
tux rute surrogates for tax incentives for lease cupitalization. Low-tax-rate firms
are more like!y to use the operating method, while high-tax jirms are more like!),
to capitalize leases. Also. low-tax jirms will he more intensive lessees.

4. The empirical model

The empirical tests use a model based on managerial incentive variables to


predict how lessees account for leases. Lessees who capitalized all of their
leases prior to SFAS No. 13 are classified as capitalizers, while firms forced to
capitalize former operating leases following adoption of SFAS No. 13 are
classified as non-capitalizers. Firm membership in the capitalizer and non-
capitalizer groups is the dependent variable; proxies for each of the managerial
incentives are independent variables. In order to allow testing of the relevant
hypotheses and subhypotheses, four variations of the basic model are used.
The models use data from the 1976 financial statements of lessees.

4.1. Coding the compensation variable

All four models use the existence of an incentive plan based on after interest
income as an independent variable. A dummy variable takes the value one if
an incentive plan existed and incentive income was defined on an after interest
basis. If an income-based bonus plan does not exist, or incentive income is
calculated using income before interest expense, the dummy variable takes the
value zero.
The compensation information source is lessees Form 10-K and its exhibits.
The exhibits often, but not always, contain copies of compensation plans
and/or proxy statements that contain the plans. If the existence of a manage-
ment incentive plan is not mentioned in the Form 10-K or its footnotes or
exhibits, it is assumed that no compensation plan existed.
Column 1 of table 2 shows that 21 non-capitalizers did not have income-
based incentive plans and nine non-capitalizers had incentive plans based on
22x S. El-Guzzur et ul.. Lear uccounrrng

Table 2
Basis for coding of managerial incentive variable using proxy statement and Form 10-K
information,

Non-capitalizers Capitalizers

Incentive plan non-income-based


or no plan 21 2x
All available incentive plans
based on before-interest income 9 0
Totul lessees thut tuke the dumq
cwiuhle zero rn prohrr tests 30 28
Proxy and/or Form 10-K information
indicates short-term bonus plan
uses after-interest income 62 10
Proxy and/or Form 10-K information
indicates that short-term plan is
on before-interest income but long-
term incentive is based on
after-interest income 4 0
Totul sample lessees rhur rake
u dunmy r~lue one m the
multicwrrute fests 66 I0
Lessees used in emprricul tests 96 38
Incentive plans exist but there is
insufficient information available
for classification; thus, firms are
not included in the multivariate
tests 17 3
Tofu1 lessees in the reporrmg
sumple in ruble I 113 41

before interest income. These 30 non-capitalizers take the dummy value zero.
Sixty-two non-capitalizers have short-term bonus plans based on after-interest
income and take the dummy value one. In four other cases, the short-term
bonus plan is based on before-interest income but the long-term bonus plan is
based on after-interest income. These four firms also take the dummy value
one because their long-term plans provide incentives for managers to report
higher income. In total, 66 non-capitalizers are assigned dummy values of one.
Column 2 of table 2 indicates that only 10 capitalizers have incentive plans
based on after-interest income; thus, these ten lessees are assigned a managerial
incentive dummy of one. Twenty-eight capitalizers without incentive plans
take the dummy value zero.
In the case of 20 lessees, the existence of compensation plans is indicated by
the footnotes in Form 10-K; however, detailed information about the income
definitions used in the plan is not included in the exhibits. These 17 non-
capitalizers and three capitalizers are excluded from the empirical testing.
Thus, each of the four models is tested on the basis of the empirical sample of
S. El-Garrar et al., Lease accounting 229

134 lessees, 96 non-capitalizers and 38 capitalizers. Since the same elimination


procedure is used for capitalizers and non-capitalizers, we assume that the
empirical tests are not biased by the exclusion of the 20 firms.

4.2. Specific models used in empirical tests

The four model variations are:

Sign = + + _

Model 1: Z = a + b,LEV, + b,MC + b,SIZE,

Model 2: Z = a + b,LEV1 + b,MC + b,TAX,

Model 3: Z=a+b,LEV~+b,MC+b,TAX,

Model 4: Z = a + b,LEI/, + b,MC + b,TAX,

where

Z = 1 for non-capitalizers (i.e., income maximizers), = 0 for capitalizers


(i.e., income minimizers);
LET/, = change in the D/E ratio for 1976 as a result of lease capitalization;
the numerator includes the capitalized lease debt of the capitalizers
and the potential lease debt of non-capitalizers as defined in ASR No.
147;
LEI/, = the D/E ratio for 1976; non-capitalizers potential lease debt from
ASR No. 147 is included in the numerator;
LEV, = the D/E ratio for 1976 minus its four-digit industry average D/E
ratio as derived from the Compustat Tapes;
MC = 1 if a incentive plan based on income net of interest exists, = 0
otherwise;
TAX = effective tax rate for 1976 (tax expense net of changes in deferred
taxes/current gross margin);
SIZE = sales in dollars for 1976.

4.3. Multivariate models used in empirical testing

The four models are tested using both N-chotomous probit analysis (NPA)
and multiple discriminant analysis (MDA). NPA was developed by McKelvey
and Zavoina (1975) and used for empirical tests by Kaplan and Urwitz (1979)
Zmijewski and Hagerman (1981), Bowen, Noreen and Lacey (1981) and Lilien
and Pastena (1982). The NPA technique gives significance tests on individual
variables as well as significance tests on overall classifications. The MDA tests
use the holdout approach developed by Lachenbruch and Mickey (1968) to
avoid biasing results by testing the model on the same data used to develop
the model.
230 S. El-Gazrar et al., Lease accounting

Table 3
Probit results in which the dependent variable is the lease reporting choice (capitalizers take the
dependent value zero and non-capitalizers one).

Independent
variables Model 1 Model 2 Model 3 Model 4

Leverage Change D/E Change D/E D/E D/E net


of industry
Bonus based on 1 = YES. 1 = YES. 1 = YES. 1 = YES.
after interest O=NO. O=NO. O=NO. O=NO.
Tax. political. Size Effective EtTective Effective
and reporting (sales) tax rate tax rate tax rate
incentives
Observations 134 134 134 134
Prohir Results
R-squared 0.952 0.966 0.879 0.87X
C&squared
(3 degrees) 58.1a 76.1 86.2n X4.5
% correctly 79.8 83.5 85.8 x5.1
predicted
Intercept - 2.29 0.21 ~ 0.53 0.81
Leverage 9.76 11.10 2.99 3.20
(t-value) (3.35)a (3.49) (4.37) (4.32)
Bonus 1.19 1.11 1.25 1.16
(r-value) (4.20) (3.58)a (3.75) (3.56)
Size 0.23
(t-value) (1.33)
Tax rate - 0.072 - 0.068 - 0.077
(t-value) ( ~ 4.06) (~ 3.47) (- 3.85)
-__
Significant at the 0.001 level.

5. Empirical results

5.1. The models signi$cance and prediction success

Probit results for all four of the managerial incentive models are presented
in table 3. The chi-squared statistics indicate that all four models are signifi-
cant at the 0.001 level with the R2 ranging from 0.878 in model 4 to 0.966 in
model 2. The percent correctly predicted ranged from 79.8% in model 1 to
85.8% in model 3. Even the 79.8% correctly predicted generated in model 1
significantly exceeds at the 0.1 level of 71.6% correct achievable under the
most successful naive model.
As explained in Pincus (1980), the most successful naive model classifies all
observations as members of the larger group, non-capitalizers in the current
S. El-Gazzar et al., Lease accouniing 231

study. Classifying all observations as non-capitalizers leads to 96 correct


predictions in a sample of 134 (71.6% correct). The percentages correctly
predicted by probit models 2, 3 and 4 exceed the 71.6% achieved by the most
successful naive model at the 0.01 level.
Models 1 through 4 were also tested using the MDA holdout technique.
Prediction success ranged from 78.4% in the case of model 1 to 84.3% in the
case of models 3 and 4. Models 2, 3 and 4 achieve successful prediction rates
that are significantly (0.01 level) greater than the 71.6% success which would
be achieved by the most successful naive technique. The prediction success of
model 1 exceeds the best naive technique at the 0.1 level.

5.2. Results for leverage-based hypotheses

The probit results for models 1 through 4 as reported in table 3 indicate that
all three variations of the covenant constraint variable, the change in D/E due
to capitalization in models 1 and 2, the D/E ratio in model 3, and the
industry-adjusted D/E ratio in model 4, assume the predicted positive
correlation with the operating method. (0.001 significance level). The signifi-
cant positive correlation between the change in the D/E and the operating
method in models 1 and 2 supports the Change in Leverage Hypothesis and
implies that lessees whose D/E ratios are most affected by capitalization are
unlikely to capitalize.
The high explanatory ability of the industry-adjusted leverage variable in
model 4 implies that the D/E ratio of operating lessees is high compared to
the industry average; thus, the level of the lessees D/E ratio is not merely
surrogating for industry membership.
The Change in Leverage Hypothesis, the Leverage Hypothesis, and the
Industry-Adjusted Leverage Hypothesis are not mutually exclusive. In fact, the
results are consistent with all three of these hypotheses. Also, given the success
of the leverage-based surrogates for closeness to covenant constraints, we did
not further improve our model as suggested by Lys (1984) by including the
variability of firms cash flows as an additional explanatory variable. This
omission works against our achieving adequate prediction of managements
choices.

5.3. Results for the incentive plan hypothesis

In table 3, models 1 through 4 all use the incentive compensation dummy


variable. The bonus variable assumes the predicted positive correlation (0.001
level) with the operating approach in all probit tests. This is consistent with
the hypothesis that managers increase their total compensation by choosing
the operating method. Our incentive compensation variable reflects an elemen-
tary analysis of the contents of bonus plans but our results are consistent with
232 S. El-Gazzar et al., Lease accomting

those of earlier research, where the coding of the incentive variable was based
only on the existence of plans.

5.4. Results for the size hypothesis

In model 1 (reported in column 1 of table 3), covenant constraints and the


existence of after-interest based bonus plans are used to explain managements
leasing choice while size (sales) is used to proxy for political costs. The Size
Hypothesis predicts that large firms would lower income and avoid the
operating approach, that is, a negative correlation between size and the
operating method. Empirical results indicate that the Size Hypothesis must be
rejected because size assumes the wrong direction; it is positively correlated
with the operating method at a statistically insignificant level. Moreover,
results, not reported in table 3, reveal that when size is used along with the
effective tax rate as one of two political cost variables, size again assumes the
wrong direction at an insignificant level.
Zimmerman (1983) indicates that the largest 50 firms had higher effective
tax rates in comparison to smaller firms in the 1972 to 1981 period. Only 12 of
our sample firms are among the largest 50 for 1976. In a contradiction of the
size-based political cost hypothesis, all 12 of these firms use the operuting
method, not the hypothesized capitalization method.

5.5. Results for the tax-based political hypothesis

The Tax-Based Political Hypothesis states that high-tax-rate lessees attempt


to lower their political costs by lowering reported income through capitaliza-
tion of leases. This creates a negative correlation between the effective tax rate
and the operating method.
Results from the probit tests of models 2, 3 and 4 show that the eflective tax
rate is negatively correlated with the operating method at the 0.001 level of
significance. Also, these three models achieve a higher prediction success rate
and chi-squared statistics than model 1, which uses size as the political
variable.

5.6. Results for the tax savings/reporting incentives hypothesis

The Tax Savings/Reporting Incentives Hypothesis states that high-tax firms


gain tax return advantages by capitalizing for reporting purposes. Also, the
Tax Savings/Reporting Incentives Hypothesis argues that firms with low tax
rates have economic incentives to lease intensively. These intensive lessees
have stronger reporting incentives to use the operating method. As reported
above, lessees tax rates and the operating method are negatively correlated as
predicted by the Tax Savings/Reporting Incentives Hypothesis.
S. El-Gazzar et al,, Lease accounting 233

The Tax Savings/Reporting Incentives Hypothesis also implies a positive


correlation between the operating method and leasing intensity. The Tax-Based
Political Cost Hypothesis does not have direct implications concerning leasing
intensity. Leasing intensity is the ratio of leasing debt, including the ASR No.
147 off balance sheet leasing debt disclosures, to total assets. Estimates of the
total leased assets are not available for most lessees.
Table 4 provides the correlations between the leasing reporting choice,
the effective tax rate, and leasing intensity. Consistent with the Tax Savings/
Reporting Incentives Hypothesis, the operating method is negatively corre-
lated (0.01 level) with the tax rate but is positively correlated (0.01 level) with
leasing intensity. Table 4 also shows that the mean levels of these variables
differ considerably for capitalizers and non-capitalizers.

5.7. Insights from the analysis of other accounting choices

The negative correlation between the tax rate and the operating method in
the probit tests is consistent with both the Tax-Based Political Cost and the
Tax Savings/Reporting Incentives Hypotheses, so more evidence is required
to indicate which of the two hypotheses is more plausible. Lessees reporting
choices outside of leasing may provide additional insight. Table 5 contains a
comparative analysis of lessees reporting choices for depreciation, the ITC,
and the past service cost amortization period.3 Reporting. choices in these
areas do not have tax return implications so the Tax Savings/Reporting
Incentives Hypothesis does not imply particular reporting choices.
On the other hand, if the lease capitalization choice reflects the desire of
high-tax firms to reduce income, these high-tax-rate firms should be motivated
to reduce reported income with their reporting choices outside of leasing.
Thus, under the Tax Based Political Hypothesis, the reporting choices of the
capitalizers and non-capitalizers should be different because the capitalizers
will choose income reducing methods. Accelerated depreciation, the deferred
method for the ITC, and short pension amortization periods reduce reported
income.

Although not reported in table 5, we did compare the inventory choices of capitalizers and
non-capitalizers. Both the Tax-Based Political Hypothesis and the Tax Savings/Reporting Incen-
tives Hypothesis predict that thC two groups of lessees would have different inventory choices with
the high-tax capitalizers using predominantly LIFO. Consistent with both the Tax-Based Political
Hypothesis and the Tax Savings/Reporting Incentives Hypothesis, almost 75% of capitalizers use
LIFO, while only 40% of the non-capitalizers use LIFO. A cm-square test for differences between
the capitalizer and non-capitalizer groups produces a &-square statistics of 8.23 (significant at the
0.01 level).
Another result not reported in the tables is that growth is positively correlated with the
operating choice (0.05 level of statistical significance). As argued by Ernst & Ernst (1977), lessees
with growing leasing activities will report substantially lower income under capitalization. Thus.
growing lessees have greater motivation to choose the operating method. This empirical finding of
a positive correlation between growth and the operating choice provides additional support for the
Tax Savings/Reporting Incentives Hypothesis.
234 S. El-Gazrur et ul., Lease accounting

Table 4
A comparison of the leasing choice (LC), leasing intensity (LI), and effective tax rates (TAX)
in 1976.

Panel A. Sample mean


T-value of
Capitalizers Non-capitalizers difference

EtTective tax 22.5% 10.0% 6.96a


rate (TAX)
Leasing intensityb 2.4% 7.8% 3.91=

Panel B. Pooled correlation


LCC LI TAX

LC 1.000 0.271a -0.541a


LI 1.000 - 0.306=
TAX 1.000

aSigniticant at the 0.01 level.


bLeasing intensity is leasing debt including ASR No. 147 off balance sheet leasing debt
disclosures divided by total assets.
The choice of the operating method is coded as one, while the use of capitalization is coded as
zero.

Table 5
Comparative analysis of alternate accounting choices in 1976.

Panel A. Depreciniion rhowe


Accelerated Straight line

Capitalizers 4 30
Non-capitalizers 6 73

Panel B. Inoestment credit accounting choiceC


Deferred Flow through

Capitalizers 5 26
Non-capitalizers 16 64

Panel C. Thepension accounting choked


Amortization period for past service costs
Less than 30 years 30 years or more

Capitalizers 11 13
Non-capitalizers 20 43

a Only those lessees who indicated a predominant accounting choice in a given area are included
in these tables.
bThe &i-square statistic of 0.128 is not significant at the 0.1 level.
The &i-square statistic of 0.039 is not significant at the 0.1 level.
dThe &i-square statistic of 0.960 is not significant at the 0.1 level.
S. El-Gazzar et al.. Lease uccouniing 235

Panels A, B, and C of table 5 report lessees depreciation, ITC, and past


service pension amortization reporting choices, respectively. In contradiction
of the Tax-Based Political Hypothesis, the results do not indicate a statistical
difference in the reporting of depreciation among the two groups of lessees
because 88% (30 out of 34) of the high-tax capitalizers use straight line
depreciation for reporting. In a second contradiction to the Tax-Based Politi-
cal Cost Hypothesis, results indicate that the ITC choice of the capitalizing
and operating lessees is not different. In fact, 80% of the capitalizers use the
flow through method. Finally, the chi-square statistic does not indicate any
difference in the pension amortization choice. Interestingly, the majority of the
capitalizers used the 30 years or longer amortization period.
An alternate approach to determining whether tax factors influence account-
ing choices consists of using a univariate probit model with accounting choice
as the dependent variable and the effective tax rate as the independent
variable. In five separate tests, we explored the relationship between the
effective tax rate and the following accounting choices: (1) depreciation
methods, (2) ITC accounting, (3) pension past service amortization periods. (4)
inventory accounting, and (5) lease accounting.
The relation between accounting choice and the effective tax rate was
significant only in the case of inventory and lease accounting.4 As expected the
effective tax rate was negatively correlated with the FIFO inventory method

Probit results show that only the inventory and leasing choices are correlated with the elfective
tax rate at a statistically significant level. The results follow:

Probit analysis with accounting choices as the dependent variable and the effective tax rate as the
independent variable
Type of accounting choice Slope C&square statistic

Depreciation ~ 0.003 29.5 (33 DF)


(accelerated methods = 0,
straight line = 1)
ITC 0.002 35.6 (32 DF)
(deferred method = 0,
flow through method = 1)
Pension amortization - 0.002 34.2 (30 DF)
(less than 30 years = 0,
30 years or more = 1)
Inventory ~ 0.001 46.1 (34 DF)
(LIFO = 0,
FIFO = 1)
Lease accounting ~ O.OQO5 67.8 (33 DF)
(capitalization = 0,
operating = 1)

aDF = degree of freedom.


bSignificant at the 0.1 level.
CSignificant at the 0.01 level.
236 S. El-Gurzar et (11..Lease accounting

and the operating method for leasing. Interestingly, this negative correlation
between the tax rate and income-maximizing accounting choices was signifi-
cant at the 0.1 level for inventory accounting but significant at the 0.01 level
for the leasing choice.
In so far as political cost considerations do not determine the reporting
choices of capitalizers outside of the tax-related areas of leasing and inventory,
it is doubtful that the desire to minimize political cost by reporting lower
income is a prime motivator for capitalizers. As reported in prior research, the
inventory reporting choice of many firms seems to be tax motivated. Similarly,
the current results are consistent with the Tax Savings/Reporting Incentives
Hypothesis because tax factors affect the lease accounting choice.

6. Conclusions

Given the potential effect of capitalization on covenant constraints, we


hypothesize that those firms that would be most affected by capitalization
would be the most likely to use the operating approach prior to SFAS No. 13.
Also, as firms approach debt covenant constraints as measured by variations
of the D/E ratio, lessees should choose the operating approach. In probit
tests, the operating method is positively correlated at the 0.01 significance level
with the D/E ratio.
We also hypothesize that lessees whose managerial incentive plans are
defined in terms of income after deducting interest are more likely to use the
operating approach. Our modeling of the bonus incentive variable is based on
an elementary analysis of plan details. As expected, the use of the operating
method is positively correlated (0.01 significance level) with the existence of
bonus plans based on after-interest income.
Some prior research indicates that firms with high political cost, whether
measured by size or effective tax rate, should be motivated to decrease income
by capitalizing leases. An alternate scenario based on the tax and reporting
incentives of firms who are intensive lessees also predicts negative correlation
between the tax rate and the operating method. Empirical results do not
support the Political Cost Hypothesis when size is used to surrogate for
political costs, but our findings indicate that the tax rate is negatively corre-
lated with the choice of the operating method. This negative correlation is
consistent both with the Tax-Based Political Hypothesis and the alternate Tax
Savings/Reporting Incentives Hypothesis. However, our analysis of other
reporting choices of lessees supports the Tax Savings/Reporting Incentives
Hypothesis and does not support the Tax-Based Political Hypothesis.

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