Accounting treatments of leases have been a controversial issue for decades. To address concerns about operating leases pervasively reported off the balance sheet under the legacy standard, the Financial Accounting Standards Board (FASB) issued Accounting Standards Update No. 2016-02, Leases (codified as ASC 842), which requires firms to recognize operating leases on the balance sheet. The FASB expected ASC 842 to increase transparency and discourage lease transactions motivated by reporting considerations. However, managers are concerned that recognizing operating leases on the balance sheet would inflate leverage ratios and reduce profitability ratios, thus making them appear riskier and deteriorating their borrowing ability. For example, the National Association of Realtors states that “[t]he new lease accounting proposal reduces the overall borrowing capacity of many commercial real estate lessees and lessors, by requiring them to recognize leases on their balance sheets as liabilities and assets, as opposed to their current treatment as operating expenses, which are not reflected on balance sheets. Including leases on balance sheets may have the effect of ‘bloating’ them, and some companies may see their debt-to-equity ratios increase as a result, making it more difficult for them to get credit.” 1Despite the hot debate, FASB released the new lease standard and called for more research to inform the post-implementation review of the new lease standard.
In response to FASB’s call, our study examines whether implementing ASC 842 affects internal credit assessments by banks, an important group of users that lie in the epicenter of the debate. 2To empirically test this question and to gauge the impact of ASC 842 on credit assessments by banks, we utilize a novel dataset of monthly consensus internal bank ratings on client firms gathered by Credit Benchmark, a data analytics company specializing in credit risk management. Banks assess their clients’ credit risk and assign internal bank ratings based on their clients’ estimated probability of default, primarily to monitor client risk and their regulatory capital level. C3redit Benchmark aggregates these credit risk estimates across partner banks and releases firm-specific aggregate ratings monthly.
Leveraging ASC 842’s de facto staggered implementation due to different fiscal year ends in a difference-in-differences framework, we find that, on average, firms are perceived to be less risky by banks post-ASC 842. These results do not support the concern held by most firms that ASC 842 would make them appear riskier. Instead, our results are consistent with ASC 842 reducing banks’ perceived risk of their clients.
We perform three cross-sectional tests to investigate whether credit assessment uncertainty before ASC 842 implementation drives our results. We expect the change in bank ratings will be more pronounced for firms with greater credit assessment uncertainty before implementing ASC 842. To test this argument, we first construct a direct measure of uncertainty faced by banks based on the dispersion in ratings given by different banks. Supporting our expectation, we find that the reduction in the perceived credit risk of firms by banks is significantly greater for firms with a higher pre-period rating dispersion.
Our second measure of credit assessment uncertainty considers the extent of abnormal operating lease activities by firms prior to ASC 842’s implementation. Abnormal operating leases are those not justified by tax or operational requirements and may indicate attempts to conceal financing activities off the balance sheet. Such structuring for reporting purposes can raise concerns about firm self-serving behavior and increase credit assessment uncertainty for banks. Recognition of these leases on the balance sheet can thus alleviate concerns about such rent extraction behaviors, especially for firms with more abnormal operating leases before the implementation. Supporting our expectation, we find that firms with more abnormal operating leases before ASC 842 experience a greater reduction in perceived credit risk after implementing ASC 842.
Third, we categorize firms based on the extent of operating lease information disclosed in their financial statement footnotes following the implementation of ASC 842. The amount of disclosure may differ among firms due to differences in their adherence to the lease standard and the extent of their voluntary disclosures beyond what is mandated by ASC 842. Our premise is that firms’ greater disclosure of operating lease information will alleviate credit assessment uncertainty, reducing the firm’s perceived credit risk. Our findings support this idea, showing that a firm’s perceived credit risk decreases more significantly when it discloses more operating lease information in the post-period.
Collectively, these three sets of cross-sectional findings further support the argument that balance sheet recognition and additional disclosures after implementing ASC 842 reduce banks’ perceived credit risk of borrowers by improving the transparency of firms’ operating lease activities, reducing the uncertainty faced by banks.
Our study has important implications for practitioners and regulators. Our evidence that banks’ perceived credit risk lowers after their clients adopt ASC 842 supports the FASB’s goal to increase transparency. Thus, firms’ concerns that the new lease accounting standard would constrain their access to credit seem unwarranted.
Haomiao He is a Ph.D. in Accounting at the University of California Irvine’s Paul Merage School of Business.
Ben Lourie is an Associate Professor in the Accounting department at the University of California Irvine’s Paul Merage School of Business.
Mark Ma is an Assistant Professor in the Accounting department at the University of Pittsburgh’s Katz Graduate School of Business.
Chenqi Zhu is an Assistant Professor in the Accounting department at the University of California Irvine’s Paul Merage School of Business.
This post is adapted from their “Operating Lease Recognition and Credit Assessment by Banks” post, available on SSRN.
banks’ perceived credit risk lowers after their clients adopt ASC 842 supports