2001 American Accounting Association Accounting Horizons Vol 15 No 3 September 2001 pp 289 298 COMMENTARY Evaluation of the Lease Accounting Proposed in G4 1 Special Report AAA Financial Accounting Standards Committee Stephen G Ryan Chair Robert H Herz Teresa E Iannaconi Laureen A Maines Krishna G Palepu Katherine Schipper Catherine M Schrand Douglas J Skinner Linda Vincent CHARACTERISTICS OF A CONCEPTUALLY SOUND LEASING STANDARD The Committee supports development of a single conceptually sound approach to accounting for all types of leases and believes that such an approach should have the following characteristics 1 The approach should recognize that all leases regardless of their specific terms and conditions convey rights and obligations and so create assets and liabilities The nature of the property under lease should not affect the accounting nor should the length of the lease 2 The approach should recognize that accounting for leases is a special case of accounting for contracts Accounting for all contracts should be placed on a sound conceptual footing and the principles developed for leases should be both internally consistent and generalizable in the sense that the principles governing accounting for leases should be suitable for application to accounting for contracts generally 3 The approach should be robust to shifts in the contractual details of lease contracts when such shifts do not materially alter the economic substance of the arrangements In particular the approach should require that substantially similar lease contracts be accounted for similarly and substantially dissimilar lease contracts not be forced into a misleading appearance of comparability 4 The approach should take account of practical realities of the leasing market that make measuring lease assets and liabilities difficult Because lease contracts are The Financial Accounting Standards Committee of the American Accounting Association hereafter the Committee is charged with responding to requests for input from standard setters on issues related to financial reporting This article is based on the Committee s response to the FASB s invitation to comment on the G4 1 Special Report Leases Implementation of a New Approach hereafter the Special Report This article reflects the views of the individuals on the Committee and not those of the American Accounting Association Principal authors are Stephen G Ryan Katherine Schipper and Linda Vincent 290 Accounting Horizons September 2001 frequently tailored to the desires of the parties to the lease it can be difficult or even infeasible to identify similar lease contracts 1 Moreover public information about the specifics of lease contracts is often unavailable 2 For these reasons the markets for trading lease assets and liabilities are relatively undeveloped In addition the existence of transaction costs associated with relocating and releasing assets under lease may yield incentives that affect the contractual lease provisions While the measurement difficulties discussed in point 4 above must be considered carefully the Committee believes that the principles governing accounting for lease receivables and liabilities should conform to the accounting for other financial instruments In this regard we note that in previous comment letters to the FASB most recently to its December 1999 Preliminary Views Reporting Financial Instruments and Certain Related Assets and Liabilities at Fair Value the Committee stated its support for fair value accounting for financial instruments once the conceptual and measurement issues are resolved REVIEW AND DISCUSSION OF EMPIRICAL RESEARCH This section contains three parts Part 1 surveys empirical research and related practice on the use of financial report disclosures of minimum operating lease payments hereafter operating lease disclosures by investors for equity valuation and equity risk assessment purposes This research generally finds that estimates of the lease obligation derived from operating lease disclosures are associated with the market value of equity and market based measures of equity risk similar to recognized capital leases and debt Likewise evidence indicates that practitioners treat operating leases like debt Part 2 summarizes empirical research bearing on whether balance sheet recognition of operating leases would be more useful for decision making purposes than the current disclosures of minimum lease payments The research findings are mixed but suggest that the usefulness of lease information to decision makers would not be reduced and might be improved by recognition rather than disclosure of all leases Part 3 surveys empirical research that describes how leasing behavior has changed over time in response to changes in accounting rules 1 Existing research indicates that operating leases are similar to capital leases and debt for valuation and risk assessment purposes Academic accounting research generally finds that leases whether accounted for as operating or capital leases are treated like debt for risk assessment and valuation purposes For example Bowman 1980 finds that estimated lease liabilities based on ASR No 147 disclosures are positively associated with market based measures of equity risk Similarly Ely 1995 and Imhoff et al 1993 1995 find that estimated operating lease liabilities based on SFAS No 13 disclosures are positively associated with measures of equity risk Whisenant 1998 finds that the market value of equity reflects estimated operating lease liabilities based on SFAS No 13 disclosures 1 2 Contrast this with the market for mortgage backed securities which was created by entities such as Fannie Mae and Ginnie Mae that devised standards for conforming mortgages Item 601 of Regulation S K which defines the exhibits to be included in SEC filings requires in the section on Material Contracts that any material lease under which a property described in the registration statement or report is held by the registrant be included as an exhibit Evaluation of the Lease Accounting Proposed in G4 1 Special Report 291 Finance research provides a slightly different view in part because it focuses on attributes that distinguish lease financing from debt financing such as differences in tax benefits Classical finance theory e g Myers et al 1976 assumes Miller Modigliani markets Assuming no taxes or that leases and debt are taxed in the same way and that the lessor is able to finance the leased asset with