Operating Leases and Credit Assessments

Operating leases have grown significantly as a source of corporate financing over the last 30 years. Their off-balance sheet treatment, which may in part explain their popularity, raises concern that financial risk may be misjudged and capital misallocated. Prior research evidence on the above issue is mixed. To improve reporting transparency, regulators propose a new accounting concept, right of use, which will add the present value of most leases to the balance sheet. We examine the effect of operating leases on loan pricing by banks, a sophisticated financial statement user. Since leases are a potential debt substitute, we expect them to be important in our setting. With loan spreads as the dependent variable, we test the differential explanatory power and model fit of as-reported financial ratios versus financial ratios adjusted for the capitalization of operating leases. We find that lease-adjusted financial ratios better explain loan spreads, especially for larger lenders. Our results also suggest that retailer leases that are closer in substance to rental agreements than financed asset purchases are less relevant for credit risk assessments. Thus we conclude that banks not only price operating leases, on average, but also make distinctions about which leases should be priced. Second, we explore the role of credit rating agencies and confirm that credit ratings also reflect capitalized operating leases, and find support for an informational role for others' credit assessments. However, unlike banks, rating agencies appear to capitalize all operating leases mechanically. Overall, our results suggest that banks and rating agencies adjust for the off-balance sheet presentation of operating leases and, at least in the case of banks, attempt to do so to reflect the underlying economics of the leases. This evidence lessens concern over the potential negative consequences of existing operating lease accounting and raises concern over proposed accounting that capitalizes all leases regardless of their economic characteristics