FEATURE
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Table 1
Table 2
Panel A – Economic Life Decision Criteria Under GAAP and IFRS GAAP
IFRS
A lease shall be capitalized if the lease term is equal to or greater than 75 percent of the economic life of the leased asset.
A lease shall be capitalized if the lease term is for the major part of the economic life of the leased asset.
Panel B – Reporting Decisions Under GAAP and IFRS GAAP (49 professionals)
IFRS (47 professionals)
Capital
Capital
Operating
39% 61%
85%
Operating 15%
be treated as operating, and four capitalized, as shown in Panel A of Table 3. Instead, a company might decide to go against what they prefer from an operating standpoint, in favor of a desired financial reporting outcome. In Panel B, the company has negotiated shorter lease terms for two contracts so that they come in at 74 percent of the economic life, thus avoiding capitalization. If a company was intent on managing its financial position to the greatest extent possible, it might pursue an aggressive strategy, negotiating with lessors so that all lease contracts come in under the 75 percent criteria (see Table 3, Panel C). While both GAAP and IFRS companies may engage in this type of behavior, it is certainly a different game to play under GAAP than under IFRS. With GAAP, there is the safe harbor of the 75 percent threshold in the standard whereas under IFRS, as previously noted, 75 percent is an interpretation subject to second guessing. One response on the part of an IFRS company is to “not play the game.” This corresponds to Panel A in Table 3 where leases are written with only business purposes in mind. If an IFRS company’s behavior corresponds to Panel A while a GAAP company engages in strategic behavior, the IFRS company will likely have a higher lease capitalization ratio (LCR). Even if an IFRS company engages in no strategic behavior, it still may seek protection against second guessing by lowering the threshold for capitalization, to say 65 or 70 percent, resulting in additional leases being capitalized. Here too, the IFRS company will tend to exhibit a higher LCR than a similar GAAP company using the 75 percent criteria. Strategic behavior is likely exhibited to some degree by both GAAP and IFRS companies. In this regard, data in the Collins study show that 10 of the 32 GAAP companies had lease capitalization ratios of 0 percent (corresponding to, for example, Panel C in Table 3). Of the 32 IFRS companies, four had LCRs equal to zero. These companies appear to be using leasing as a form of off-balance-sheet financing, but with more GAAP companies doing so in comparison to IFRS companies. As an archival study, one should ask what factors other than the proposed one (i.e., different accounting regimes) could be responsible for the observed difference in lease capitalization rates. IFRS contains one criteria requiring capitalization that GAAP does not have. This rule requires capitalization if the leased assets are unique such that only the lessee can use them. While this rule no doubt applies in specific 38
Lease Capitalization Ratio (LCR) Data GAAP (32 Companies)
IFRS (32 Companies)
2008
2009
2008
2009
Average (mean)
9%
9%
12%
14%
Median
3%
3%
10%
10%
instances, it is unlikely that it could account for the overall differences we see in the sample of 64 companies. Could there be legal, regulatory or taxation differences between the U.S. and Europe that could account for the difference? Collins addresses these factors by examining whether the overall level of leasing activity differs between the two groups in their sample. They calculate the percentage of total assets that are obtained by leasing for the two groups, both operating and capital, and find that there is no significant difference in leasing activity between the two. This increases our confidence that differences in lease reporting outcomes are related to accounting rules, rather than other institutional or regulatory factors.
Summary of Behavioral and Archival Studies The two studies provide complementary evidence about how a principles-based regime impacts financial reporting behavior in comparison to a rules-based regime. In the behavioral study, the accountant decides how to classify a specific lease contract, one that could reasonably be classified as either capital or operating. It shows how reporting regime influences professional judgment in situations that are “close calls.” The principles-based regime has the effect of making accountants more conservative, tending toward capitalization, the decision that gives the company a less favorable financial profile. In the archival study, we find that lease contracts are written with less strategic behavior under the principles-based regime, with more leases being capitalized, which again is more conservative. Both of these findings are consistent with a “second guessing” phenomenon associated with a principles-based regime. By removing detailed guidance, the principles-based regime requires the exercise of more professional judgment, which increases the uncertainty the professional faces as to whether his/her decisions may subsequently be questioned or second-guessed. The reaction to this uncertainty is more conservatism on the part of the accountant. Discussion of Results How do these results relate to the SEC’s vision for principles-based standards in the U.S. as expressed in their seminal 2003 document? The SEC does anticipate the possibility for increased professional liability as a result of adopting a principles-based regime in the United States. The evidence thus far indicates that CPAs would respond by becoming more conservative. However, the SEC’s vision is that eventually CPAs will experience decreased professional liability. CPAs will achieve this because by faithfully pursuing the objectives of principles-based standards, they will report the economic substance of events and this Today’sCPA