Impact of constructive capitalisation of operating leases on South African companies considering new proposed lease accounting rules

Includes bibliographical references.This study analyses the impact that operating lease capitalisation has on key financial statement ratios and failure prediction indicators of listed South African companies operating within five sectors (namely General Industrials, Industrial Transportation, Food & Drug Retailers, General Retailers and Travel & Leisure), as well as whether the impact thereof is substantially the same as the new proposed accounting treatment for Type A and Type B leases in terms of ED/2013/6 (IASB, 2013). Furthermore, the extent of lease usage in South Africa and whether the size of a company has a bearing on its extent of leasing is examined. Additional analysis is also performed investigating the materiality of straight-lining and onerous contract provisions relating to operating leases, as well as the impact of operating lease capitalisation on disclosed loan covenants. Based predominantly on the constructive operating lease capitalisation method developed by Imhoff, Lipe and Wright (1991 & 1997), a refined constructive lease capitalisation model is developed in this study which incorporates aspects of current lease accounting rules not previously considered, namely provisions recognised in respect of the straight-lining of operating leases as well as onerous operating lease contracts. This model also incorporates the new proposed lease accounting rules which require the capitalisation of all leases (Type A and Type B). The results indicate that the capitalisation of future non-cancellable operating lease commitments have a significant impact on key financial statement ratios and failure prediction indicators, most notably leverage and other debt-related ratios. Furthermore, of the five sectors analysed, retailers were the most affected. When considering the new proposed accounting treatment for Type A and Type B leases, the results indicate that operating lease capitalisation has substantially the same impact on key financial statement ratios and Altman‟s failure prediction models as the conventional operating lease capitalisation method, except for certain debt-related and profitability ratios. Further results indicate that operating leases are used extensively and substantially more than finance leases within South Africa. It was also found that operating lease usage was positively related to company size, while finance lease usage decreased as company size increased. Curvilinear relationships were also noted between a company‟s size and its extent of leasing. Further analysis revealed that recognised straight-lining lease provisions are substantially more material than recognised onerous lease contract provisions and are capable of distorting the analysis of operating lease capitalisation if ignored. When scrutinising loan covenants disclosed, it was established that none of the loan covenants were breached when capitalising operating leases; however, in each instance operating lease capitalisation negatively impacted all covenant related ratios