Recognition versus disclosure of finance leases: Evidence from Japan

• Author: Masaki Kusano
• DOI: http://doi.org/10.1111/jbfa.12366
• Published date: 01 January 2019
• Date: 01 January 2019

DOI: 10.1111/jbfa.12366

Recognition versus disclosure of finance leases:

Evidence from Japan

Masaki Kusano

KyotoUniversity, Graduate School of Economics,

Yoshida-honmachi,Sakyo-ku, Kyoto, Japan

Correspondence

MasakiKusano, Kyoto University,Gradu-

ateSchool of Economics, Yoshida-honmachi,

Sakyo-ku,Kyoto, Japan.

Email:kusano@econ.kyoto-u.ac.jp

Fundinginformation

JapanSociety for the Promotion of Science,

Grant/AwardNumbers: 26380607, 17K04051

JELClassification: M41, M48

Abstract

This study examines whether credit market participants—bond

investors and credit rating agencies—treat recognized and disclosed

finance leases differently when assessing firms’ credit risk in Japan.

I use firms’ credit risk, measured by bond spreads and credit ratings,

to investigate the relations between recognized versus disclosed

finance lease obligations and firms’ credit risk following the adoption

of Statement No. 13, Accounting Standard for Lease Transactions.For

a sample of firms issuing new bonds, I find that, unlike recognized

finance leases, disclosed finance leases are not associated with bond

spreads. Moreover,the associations between recognized versus dis-

closed finance leases and bond spreads are substantially different.

Conversely, recognized and disclosed finance leases are associated

with credit ratings and are processed similarly when credit ratings

are determined. Takentogether, my results suggest that the sophis-

tication of capital market participants influences their credit risk

assessments of recognized versus disclosed finance leases.

KEYWORDS

bond spreads, credit ratings, finance leases, recognition versus

disclosure

1INTRODUCTION

Focusing on the Japanese debt market, I investigate whether capital market participants treat recognized finance

leases in financial statements differently from disclosed finance leases in the notes. In Japan, finance leases are

required to be recognized on lessees’ balance sheets. However, until 2008, Japanese firms had the choice to either

recognize or disclose finance leases that do not transfer ownership to lessees. Almost all Japanese firms avoided the

capitalization of finance leases by choosing the off-balance sheet disclosure alternative. In March 2007, the Account-

ing Standards Board of Japan (ASBJ) issued Statement No. 13, Accounting Standard for Lease Transactions (ASBJ,

2007a) and Guidance No. 16, Guidance on Accounting Standard for Lease Transactions(ASBJ, 2007b). Statement No. 13

requires lessees to recognize all finance leases on their balance sheets retroactively, while Guidance No. 16 permits

an important exception:Japanese firms are allowed to continue the off-balance sheet treatment of preexisting finance

leases that do not transfer ownership to lessees. Thus, two accounting treatments exist: (i) the preferred treatment

that requires lessees to recognize all finance leases on their balance sheets retroactively; and (ii) an exception that

J Bus Fin Acc. 2019;46:159–182. wileyonlinelibrary.com/journal/jbfa c

2018 John Wiley & Sons Ltd 159

160 KUSANO

permits lessees to recognize only finance leases contracted after the adoption of Statement No. 13. Japanese firms

that choose the off-balance sheet disclosure alternative must disclose information equivalent to the capitalization of

finance leases. This unique setting allows me to compare different financial statement users’ use of recognized and

disclosed finance leases.

Specifically, I examine whether financial statement users of different sophistication levels treat recognized and

disclosed finance leases differently when assessing firms’ credit risk. Stated differently, I explore whether credit risk

assessments differ between two key credit market participants: bond investors and credit ratings agencies. Using

bond spreads and credit ratings as measures of firms’ credit risk, I investigatethe relations between recognized versus

disclosed finance lease obligations and firms’ credit risk after the adoption of Statement No. 13. For a sample of firms

issuing new bonds, I find that the associations between recognized versus disclosed finance leases and bond spreads

are substantially different, suggesting that bond investors may face higher information processing costs and may not

fully understand the implications of disclosed finance leases. Conversely,I find that recognized and disclosed finance

leases are treated similarly when credit ratings are determined, suggesting that credit rating agencies are more

sophisticated at processing disclosed finance leases. Overall, my results suggest that differences in the sophistication

of capital market participants significantly influence recognition versusdisclosure of lease arrangements.

Prior research primarily examines the effects of recognized amounts versus disclosed financial information on

equity investors (e.g., Aboody, 1996; Ahmed, Kilic, & Lobo, 2006; Davis-Friday, Folami, Liu, & Mittelstaedt, 1999;

Israeli, 2015; Michels, 2017; Müller,Riedl, & Sellhorn, 2015; Yu, 2013). Importantly, firms also employ debt financing

as a crucial source of capital (e.g., Graham & Harvey,2001). Since prior research suggests that lease arrangements are

used as a key motivation for expanding firms’ borrowing capacity (e.g., Eisfeldt & Rampini, 2009; Krishnan & Moyer,

1994; Sharpe & Nguyen, 1995), analyzing the effects of recognized versus disclosed leases on credit risk is important.

In addition, prior research finds that credit market participants—bond investors and credit rating agencies—provide

different credit risk assessments of off-balance sheet items (Barth, Ormazabal, & Taylor, 2012).

A few previous studies investigate the associations between recognized finance leases versus disclosed operating

leases and firms’ credit risk (Bratten, Choudhary,& Schipper, 2013; Sengupta & Wang, 2011). However,their research

designs consist of a joint test of the conjectures that operating leases are economically similar to finance leases and

that capital market participants treat disclosed and recognized leases similarly.This assumption may be problematic

since prior studies suggest that capital market participants perceive operating leases to have different economic

characteristics relative to finance leases (Caskey& Ozel, 2015; Dhaliwal, Lee, & Neamtiu, 2011). Furthermore, these

studies have to constructively capitalize operating lease obligations using future minimum lease payments. Since the

assumptions underlying lease arrangementsand the parameter estimates affect the estimated amounts, measurement

errors concerning constructively capitalized leases can occur, affecting the analyses of recognition versus disclosure

(Bratten et al., 2013; Callahan, Smith, & Spencer,2013). Using the same type of leases for which both recognition and

disclosure are possible can overcome these limitations. Japanese lease accounting provides an ideal research setting

for examining recognition versusdisclosure of lease arrangements.

The first objective of this study is to examine whether disclosed finance leases are associated with firms’ credit

risk. Capital market participants consider off-balance sheet leases when assessing firms’ risk (e.g.,Altamuro, Johnston,

Pandit, & Zhang, 2014; Bowman, 1980; Ely, 1995; Imhoff, Lipe, & Wright, 1993; Kraft, 2015). However, previous

studies, using a sample of Japanese firms, do not find an association between disclosed finance leases and firms’

risk (Arata, 2012; Shimizu & Yoshida,2016). Thus, I analyze the risk relevance of disclosed finance leases using bond

spreads and credit ratings to measure firms’ credit risk.1The results indicate that, unlike recognized finance leases,

disclosed finance leases are not associated with bond spreads. On the contrary, I find that recognized and disclosed

finance leases are risk relevant in explainingcredit ratings.

In addition to examining the effects of disclosed finance leases on credit market participants, understanding

whether disclosed finance leases have the same risk relevance as recognized finance leases for explaining credit risk

1Consistentwith prior research on the risk relevance of lease arrangements (e.g., Bowman, 1980; Bratten et al., 2013; Dhaliwal et al., 2011; Ely, 1995; Imhoff

etal., 1993), I assume that finance leases are risk relevant if they are associated with firms’ risk.