Mandatory Accounting Rules and Private Contract Solutions—Evidence from Lease Accounting

Abstract

Abstract: We study the private lending market’s accounting solutions for operating leases and how FASB’s new lease accounting standard (ASC 842) affects them. Contrary to a popular assumption in prior literature, we find that most loan contracts exclude capitalized operating leases from debt and debt-based covenants (like debt-to-earnings ratio covenants), regardless of the accounting standards in place. Where operating leases are counted as debt, their measurements are often tailored to individual transactions. We report that firms with larger operating lease obligations pay no higher or lower interest spread than firms with smaller operating lease obligations, and the new standard’s implementation does not change this pattern. Firms with more intense operating lease obligations are more likely to renegotiate contracts to include/update fixed-GAAP clauses to undo ASC 842’s capitalization requirement. The new standard creates a potential unintended effect: upon losing leases’ off-balance sheet treatment, firms gravitate away from leases to purchases, and the associated (expected) borrowings subject firms to more and tighter debt-based covenants.