2001 American Accounting Association Accounting Horizons Vol 15 No 3 September 2001 pp 299 310 COMMENTARY Lease Accounting Research and the G4 1 Proposal Robert C Lipe Robert C Lipe is an Associate Professor at the University of Oklahoma INTRODUCTION The Group of Four Plus One or G4 1 for short is a cooperative effort by national accounting standard setters from Australia Canada New Zealand the United Kingdom and the United States plus the International Accounting Standards Committee Conclusions reached by the G4 1 are not recognized as GAAP in any financial reporting jurisdiction However by the very nature of its membership its conclusions influence standard setting in many jurisdictions Thus publication of Leases Implementation of a New Approach Nailor and Lennard 2000 indicates that accountants may soon be redeliberating the appropriate accounting treatment for lease transactions Evidence from empirical academic research on lease accounting may be useful to regulators and their constituents as they redeliberate reporting standards for lease transactions This commentary provides an overview of key results from prior research and where appropriate proposes possible future research topics in the leasing area 1 LESSEE ACCOUNTING ISSUES Most empirical research on financial reporting of leases concentrates on the lessee s use of operating vs capital lease accounting The term operating lease accounting method means that the lessee recognizes rent expense on the income statement and does not recognize lease assets or lease liabilities in the balance sheet Under the alternative capital lease accounting method the lessee initially recognizes a lease asset and a lease liability in the balance sheet and subsequently records interest expense on the liability and depreciation expense on the asset On average lessees seem to prefer operating lease accounting and much of the empirical research investigates the implications of unrecorded lease commitments 1 My scope is limited to empirical research relating to financial reporting Thus several extensive research streams are omitted including 1 economic analysis of the lease versus buy decision 2 how leasing can be used to minimize taxation and 3 thought pieces on the merits of lease capitalization This paper is adapted from my presentation at the 2000 AAA FASB conference I thank Gene Imhoff James Leisenring Tom Porter Steve Ryan James Wahlen Terry Warfield and participants at the University of Houston and University of Oklahoma seminars for helpful comments The paper benefited from research assistance by Evan Shough and Yinghong Zhang and research funding by the KPMG Foundation All errors and omissions are the responsibility of the author 300 Accounting Horizons September 2001 Statement of Financial Accounting Standards No 13 FASB 1976 hereafter SFAS No 13 provides current guidance for lessees Noncancelable leases that meet any one of four general criteria transfer of ownership bargain purchase option lease term 75 percent useful life present value of commitments 90 percent of asset s fair value must be capitalized 2 Future payments under both capital and operating leases must be disclosed in the notes Under the G4 1 proposal lessees recognize the fair value of any assets and liabilities contained in a lease contract Recognition begins when the lessor makes the property available to the lessee Thus lessee balance sheets are expected to reflect additional lease liabilities if this new approach is adopted Evidence in Imhoff et al 1993 347 and others suggests that the additional lease liabilities could be substantial Using the operating lease commitments disclosed under SFAS No 13 Imhoff et al 1993 constructively capitalize operating leases by estimating the present value of operating leases PVOL for a sample of 29 airlines and 51 grocery stores The median PVOL is 195 million for airlines and 57 million for grocery stores and these amounts are 35 40 percent as large as median total on balance sheet liabilities Lessee Accounting Research An Analysis of Three Decision Contexts The members of G4 1 agree that the purpose of financial reporting is to provide information for making economic decisions Empirical research incorporates this view by identifying and estimating linkages between accounting information and actions taken by decision makers In my discussion of research on lessee accounting I decompose the research into three decision contexts financial statement analysis of equity risk financial statement analysis of equity value and decisions actions by management Research Related to the Risk of the Lessee s Equity Most empirical research on lessee accounting is based on financial statement analysis as the decision context with particular emphasis on how unrecorded lease commitments might affect assessments of shareholder risk Possible reasons for this emphasis are 1 finance theory links debt like obligations to risk 2 unrecorded leases are large for some companies 3 and 3 mandated disclosures facilitate estimation of the unrecorded obligations 4 The finance literature linking shareholder risk to leverage includes Modigliani and Miller 1958 Hamada 1969 Rubenstein 1973 Bowman 1979 and Christie 1982 5 2 3 4 5 Prior to SFAS No 13 guidance came from APB No 5 Accounting Principles Board 1964 ASR No 147 SEC 1973 and APB 31 APB 1973 In addition SFAS No 13 spawned numerous interpretations and amendments Note that for certain types of assets such as real estate a subset of the four criteria applies SFAS No 13 paras 24 28 The magnitude of the effect matters because empirical research cannot prove that a hypothesis is true rather it seeks to provide reliable evidence that a null hypothesis is false This is referred to as rejecting the null If the effect being researched is small and the null cannot be rejected then we do not know whether the null is indeed true or the tests used are incapable of detecting such a small effect Unrecorded assets also occur under operating lease accounting but research devotes less attention to the assets possibly because the asset effects are more difficult to estimate see Imhoff et al 1991 Figure 2 and Table 3 Empirical evidence of association between financial leverage and shareholder risk can be found in Hamada 1972 and Beaver et al 1970 Lease Accounting Research and the G4 1 Proposal 301 Ryan 1997 87 88 provides an excellent intuitive explanation of this link In essence shareholder risk is the product of asset risk and