Accounting Horizons American Accounting AssociationVol. 27, No. 1 DOI: 10.2308/acch-502782013pp. 51–74

Amortized Cost for Operating Lease Assets

Ross Jennings and Ana Marques

SYNOPSIS: A proposed accounting standard issued jointly by the Financial Accounting

Standards Board (FASB) and the International Accounting Standards Board (IASB)

would require firms to recognize many more lease assets than are currently required and

to amortize those assets on a straight-line basis. A number of respondents to the

exposure draft argue that the ‘‘front-loading’’ of lease expense resulting from straight-line

amortization would not reflect the economics of the lease assets. This study compares

straight-line amortization with the most-often cited alternative, present value amortiza-

tion. First, we illustrate by example that under stylized conditions, present value

amortization provides information that more faithfully represents the future cash flows of

lease assets than straight-line amortization. Second, for a large subset of firms that are

more likely to conform to the stylized conditions in our example, we find that investors

value those firms as though the lease assets are capitalized and amortized on a present

value basis. Finally, we find that financial ratio comparability is substantially increased

when operating leases are constructively capitalized and amortized using straight-line

amortization, and further increased when using present value amortization. Taken

together, these results provide no evidence for favoring straight-line amortization over

present value amortization as the default method for amortizing capitalized operating

leases.

Keywords: leasing; straight-line amortization; present value amortization;

value-relevance.

Data Availability: Data used in this paper are publicly available.

INTRODUCTION

This study compares two alternatives for computing amortized cost for operating lease

assets: straight-line amortization and present value amortization. This issue is important and

timely because it is currently being considered by the Financial Accounting Standards

Ross Jennings is a Professor at The University of Texas at Austin, and Ana Marques is an Assistant Professorat Nova School of Business and Economics.

We acknowledge the excellent research assistance of Arash Aloosh. Professor Jennings gratefully acknowledges thefinancial support of the PwC Centennial Fellowship and the McCombs School of Business. Professor Marques gratefullyacknowledges the financial support of the Foundation for Science and Technology (PTDC/ECO/72021/2006) andINOVA.

Submitted: November 2011Accepted: May 2012

Published Online: August 2012Corresponding author: Ross G. Jennings

Email: ross.jennings@mccombs.utexas.edu

51

Board (FASB) and the International Accounting Standards Board (IASB). The Boards issued a joint

exposure draft for a new leasing standard in August 2010, and plan to issue a second exposure draft

in 2012.

The proposed standard would require lessees to record a ‘‘right-of-use asset’’ and associated

liability when entering into a noncancellable lease arrangement, bringing large amounts of currently

unrecognized assets and liabilities onto corporate balance sheets. Initial measurement for both the

asset and the liability would be at the present value of expected future lease payments. Subsequent

to initial recognition, the liability would be reduced using the effective interest method and the asset

would be amortized using a method that reflects the pattern of consumption of economic benefits,

with straight-line amortization as the default method if an alternative pattern cannot be reliably

determined. Relative to current standards, use of straight-line amortization for lease assets would

accelerate expense recognition, lowering net income during the early part of the lease’s life and on a

cumulative basis.

In their public comments on the exposure draft, a number of respondents argue that the

‘‘front-loading’’ of lease expense that would result from straight-line amortization will reduce

comparability across firms, because two companies with identical leased assets who are at different

years in the lease term, but are otherwise identical, will report different net income. To avoid this

outcome, to promote comparability, and to provide information that more faithfully represents the

future cash flows of these lease arrangements, some respondents have recommended setting

amortization of the lease asset equal to the reduction in principle of the lease liability, so that total

lease expense would be equal to the lease payment, mitigating or eliminating the effect on net

income of the new standard. This can be accomplished by utilizing a form of present value

amortization in place of straight-line amortization. While this argument appears to be

self-serving—to avoid the reduction in income the proposed standard would produce for firms

whose operating lease activity is growing—it is nevertheless supported by a long line of theoretical

research in accounting and economics, beginning with Hotelling (1925).

In this study, we examine the Boards’ choice of straight-line amortization as the default method

for amortizing lease assets. We conduct this analysis in two stages. In the first stage, we use stylized

examples to compare the two alternative amortization methods. In the second stage, we use a

sample of 34,707 firm-year observations drawn from 19 industries with substantial operating leases

for the years 1998–2008 to compare the two alternative amortization methods in terms of investor

valuations and their effect on financial statement comparability.

In the first stage, we conclude that whether alternative amortization methods provide relevant

and representationally faithful information to financial statement users depends on both the amount

and pattern of the expected future cash flows. In particular, under the assumption that lease assets

are zero net present value investments with certain future cash inflows, present value amortization

dominates straight-line amortization in providing representationally faithful information about the

future cash flows of the lease asset (Anton 1956; Feltham and Ohlson 1996). In contrast, when lease

assets are positive net present value investments, neither present value amortization nor straight-line

amortization clearly dominates the other in providing information that is representationally faithful

about future cash flows.

In the second stage, we first regress stock prices for sample firms on balance sheet components,

including the incremental asset that would be recorded if lease assets were valued on a present value

basis rather than a straight-line basis. For the sample as a whole, our results provide evidence that

investors view lease assets, on average, as positive net present value investments. We then repeat

the analysis for two subsamples of firms that vary on the basis of relative profit margin within their

industry. For firms in the higher profitability group, we find that investors view lease assets, on

average, as positive net present value investments. For firms in the lower profitability group, the

52 Jennings and Marques

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results are consistent with zero net present value lease assets that are amortized using present value

amortization.

Finally, we assess the effect of capitalizing operating leases and choice of amortization method

on financial statement comparability, using three common financial ratios. We find that capitalizing

operating leases substantially improves comparability regardless of amortization method, and that

the improvement is slightly greater using present value amortization.

Taken together, the results in this study provide no support for straight-line amortization over

present value amortization as the default method for amortizing capitalized operating leases. Rather,

our analyses indicate that operating leases are positive net present value investments for many firms

for which neither method is clearly favored over the other. In addition, for firms that are most likely

to have zero net present value leases, we find some evidence that investors value those firms

consistently with present value amortization. Finally, we find evidence that present value

amortization enhances comparability slightly more than straight-line amortization.

The next section summarizes prior research and comments on the proposed standard for lease

accounting. The third section describes a simple example that illustrates the difference between

straight-line amortization and present value amortization. The fourth section presents our main

empirical analysis, and concluding comments are provided in the fifth section.

BACKGROUND AND THE RESEARCH QUESTION

Prior Research

Research articles and textbooks have advocated ‘‘constructively capitalizing’’ operating leases

for many years, and generally agree that lease assets and liabilities should be recorded at the present

value of expected future lease payments, and the liabilities should be reduced over time using the

effective interest method (e.g., Imhoff et al. 1997; White et al. 2003; Stickney et al. 2007; Wild et

al. 2007; Easton et al. 2009; Revsine et al. 2009). There is less agreement on how to value the lease

asset over time. Some estimate the lease asset as equal to the lease liability (White et al. 2003;

Stickney et al. 2007; Wild et al. 2007; Easton et al. 2009), which is implicitly consistent with

amortization on a present value basis. Others explicitly amortize the lease asset on a straight-line

basis (Imhoff et al. 1997; Revsine et al. 2009).

A number of studies provide evidence on the materiality of capitalizing operating leases for

financial statement analysis in the U.S. (Imhoff et al. 1991), in the U.K. (Beattie et al. 1998), in

New Zealand (Bennett and Bradbury 2003), and in Canada (Durocher 2008). An additional line of

research focuses on the effect on measures of leverage and risk of omitting operating lease assets

and liabilities from the balance sheet (Imhoff et al. 1993; Ely 1995; Boatsman and Dong 2011;

Dhaliwal et al. 2011).

The Proposed Change to Lease Accounting

In 2010, the Financial Accounting Standards Board and the International Accounting Standards

Board jointly issued an exposure draft for a revised accounting standard for lease accounting

(FASB 2010). The Exposure Draft (ED) states that the objective of the proposed standard is ‘‘to

report relevant and representationally faithful information to users of financial statements about the

amounts, timing, and uncertainty of the cash flows arising from leases’’ (FASB 2010, para. 4). To

accomplish this, the ED requires lessees to record a liability and asset at commencement of the lease

that are both equal to the present value of expected future lease payments. Subsequently, the

liability is reduced as payments are made, using the effective interest method. Requirements for

amortizing the lease asset are provided in FASB (2010, para. 20):

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Accounting HorizonsMarch 2013

A lessee shall amortize the right-of-use asset on a systematic basis from the date of

commencement of the lease to the end of the lease term or over the useful life of the

underlying asset if shorter. The lessee shall select the amortization method . . . in

accordance with Topic 350.

Topic 350 provides the following guidance in 350-30-35-6:

A recognized intangible asset shall be amortized over its useful life to the reporting entity

unless that life is determined to be indefinite . . . The method of amortization shall reflect

the pattern in which the economic benefits of the intangible asset are consumed or

otherwise used up. If that pattern cannot be reliably determined, a straight-line

amortization method shall be used.

Thus, the ED requires straight-line amortization unless ‘‘the pattern in which the economic benefits

of the intangible asset are consumed’’ can be ‘‘reliably determined’’ by the reporting entity (FASB

2010).1 Relative to current practice, straight-line amortization for leased assets would accelerate

expense recognition, resulting in lower net income in the asset’s early years and cumulatively over

the asset’s life.

Reaction to the Proposed Changes

Predictably, many respondents to the ED reacted negatively to this outcome.2 For example, in a

typical letter, McDonald’s made the following comment:

The proposal significantly changes the pattern of income/expense recognition from both

the lessee and lessor perspective with the front loading of income/expense. We believe that

the proposed approach will provide less relevant information to users of our financial

statements and does not reflect the economics of the transactions.

In their letter, Starbucks argued that:

Recognizing higher occupancy cost in the early part of the lease compared to the latter part

is out of step with the underlying economics and would misrepresent net income. It would

not enhance a user’s ability to make comparisons among companies, and would

significantly complicate the ability to understand trends or forecast future results.

Finally, Toys‘R’Us argues that financial statement users will have to undo the effects of this

mismatching to make the financial statements more useful:

We feel these drastic changes in expense recognition will jeopardize the reliability and

comparability of our financial information, forcing financial statement users and investors

to continue adjusting our results to compensate for the front loading effect of the proposed

guidance.

Thus, respondents argue that straight-line amortization for lease assets will provide less-

relevant information that does not faithfully represent the economics of leasing arrangements, and

would reduce comparability across firms, requiring investors to continue adjusting financial

1 These requirements are consistent with the Boards’ preliminary view on this issue presented in FASB (2009a,para. 5.19). The Boards also considered valuing the lease assets at fair value, but decided to value them at cost tobe consistent with the measurement of other nonfinancial assets and to minimize complexity (FASB 2009a,paras. BC72–74). However, at the same time, the Boards concluded that ‘‘cost usually provides a reasonableapproximation to the fair value of the right-of-use asset at its inception’’ (FASB 2009a, para. BC72).

2 For a summary, see FASB (2011, paras. 67–68). Similar comments were made in response to the earlierDiscussion Paper; see FASB (2009b, paras. 44–46).

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Accounting HorizonsMarch 2013

statements for weaknesses in lease accounting.3 The primary alternative amortization method

proposed by respondents to the ED is present value amortization, also referred to as ‘‘economic,’’‘‘annuity,’’ and ‘‘mortgage-based’’ amortization. Under this method, amortization of the lease asset

is equal to the decline in value from one period to the next in the present value of the remaining

expected future lease payments, and total lease expense is equal to the lease payment. Applying this

method would eliminate the net income effect of the new standard.

Amortized Cost Alternatives

Present value amortization was considered by the Boards as part of the so-called ‘‘linked

approach,’’ under which ‘‘a lease that does not have the same economic effect as a loan and

purchase should be accounted for in a way that links the amortization of the asset and liability

arising from the lease’’ (FASB 2010, para. BC8(b)). The Boards rejected this alternative for three

reasons described in paragraph BC10 of the ED. First, the Boards decided that this alternative was

not consistent with the treatment for other financial liabilities, even though the liability treatment is

not different under this approach from the approach adopted by the Boards. Second, the Boards

rejected this alternative because they viewed that the values of the lease asset and liability should

not be necessarily linked subsequent to inception of the lease. However, subjecting the lease asset to

subsequent review for impairments, as the proposed standard requires (FASB 2010, para. 24),

results in asset and liability values that are not necessarily linked. Third, the Boards rejected this

alternative because ‘‘the treatment of amounts recognized in the income statement is inconsistent

with the boards’ view that the lessee has acquired a right-of-use asset and is paying for that right

over the term of the lease’’ (FASB 2010, BC10(c)). However, the only necessary distinction

between straight-line amortization and present value amortization is the amounts that remain on the

balance sheet and flow through the income statement as expense, not their consistency with the

right-of-use model.

During re-deliberation of the exposure draft at a joint Board meeting on February 28–29, 2012,

the FASB and IASB considered a third alternative amortization method, the underlying asset

approach (FASB 2012). This method is a blend of the straight-line and present value methods, and

produces a result that lies between the two. The pattern of amortization produced by the underlying

asset approach (UAA) varies with the portion of the underlying asset consumed during the lease

period, and is identical to straight-line (present value) amortization when all (none) of the

remaining life of the underlying asset is consumed during the lease period.

In this study, we compare the two alternative methods for applying amortized cost to lease

assets, straight-line amortization and present value amortization. We do not explicitly examine

UAA amortization because doing so would require us to estimate for each firm-year the average

portion of the underlying asset expected to be consumed during the lease period. However, because

UAA amortization is itself a weighted-average of straight-line amortization and present value

amortization, our results also allow for some inferences about UAA amortization.

Both straight-line amortization and present value amortization have strengths and weaknesses.

The principle strengths of the straight-line method are that it is simple to use and is commonly used

for other finite-lived intangible assets. Thus, it is not surprising that this is the method preferred by

standard setters and many others. However, there is little economic rationale for straight-line

amortization. In contrast, the present value method, although less familiar to most practicing

accountants, is also relatively simple to use and, as applied to depreciating physical assets, has a

3 Note that although ‘‘comparability’’ is not stated as an objective of the proposed standard in FASB (2010)paragraph 4, it is mentioned in the basis for conclusions in 14 separate paragraphs (BC6, BC10, BC72, BC74,BC77, BC83, BC84, BC94, BC125, BC137, BC182, BC188, BC189, and BC204).

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long history dating back to a famous paper by Hotelling (1925). Anton (1956) uses examples to

compare the pattern of present value depreciation to other common depreciation methods for

various patterns of future cash flows, and concludes in favor of present value depreciation. Present

value depreciation for physical assets was also the subject of an active discussion in the accounting

literature in the 1960s.4 More recently, Feltham and Ohlson (1996) discuss present value

depreciation as having ‘‘desirable’’ properties under conditions of zero net present value

investments with certain future cash flows.5

The intuition underlying present value depreciation for physical assets, as applied to lease

assets, is that otherwise-equivalent lease assets of different ages should earn about the same rate of

return. If shorter leases of the same asset earn a higher rate of return than longer leases, the price of

the shorter leases would be bid up until the rates of return are equalized. Conditional on estimates of

the amount and timing of expected future cash flows, present value amortization computes the

decline in value of the lease asset in such a way that the rate of return on the asset is equal over the

life of the lease, an outcome that will be achieved by straight-line amortization only if the expected

future cash flows follow a certain pattern. In contrast, present value amortization insures that the

lease’s rate of return is equal for each year of its life for any pattern of expected future cash flows, as

long as the lease asset is zero net present value and there is certainty about the amount and timing of

the future cash flows (Feltham and Ohlson 1996).

In the next section, we present a simple example of capitalizing an operating lease to

demonstrate (1) the differences between straight-line amortization and present value amortization,

and (2) the importance of whether the lease is a zero or positive net present value investment. In the

following section, we use a large sample of firms that rely on leasing to compare the two

amortization methods in terms of investor valuation and financial statement comparability.

EXAMPLES OF ALTERNATIVE AMORTIZATION METHODS

The Basic Example Assuming Zero Net Present Value

We illustrate the difference between straight-line amortization and present value amortization

using the following stylized example (presented in Table 1), which is consistent with the conditions

identified by Feltham and Ohlson (1996), zero net present value and certain future cash flows.

Assume a five-year lease with an option to renew for a second five years that is initially recorded as

a ten-year lease with annual payments of $1,000.6 The proposed accounting standard requires that

at inception of the lease, an asset and liability be recorded that are both equal to the present value of

the expected lease payments discounted at the lessee’s incremental borrowing rate (FASB 2010,

para. 12(a)). In this example, we assume a discount rate of 7 percent so that the initial present value

is $7,024, and under the proposed accounting in the exposure draft, the company will record an

asset and a liability for this amount. In subsequent years, the liability will be reduced by the amount

of the annual payment less the accrued interest expense for the current period, and the asset will

decline according to its amortization schedule (subject to potential impairments, which is a separate

issue and beyond the scope of this study).

4 In this discussion, authors generally favored using present value depreciation for physical assets, but differed insome details of application. See, for example, Coughlan (1959), Dixon (1960), Reynolds (1961), Bodenhorn(1961), Bierman (1961), and Staubus (1962).

5 The ‘‘desirable’’ properties are book value equal to market value, accounting earnings equal to economicearnings, and book rate of return equal to cost of capital. We demonstrate these features in our example below.

6 In this and the following examples, for computational convenience, we assume that all cash inflows and outflowsoccur at the end of each period. This assumption is not necessary for any of the conclusions we reach; rather, weonly need to assume that cash inflows and outflows follow the same pattern within each period (e.g., at beginningor end of period or evenly throughout the period) for both amortization methods.

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TABLE 1

Example of Alternative Amortization Methods for a Lease Asset

Panel A: Zero NPV Asset Straight-Line Amortization

Year of Lease

1 3 5 7 9

Cash Inflow 1,000 1,000 1,000 1,000 1,000

Straight-Line Amortization 702 702 702 702 702

Income Before Interest 298 298 298 298 298

Beginning Book Value � SL Amort 7,024 5,619 4,214 2,809 1,404

Rate of Return 4.2% 5.3% 7.1% 10.6% 21.2%

Beg MV Asset/Beg BV Asset 1.00 1.06 1.13 1.21 1.29

Panel B: Zero NPV Asset Present Value Amortization

Year of Lease

1 3 5 7 9

Cash Inflow 1,000 1,000 1,000 1,000 1,000

Present Value Amortization 508 582 666 763 873

Income Before Interest 492 418 334 237 127

Beginning Book Value � PV Amort 7,024 5,971 4,767 3,387 1,808

Rate of Return 7.0% 7.0% 7.0% 7.0% 7.0%

Beg MV Asset/Beg BV Asset 1.00 1.00 1.00 1.00 1.00

Panel C: Positive NPV Asset Straight-Line Amortization

Year of Lease

1 3 5 7 9

Cash Inflow 1,500 1,500 1,500 1,500 1,500

Straight-Line Amortization 702 702 702 702 702

Income Before Interest 798 798 798 798 798

Beginning Book Value � SL Amort 7,024 5,619 4,214 2,809 1,404

Rate of Return 11.4% 14.2% 18.9% 28.4% 56.8%

Beg MV Asset/Beg BV Asset (SL) 1.50 1.59 1.70 1.81 1.93

Panel D: Positive NPV Asset Present Value Amortization

Year of Lease

1 3 5 7 9

Cash Inflow 1,500 1,500 1,500 1,500 1,500

Present Value Amortization 508 582 666 763 873

Income Before Interest 992 918 834 737 627

Beginning Book Value � PV Amort 7,024 5,971 4,767 3,387 1,808

Rate of Return 14.1% 15.4% 17.5% 21.8% 34.7%

Beg MV Asset/Beg BV Asset (SL) 1.50 1.50 1.50 1.50 1.50

(continued on next page)

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Table 1 presents two alternative amortization schedules for this lease asset. The first is straight-

line amortization and is presented in Panel A. In this example, we assume the lease asset is a zero

net present value investment, with net cash inflows that are equal in amount and timing to the lease

payments and that are discounted at the same incremental borrowing rate of 7 percent. In this

example, straight-line amortization is $702.40 per year for each of the ten years.

In this case, total expense from the lease is greater than the lease payment in the early years of

the lease and less in the later years. For example, total lease expense in the first (last) year of the

lease’s life is the sum of interest expense of $491.65 ($65.42) and amortization expense of $702.40

($702.40), which is equal to $1,194.05 ($767.82) and greater (less) than the lease payment of

$1,000. Moreover, the rate of return on the lease asset grows over time, from 4.2 percent in the first

year to 21.2 percent in the ninth year. As noted as far back as Hotelling (1925), this is unlikely to

reflect the underlying economic value of the leased asset, where market forces should insure that the

asset generates a stable rate of return over its life.

The final line of Panel A reports the ratio of the market value of the lease asset to its book

value.7 This ratio is 1.00 at inception of the lease, but slowly rises over the life of the lease as the

book value of the lease asset under straight-line amortization falls more rapidly than its market

value. By the ninth year, this ratio is 1.29, indicating that the asset’s book value is substantially

below its market value.

The second alternative is present value amortization, under which the asset value each year is

the present value of the remaining cash payments, and the value of the lease asset declines at the

same rate as the lease liability. This is represented in Panel B of Table 1, where we continue to

assume that the amount and timing of the cash inflows are equal to the lease payments. In this case,

amortization expense is lower in the early years of the asset’s life and higher in later years, and total

lease expense equals the lease payment each year.8 More importantly, the rate of return is the same

TABLE 1 (continued)

This table presents four examples of alternative combinations of (1) the pattern of cash inflows over the life of a ten-year

lease, and (2) the amortization of the lease asset. In the first two cases, the present value of the future cash inflowsgenerated by the lease is $7,024, so that the lease is a zero net present value investment. In the last two cases, the presentvalue of the future cash inflows generated by the lease is $10,535, so that the lease is a positive net present valueinvestment. In all four cases, net income is cash inflow minus amortization, and rate of return is net income divided bybeginning book value of the lease asset.In Panel A, the cash inflows are constant at $1,000 each year for ten years, and straight-line amortization each year is 10

percent ($702) of the original lease value.In Panel B, the cash inflows are constant at $1,000 each year for ten years, and present value amortization each year is

equal to the decline in present value of the remaining future cash flows from beginning to end of period.In Panel C, the cash inflows are constant at $1,500 each year for ten years, and straight-line amortization each year is 10

percent ($702) of the present value of the lease payments.In Panel D, the cash inflows are constant at $1,500 each year for ten years, and present value amortization each year is

equal to the decline in present value of the remaining future lease payments from beginning to end of period.

7 Throughout the examples illustrated in Table 1, we assume that the market has the same expectations of thefuture cash inflows from the lease as the lessee, and uses the lessee’s incremental borrowing rate to discount theexpected future cash inflows. We also assume that those shared expectations do not change over time and arefully realized each period, consistent with the certainty condition in Feltham and Ohlson (1996).

8 For example, under present value amortization, total lease expense in the first (last) year of the lease’s life is thesum of interest expense of $492 ($65) and amortization expense of $508 ($935), which is equal to $1,000($1,000), the amount of the lease payment. This example is similar to Case I in Anton (1956).

58 Jennings and Marques

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in every year, equal to the discount rate of 7 percent. The last line in Panel B reports that the market

value and book value of the lease asset are equal each year over the life of the lease.

In Appendix A, we apply the underlying asset approach (UAA) to amortization of lease assets

to this example. This extension demonstrates that UAA amortization is a weighted-average of

straight-line amortization and present value amortization, and will be equal to straight-line (present

value) amortization if, during the lease, all (none) of the remaining life of the underlying asset is

consumed. Thus, under this method, a lease that is for the entire life of the asset and is, essentially, a

purchase of the asset, will be amortized on a straight-line basis, while a lease that is for land, in

which none of the asset’s remaining life is consumed, will be amortized on a present value basis.9

Taken together, these results indicate that for this stylized example, present value amortization

provides information that faithfully represents the future cash flows of the lease asset, and is

comparable across firms that have similar leased assets with remaining leases of different lengths. In

contrast, this is generally not the case for straight-line amortization (as shown in Panel A of Table 1)

or for the underlying asset approach (as shown in the Appendix A). Feltham and Ohlson (1996,

209–210) describe these characteristics (book value equal to market value and stable rate of return)

as potentially ‘‘desirable’’ outcomes of present value depreciation. A stable rate of return and book

value equal to market value is possible with straight-line amortization, but only if the future net cash

inflows are expected to follow a particular pattern of decline over the life of the lease.10 In contrast,

any pattern of net cash inflows that has a present value of $7,024 will produce a stable rate of return

and book value equal to market value under present value amortization.

An additional feature of present value amortization (Panel B) is that this method does not require

gains and losses to be recorded when expectations about the term or payments for the lease are

subsequently changed. This is especially important because under the proposed standard, both the

term and the amount of future payments may be uncertain estimates at the inception of the lease. In

the example above, if, at the end of the first five years, the lessee decides not to renew the lease, the

remaining lease liability and asset would need to be reversed. Under straight-line amortization (Panel

A), the value of the lease liability is greater than the value of the lease asset at the end of the fifth year

(and throughout the life of the lease), so that failure to renew would result in the lessee recording a

one-time gain. In contrast, under present value amortization (Panel B), the liability and the asset have

the same value, so there would be no gain or loss for reversing the lease asset and liability.

The Extended Example Assuming Positive Net Present Value

All of the above discussion assumes that leased assets are zero net present value investments;

i.e., that the present value of the cash inflows and the present value of the lease payments are equal

when both are discounted using the lessee’s incremental borrowing rate. This is a reasonable

assumption for highly competitive markets. However, it is possible that in some markets, lessees are

able to negotiate lease terms that permit them to earn abnormal profits on their lease assets, so that

the present value of the cash inflows is greater than the present value of the lease payments. We

examine this possibility next, in Panels C and D of Table 1, where the original example is adjusted

to result in a positive net present value investment by increasing the annual net cash inflows from

$1,000 to $1,500, while keeping the lease payments at $1,000 per year. This results in a market

9 Further examples of this approach are available in IASB (2012a, 2012b). In IASB (2012a), the airplane(building) example is based on the unstated assumption that the eight- (ten-) year lease begins when there is 18(45) years remaining in the asset’s life. In IASB (2012b), the equipment example is based on the unstatedassumption that the five-year lease begins when there is ten years remaining in the asset’s life.

10 Examples of this can be seen in Anton (1956, Case III) and Feltham and Ohlson (1996, Appendix A.2).

Amortized Cost for Operating Lease Assets 59

Accounting HorizonsMarch 2013

value for the leased asset that is greater than the book value, both at acquisition and throughout the

lease term, regardless of which amortization method is used.

The pattern of results in Panel C, for straight-line amortization, is similar to the pattern of

results reported in Panel A for a zero net present value investment. However, when the lease is

positive net present value, the increase in the rate of return over the life of the lease is more dramatic

and the ratio of the market value of the lease asset to its book value is larger, 1.93 in the ninth year

in Panel C, compared to 1.29 in the ninth year in Panel A. Thus, the distortion between the

accounting for the lease asset and the underlying economics is greater when the lease is a positive

net present value investment rather than zero net present value.

The pattern of results in Panel D, for present value amortization, contrasts with the pattern of

results in Panel B. In the positive net present value case, the rate of return for the lease asset is rising

over time, much as with straight-line amortization, and the market value of the lease asset is a

constant multiple of its book value. Thus, in this case, the market value of the asset exceeds the

book value regardless of whether straight-line or present value amortization is used, although the

distortion is less in both magnitude and variability for present value amortization. However, this

suggests that relative to zero net present value leases, for positive net present value leases, both

alternatives provide information that is less comparable across firms and less faithfully represents

the future cash flows of the lease asset.11

Taken together, the results for the simple examples presented in Table 1 indicate that under

‘‘ideal’’ conditions, when the lease asset is a zero net present value investment, present value

amortization produces information that is more comparable and that more faithfully represents the

future cash flows of the lease asset. On the other hand, when the lease asset is a positive net present

value investment, both alternatives provide less useful information. Although the ideal conditions

assumed in the examples are very restrictive, the examples demonstrate that, in general, the closer

that lease arrangements are to these ideal conditions, the more likely present value amortization will

provide more useful information about lease assets than straight-line amortization. Moreover, there

are no conditions under which straight-line amortization provides more useful information than

present value amortization.12 In the next section, we provide empirical evidence on how these two

amortization methods relate to investor valuation, and how they affect financial statement

comparability across firms within industries.

EMPIRICAL ANALYSIS

The Sample

We begin our sample selection process with all firms for which there are data in the Compustat

database for the period from 1998 to 2008. We require all observations to have data for our main

variables of analysis (defined below): EPS, Price, Inc_Adj, A, L, LA_Adj, and Profit_Mg. This

results in a sample of 41,753 observations.13

11 An alternative implementation of present value amortization that results in a stable rate of return and book valueequal to market involves using the internal rate of return, rather than the incremental borrowing rate, as thediscount rate and recording a gain at inception for positive net present value leases. However, this alternative wasrejected by the Boards in their decision to value the lease asset at cost rather than fair value (see FASB 2010,para. BC72).

12 This conclusion can be extended to the underlying asset approach (UAA) to amortization. As we demonstrate inthe Appendix A, UAA amortization is a weighted-average of straight-line and present value amortization, so thatas with straight-line amortization, there are no conditions under which UAA amortization provides more usefulinformation than present value amortization.

13 This initial sample excludes 305 observations with unusually high average expected lives for their lease assets ofmore than 45 years based on our algorithm (see below).

60 Jennings and Marques

Accounting HorizonsMarch 2013

Next, we control for influential observations by removing 3,356 observations in the 1 percent

tails for the variables mentioned above. Finally, we divide the observations into industry groups on

the basis of four-digit GICS (Global Industry Classification Standard) codes, and we identify

industries for which operating leases are a substantial part of the operations for the average firm in

the industry. We retain only industries with at least 500 firm-year observations and for which theaverage ratio of future lease payments to total assets is at least 0.05. This results in a final sample of

34,707 observations in 19 different industries.

Table 2 presents for each industry the number and percent of firm-year observations, the

average ratio of total future expected lease payments to total assets, the average expected life of a

leased asset, and the lease assets to lease liabilities ratio (ALR, discussed below). Three industries

each contribute more than 10 percent of the observations in our sample: software and services,technology hardware and equipment, and capital goods. The retailing industry has the largest ratio

of expected future lease payments to total assets (58.3 percent), followed by consumer services

(38.7 percent), and transportation (24.9 percent).

The average expected life for lease assets is the number of years for which we have expected

future cash flows following the algorithm described below. This length varies from 12.42 years for

the real estate industry to 6.22 years for the software and services industry.

Variable Construction

In our empirical analysis, we focus on the balance sheet rather than the income statement.

Although respondents to the exposure draft comment more on the income statement effects of

straight-line amortization than the balance sheet effects, empirically, the balance sheet effects are

more material and easier to estimate. This is because straight-line amortization records more

expense than present value amortization in the early part of the lease and less expense in the laterpart of the lease, and the two expense amounts are approximately equal at the midpoint of the lease.

In contrast, the dollar difference in asset values is near its peak at the midpoint of the lease, and any

estimation error will be only in amount, not in direction.14

We estimate the value of off-balance sheet lease assets (LA) and lease liabilities (LL) for sample

firms based on disclosures of the minimum lease payments the firm is currently required to make for each

of the next five fiscal years (Pmttþ1 . . . Pmttþ5), as well as a lump sum for all years beyond the fifth year(PmtT). Following Imhoff et al. (1997), we assume that the expected payment in the fifth year continues

in the sixth year and beyond, until all of the ‘‘thereafter’’ payments are accounted for. We use a constant

interest rate across the sample (7 percent) to discount the expected future lease payments, and this present

value is our estimate of the off-balance sheet lease liability (LL) that will be added to the balance sheet.

We construct two alternative specifications for the off-balance sheet lease asset. The first is based

on present value amortization and is equal to the lease liability (LA_PV¼LL). The second is based onstraight-line amortization (LA_SL). For this estimate, we recognize that the value of the lease asset will

decline more quickly after inception of the lease than the value of the lease liability, and we compute an

observation-specific estimate of the ratio between the lease asset and lease liability (ALR) as follows:

ALR ¼

1� ð1þ rÞ�N

r

Rem

N

� �

1� ð1þ rÞ�Rem

r

:

14 Using the examples in Panels A and B of Table 1 to illustrate these points, in year 5 lease expense under straight-line amortization is $1,036, 3.6 percent higher than present value amortization, while in year 6 lease expenseunder straight-line amortization is $989, 1.1 percent lower than present value amortization. In contrast, in year 5the lease asset is $588 higher on a present value basis and is still $578 higher in year 6.

Amortized Cost for Operating Lease Assets 61

Accounting HorizonsMarch 2013

The numerator of this ratio (the relative asset value) is equal to the present value of a one-dollar

annuity for the original life of the lease (N years) times the ratio of the remaining years (Rem) to the

original life of the lease (N). The denominator of this ratio (the relative liability value) is equal to

the present value of a one-dollar annuity for the remaining years of the life of the lease (Rem). For

this calculation, we assume that the original life of the lease (N) is the number of years for which we

have expected future cash flows (5þPmtT/Pmttþ5) rounded up to the next integer. We assume that

TABLE 2

Observations for Each Industry and Average Ratio of Future Expected LeasePayments to Total Assets

SIC Industry Obs. % P/Assets Life ALR

1510 Materials 1,971 5.68 0.055 7.53 0.891

2010 Capital Goods 3,702 10.67 0.065 6.97 0.898

2020 Commercial and Prof. Services 1,659 4.78 0.155 6.88 0.898

2030 Transportation 693 2.00 0.249 8.15 0.883

2510 Automobiles and Components 579 1.67 0.052 6.84 0.899

2520 Consumer Durables and Apparel 1,998 5.76 0.093 6.54 0.903

2530 Consumer Services 1,558 4.49 0.387 9.97 0.864

2540 Media 1,276 3.68 0.136 8.03 0.884

2550 Retailing 1,935 5.58 0.583 8.58 0.877

3020 Food, Beverage, and Tobacco 1,063 3.06 0.064 7.50 0.892

3030 Household and Personal Products 579 1.67 0.124 6.25 0.907

3510 Health Care Eq. and Services 3,159 9.10 0.128 6.44 0.905

3520 Pharm., Biotech., and Life Sciences 2,683 7.73 0.136 6.70 0.902

4020 Diversified Financials 1,127 3.25 0.111 7.23 0.894

4040 Real Estate 705 2.03 0.057 12.42 0.847

4510 Software and Services 3,862 11.13 0.152 6.22 0.907

4520 Technology Hardware and Eq. 3,760 10.83 0.092 6.33 0.906

4530 Semiconductors and Semicond. Eq. 1,487 4.28 0.057 6.92 0.899

5010 Telecommunication Services 911 2.62 0.114 7.80 0.889

Total 34,707

This table presents, for each industry and for the full sample, the number of firm-year observations (Obs.) and the percentof total sample observations (%).

Variable Definitions:P/Assets ¼ average ratio of future lease payments to total assets;Life¼ average expected life of a lease. It is computed as the number of years for which each firm-year discloses future

lease payments, assuming that the payment to be made in the fifth out-year continues until all subsequent paymentsare accounted for; and

ALR ¼ average ratio of the leased asset to the leased liability. It is computed as the formula below indicates. In thisformula, N is the number of years for which we have expected future cash flows, which is equal to 5þPmtT/Pmttþ5

rounded up to the next integer, and Rem ¼ N/2:

ALR ¼

1� ð1þ rÞ�N

r

Rem

N

� �

1� ð1þ rÞ�Rem

r

:

62 Jennings and Marques

Accounting HorizonsMarch 2013

the remaining years of the life of the lease (Rem) is one-half of its original life (Rem¼N/2).15 Thus,

the value of the lease asset that is added to the balance sheet under straight-line amortization is

given by LA_SL ¼ LL � ALR. Average values for ALR are reported for each industry in the final

column of Table 2. This ratio varies from 0.847 for real estate to 0.907 for software and services

and household and personal products.

Allowing the value of the lease asset to differ from the value of the lease liability implies that

both net income and deferred tax assets will be affected. We assume that the expense for operating

leases for tax purposes is the amount of the lease payment, while the expense for reporting purposes

is the sum of the interest expense portion of the payment and the current period amortization of the

lease asset. This accelerates operating lease expense for reporting purposes relative to operating

lease expense for tax purposes and results in a deferred tax asset, which we denote as LDTA¼ (LL�LA_SL)(T), where T is the statutory tax rate, which we assume to be 35 percent, the current

maximum statutory tax rate for corporations.16

Regressions of Security Price on Balance Sheet Components

We use the following regression each year to estimate the valuation multiple for the

incremental lease asset that would be recorded under present value amortization:17

Price ¼ c0 þ c1ðAþ LA SLþ LDTAÞ þ c2ðLþ LLÞ þ c3LA Adj þ e; ð1Þ

where Price is the price per share of common equity on the last day of the current fiscal year, A (L)

is equal to recorded assets (liabilities), and LL, LA_SL, and LDTA are as defined above. Our primary

variable of interest, LA_Adj, is equal to (LA_PV � (LA_SLþ LDTA)). This is the additional asset

that would be recorded if present value amortization were used, rather than straight-line

amortization. All variables are on a per-share basis. The average across the sample for LA_Adj is

11.24 cents per share.18

In Regression (1), we expect a positive coefficient estimate for assets and a negative coefficient

estimate for liabilities. In both cases, the theoretical value for the coefficient is 1.19 Our main focus

is on the coefficient estimate for LA_Adj. If investors view lease assets as zero net present value

investments and value them on a straight-line basis, the coefficient estimate on this variable should

15 This assumption explicitly assumes that the average lease asset is at the midpoint of its expected useful life. Thisdiffers from textbook presentations in White et al. (2003), Wild et al. (2007), and Easton et al. (2009), where thelease asset is amortized over the number of projected future payments, which implicitly assumes the averagelease asset is at the beginning of its expected useful life.

16 This procedure for adjusting the balance sheet for operating leases is generally consistent with the proceduredescribed by Imhoff et al. (1997). Revsine et al. (2009) follow a similar procedure, but ignore the tax effect.

17 Alternative versions of valuation regressions that include as independent variables only balance sheetcomponents (such as Regression (1)) have been used commonly in prior research to address a wide range ofaccounting issues. Examples from earlier research include studies of pension accounting (Barth 1991), fair valueaccounting for banks (Barth 1994; Nelson 1996; Eccher et al. 1996), inventory accounting (Jennings et al. 1996),accounting for post-employment benefits (Choi et al. 1997; Davis-Friday et al. 1999), accounting for deferredtaxes (Ayers 1998), and oil and gas accounting (Boone 2002). This analysis explicitly assumes that investors (1)are aware of the information available in the footnotes about estimated lease payments, and (2) use thatinformation to adjust the financial statements as if operating leases were recognized as assets and liabilities. DeFranco et al. (2011) provide corroborating evidence of investor attention to footnote information concerningoperating leases.

18 The pair-wise correlations between LA_Adj and (A þ LA_SL þ LADT) and (L þ LL) are 0.306 and 0.300,respectively, suggesting the potential for collinearity in the annual estimations of Regression (1). However,statistical tests are based on cross-year standard errors of the annual coefficient estimates, which are not affectedby collinearity in the annual regressions.

19 This will be the case if amortized cost (book value) equals market value, and is consistent with zero net presentvalue assets.

Amortized Cost for Operating Lease Assets 63

Accounting HorizonsMarch 2013

be 0. In contrast, if investors view the lease assets as zero net present value investments and value

them on a present value amortization basis, then the coefficient estimate on this variable should be

positive and about equal to 1. Finally, if investors view lease assets as positive net present value

investments, then the coefficient estimate on this variable should be greater than 1 regardless of the

amortization method implicitly used, consistent with the examples in Panels C and D of Table 1.20

The average results for estimation of Regression (1) each year are reported in Table 3, where t-

statistics are based on the cross-year coefficient distribution. The average coefficient estimates for

total assets and total liabilities are 0.96 (t ¼ 17.92) and �0.87 (t ¼�15.24), respectively, and the

average R2 is 0.35. These results are consistent with those presented in prior research for similar

regressions.

Our main focus is the average coefficient estimate for LA_Adj, the net asset difference between

accounting for lease assets using present value amortization and accounting for lease assets using

straight-line amortization. This average coefficient estimate is 2.16 (t¼ 3.45), which is significantly

greater than both 0 (p-value ¼ 0.003, one-tailed) and 1 (t ¼ 1.86, p-value ¼ 0.046, one-tailed).21

This suggests that investors view lease assets for our sample, on average, as positive net present

value investments.

To examine this possibility more carefully, we divide the sample into two groups based on

whether their profit margin (ratio of net income to net revenue) is above or below the median profit

margin for that industry. Observations in the higher (lower) profitability group are earning a higher

(lower) return on their overall operations and, by extension, are more likely to have lease assets that

are positive (zero) net present value investments.

Table 4 reports the median profit margin for each industry, and the median for each profitability

subgroup within each industry. We observe substantial within-industry variation in profit margins,

consistent with the idea that profit margin may capture meaningful differences in the extent to which

TABLE 3

Regressions of Security Price on Balance Sheet Components Including the Adjustment to NetAssets for Constructively Capitalizing Operating Leases Using Straight-Line Amortization

Rather than Present Value Amortization

Regression 1: Including Adjustment for Leases

Intercept Assets Liabilities Asset Adj. R2

Avg. Coeff. 8.00 0.96 �0.87 2.16

t-statistic (14.01) (17.92) (�15.24) (3.45) 0.35

This table presents average coefficient estimates for the following regression for the years 1999 to 2008:Price ¼ c0 þ c1ðAþ LA PV þ LDTAÞ þ c2ðLþ LLÞ þ c3LA Adj þ e ð1Þwhere Price is the price per share of common equity on the last day of the current fiscal year, A (L) is equal to recordedassets (liabilities), LL is lease liability, and LA_PV is lease asset on a present value basis (equal to LL). LA_Adj is equal to(LL� (LA_SLþLDTA)), where LA_SL is equal to the estimated lease asset on a straight-line basis and LDTA is equal tothe deferred tax asset. All variables are on a per-share basis. t-statistics are based on the standard deviation of thedistribution of annual coefficient estimates.For the column headings in the table: Assets ¼ Aþ LA_PV þ LDTA, Liabilities ¼ Lþ LL, and Asset Adj. ¼ LA_Adj.

20 While we are unable to explicitly test amortization based on the underlying asset approach, results for thatapproach would be similar to straight-line (present value) amortization to the extent that the portion of theunderlying asset consumed during the lease period is high (low).

21 All p-values are two-tailed unless specifically indicated otherwise. One-tailed tests are reported when thealternative hypothesis is directional.

64 Jennings and Marques

Accounting HorizonsMarch 2013

lease investments are positive net present value investments for firms in these industries that make

extensive use of operating leases. The median industry profit margin for the high profit margin group

is 0.072, while the median for the low profit margin group is �0.041, and these two medians are

statistically different (p-value , 0.000). This suggests that lease assets for the high (low) profit

margin group may be more likely to be positive (zero) net present value investments, on average.22

Next, we re-estimate a version of Regression (1) each year that permits separate coefficients for

each variable, including the intercept, for each profitability group, as follows:

Price ¼Ri¼1;2½c0þiDi þ c1þiDiðAþ LA PV þ LDTAÞ þ c2þiDiðLþ LLÞ þ c3þiDiðLA AdjÞ� þ e:

ð2Þ

Di is an indicator variable that takes the value of 1 for observations in the ith (first or second)

profitability group, and 0 otherwise. All other variables are as defined above.

TABLE 4

Median Profit Margin for Each Industry and for High and Low Profit Margin Subgroupswithin Each Industry

SIC IndustryMedian for

Industry

Median forHigh Profit

Margin Group

Median forLow Profit

Margin Group

1510 Materials 0.033 0.073 �0.022

2010 Capital Goods 0.033 0.065 �0.009

2020 Commercial and Prof. Services 0.022 0.062 �0.030

2030 Transportation 0.035 0.078 0.008

2510 Automobiles and Components 0.012 0.040 �0.049

2520 Consumer Durables and Apparel 0.030 0.064 �0.019

2530 Consumer Services 0.039 0.082 �0.022

2540 Media 0.012 0.087 �0.148

2550 Retailing 0.025 0.052 0.000

3020 Food, Beverage, and Tobacco 0.033 0.064 0.004

3030 Household and Personal Products 0.027 0.072 �0.088

3510 Health Care Eq. and Services 0.017 0.071 �0.189

3520 Pharm., Biotech., and Life Sciences �0.740 0.036 �3.605

4020 Diversified Financials 0.076 0.178 �0.041

4040 Real Estate 0.102 0.225 0.013

4510 Software and Services �0.008 0.083 �0.365

4520 Technology Hardware and Eq. 0.004 0.064 �0.171

4530 Semiconductors and Semicond. Eq. 0.029 0.117 �0.153

5010 Telecommunication Services 0.017 0.106 �0.177

Column Median 0.027 0.072 �0.041

This table presents, for each industry, the industry median profit margin and the median profit margin for the high andlow profit margin subgroups within each industry. The high (low) profit margin observations are above (below) theindustry median each year. Profit margin is the ratio of net income to sales revenue for that firm-year observation.

22 The low median profit margin for the low profitability group for the pharmaceutical industry (�3.605) and, to alesser extent, for the software and services industry (�0.365) is due to early-stage companies with very littlerevenue.

Amortized Cost for Operating Lease Assets 65

Accounting HorizonsMarch 2013

The results are reported in Table 5. For the lower profitability group, the average coefficient

estimate for LA_Adj is 1.17, which is marginally statistically greater than 0 (t ¼ 1.67, p-value ¼0.063, one-tailed), but not significantly greater than 1 (t¼ 0.24, p-value¼ 0.408, one-tailed). This

provides weak evidence, consistent with zero net present value lease assets for this group, that

investors implicitly value using present value amortization.23

The results are much different for the higher profitability group. For this group, the average

coefficient estimate is 4.67, which is statistically greater than both 0 (t¼ 4.08, p-value¼0.001, one-

tailed) and 1 (t¼3.21, p-value¼0.005, one-tailed). For this group, the results indicate that investors

view lease assets as positive net present value investments.24

The results in this section indicate that there is substantial variation across observations based

on profit margin in how investors implicitly value lease assets. For firms in the higher profitability

group, investors view lease assets as positive net present value investments, for which neither

straight-line amortization nor present value amortization will faithfully represent the underlying

economics. For firms in the lower profitability group, there is some evidence suggesting that (1)

lease assets are zero net present value investments, and (2) investors implicitly value lease assets

TABLE 5

Regressions of Security Price on Balance Sheet Components Including the Adjustment to NetAssets for Constructively Capitalizing Operating Leases Using Straight-Line Amortization

Rather than Present Value Amortization

Regression 2: Including Profitability Interactions

Intercept Assets Liabilities Asset Adj R2

Low PM Group

Coefficient 4.90 0.70 �0.60 1.17

t-statistic (8.19) (17.97) (�12.42) (1.67)

High PM Group

Coefficient 10.31 1.20 �1.13 4.67 0.67

t-statistic (17.04) (28.74) (�23.04) (4.08)

This table presents average coefficient estimates for the following regression for the years 1999 to 2008:

Price ¼ Ri¼ 1; 4½c0þiDi þ c1þiDiðAþ LA PV þ LDTAÞ þ c2þiDiðLþ LLÞ þ c3þiDiðLA AdjÞ� þ e; ð2Þ

where Price is the price per share of common equity on the last day of the current fiscal year, A (L) is equal to recordedassets (liabilities), LL is lease liability, and LA_PV is lease asset on a present value basis (equal to LL). LA_Adj is equal to(LL� (LA_SLþLDTA)), where LA_SL is equal to the estimated lease asset on a straight-line basis and LDTA is equal tothe deferred tax asset. High (low) profit margin groups are observations that are above (below) the industry median profitmargin that year, where profit margin is the ratio of net income to sales revenue. All variables are on a per-share basis. t-statistics are based on the standard deviation of the distribution of annual coefficient estimates.For the column headings in the table: Assets ¼ Aþ LA_PV þ LDTA, Liabilities ¼ Lþ LL, and Asset Adj. ¼ LA_Adj.

23 This evidence is weak in two ways. First, in the statistical sense, the standard error is large relative to thecoefficient estimate, providing weak tests of whether the coefficient estimate is different from either 0 or 1. Also,in terms of interpretation, although the results are consistent with investors viewing the lease assets for thesefirms as 0 net present value projects that are valued on a present value basis, we cannot rule out the alternativethat investors view these projects as positive net present value projects that are valued on a straight-line basis.

24 Note that the effect of allowing the regression coefficients to vary between the high and low profitability groupsis to raise the average R2 from 0.35 for Regression (1) to 0.67 for Regression (2).

66 Jennings and Marques

Accounting HorizonsMarch 2013

for these firms using present value amortization. Overall, this analysis provides no evidence in

support of requiring straight-line amortization as the default amortization method for operating

leases.

Financial Statement Comparability

In this section, we provide empirical evidence on the effect on comparability of capitalizingoperating leases and using either straight-line amortization or present value amortization. Weoperationalize comparability using the within-industry standard deviations for three commonfinancial ratios that measure return on assets, asset turnover, and financial leverage. An accountingmethod that lowers the within-industry standard deviation for an important financial ratio can besaid to enhance comparability, because that method results in similar companies (based on common

industry membership) appearing more similar (based on a lower within-industry standarddeviation). Thus, if capitalizing and amortizing operating leases results in financial statements thatare more comparable, we expect the within-industry standard deviation for these three ratios will belower after constructively capitalizing operating leases on the balance sheet relative to using as-reported numbers. Similarly, if one method of amortizing capitalized operating leases results infinancial statements that are more comparable than another method, we expect the within-industrystandard deviation for these three ratios will be lower when using asset and liability numbers based

on the first method rather than the second method.

For this analysis, return on assets is the ratio of net income to beginning-of-period total assets,asset turnover is the ratio of net sales to beginning-of-period total assets, and financial leverage isthe ratio of beginning-of-period total liabilities to beginning-of-period total assets. To compute the

average standard deviation for each industry in the sample, we first compute each ratio for eachfirm-year in the sample, then compute the standard deviation for each ratio within each industry andyear, and then average these standard deviations across years.

The results are reported in the first three columns of Table 6. Overall, it is apparent that thewithin-industry variation for all three ratios declines substantially from the as-reported column to

the straight-line column, and then declines further from the straight-line column to the present valuecolumn. For example, the average within-industry standard deviation for asset turnover on an as-reported basis is 1.842, which falls by 28.2 percent to 1.323 when total assets is computed aftercapitalizing operating leases and amortizing them on a straight-line basis. We then observe a furtherreduction by 0.6 percent to 1.315 when total assets is computed after capitalizing operating leasesand amortizing them on a present value basis.

In the fourth and fifth columns of Table 6, we report the average and median across the 19industries for the differences in the within-industry standard deviation between as-reported andstraight-line amortization and present value amortization for capitalized operating leases,respectively. We also report the frequency of positive and negative differences across the 19

industries, and the associated p-values based on a binomial distribution and the null hypothesis ofequal probability for positive and negative differences. For all three ratios, the within-industrystandard deviations are reduced for at least 18 of the 19 industries for both straight-lineamortization and present value amortization, and this is significant at less than the 0.001 level in allsix cases.25

Most importantly, the final column in Table 6 compares the within-industry standard deviation

for ratios based on amortizing operating leases using straight-line amortization with ratios based on

amortizing operating leases using present value amortization. We find that even though the

differences are generally small, the within-industry standard deviations are reduced for at least 18 of

25 The only case in which the within-industry standard deviation did not decline for straight-line amortization,relative to as-reported, is for financial leverage in the real estate industry, which increased from 0.215 to 0.352.

Amortized Cost for Operating Lease Assets 67

Accounting HorizonsMarch 2013

the 19 industries when replacing straight-line amortization with present value amortization, and this

is significant at less than the 0.001 level for all three ratios.26 This indicates that comparability of

financial statements is no worse when operating leases are amortized on a present value basis

relative to a straight-line basis, and may be slightly improved. Thus, this analysis provides no

TABLE 6

Within-Industry Standard Deviation for Three Common Financial RatiosAs-Reported, Using Straight-Line Amortization, and Using Present Value Amortization

RatioAs-Reported

Avg. Std. Dev.SL Avg.Std. Dev.

PV Avg.Std. Dev.

Diff.As-Reported

versus SL

Diff.As-Reported

versus PVDiff. SL

versus PV

Return on Assets

Average 1.149 0.567 0.563 0.582 0.587 0.004

Median 0.687 0.574 0.571 0.126 0.131 0.003

Pos. Differences 19 19 19

Neg. Differences 0 0 0

p-value ,0.001 ,0.001 ,0.001

Asset Turnover

Average 1.842 1.323 1.315 0.519 0.527 0.008

Median 1.269 1.120 1.115 0.174 0.202 0.006

Pos. Differences 19 19 18

Neg. Differences 0 0 1

p-value ,0.001 ,0.001 ,0.001

Financial Leverage

Average 0.616 0.467 0.447 0.149 0.168 0.020

Median 0.518 0.410 0.407 0.102 0.094 0.004

Pos. Differences 18 19 18

Neg. Differences 1 0 1

p-value ,0.001 ,0.001 ,0.001

This table presents average and median within-industry standard deviations and differences in within-industry standarddeviations for three financial ratios. The average within-industry standard deviation for each industry ratio is computed byfirst computing the standard deviation for each ratio for each industry each year, and then averaging across years. Returnon Assets is net income divided by beginning-of-period total assets. Asset Turnover is net sales divided by beginning-of-period total assets. Financial Leverage is beginning-of-period total liabilities divided by beginning-of-period total assets.The first column reports the average and median within-industry standard deviation for each ratio across the 19 industriesin the sample on an as-reported basis. The second (third) column reports the average and median within-industry standarddeviation for each ratio across the 19 industries in the sample assuming that operating leases are capitalized andamortized on a straight-line (present value) basis.The fourth (fifth) column reports the average and median across the 19 industries for the differences in the within-industry standard deviation between as-reported and straight-line (present value) amortization for capitalized operatingleases, the frequency of positive and negative differences for the 19 industries, and the associated p-values. The sixthcolumn reports the average and median across the 19 industries for the differences in the within-industry standarddeviation between straight-line and present value amortization for capitalized operating leases, the frequency of positiveand negative differences for the 19 industries, and the associated p-values. Probability values are based on the frequencyof positive differences assuming a binomial distribution and a null hypothesis of 50 percent positive and 50 percentnegative differences.

26 The within-industry standard deviation did not decline for present value amortization relative to straight-lineamortization for asset turnover in the commercial and professional services industry (increase from 1.480 to1.626), and for financial leverage in the retailing industry (increase from 0.298 to 0.346).

68 Jennings and Marques

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evidence in support of requiring straight-line amortization as the default amortization method for

operating leases.27

CONCLUSION

This study provides evidence on alternative methods for capitalizing operating leases, an issue

that is currently being considered by the Financial Accounting Standards Board and the

International Accounting Standards Board. First, we use a stylized example to compare the

information provided by straight-line amortization of lease assets with the information provided by

present value amortization of lease assets. Under ‘‘ideal’’ conditions, we find that present value

amortization provides information that is more comparable across firms and that more faithfully

represents the future cash flows of lease assets than straight-line amortization. We also find that

both methods provide less faithful representations of future cash flows when lease assets are

positive net present value investments.

Second, using security prices as a reference point, we find that lease assets are viewed by

investors as positive net present value investments for firms with above-industry-median

profitability, but not for firms with below-industry-median profitability. We also find weak

evidence that for firms whose profit margin is below the industry median, present value

amortization is more consistent with how investors implicitly value the lease assets. Thus, this

analysis also fails to provide justification for favoring straight-line amortization over present value

amortization.

Third, we use the distributions of three common financial ratios to examine the relative

comparability of as-reported assets and liabilities with assets and liabilities resulting from

capitalizing operating leases and amortizing them using either straight-line or present value

amortization. We find that comparability is improved when capitalizing operating leases and

amortizing them using straight-line amortization, and comparability is further improved by

replacing straight-line amortization with present value amortization. Thus, consistent with the

previous analysis, this analysis also fails to support the choice of straight-line amortization over

present value amortization.

In summary, our analysis provides no support for straight-line amortization as the de factopreferred method for amortizing right-of-use lease assets. In contrast, we provide some evidence

that presents value amortization for right-of-use lease assets is consistent with investor valuations

for many firms, and modestly enhances within-industry financial statement comparability for almost

all industries.

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APPENDIX A

LEASE ASSET AMORTIZATION USING THE UNDERLYING ASSET APPROACH

This appendix extends our example in Table 1 and the main text to apply the Underlying Asset

Approach (UAA) amortization method, an alternative method for amortizing right-of-use lease

assets under the new leasing standard proposed by the Financial Accounting Standards Board and

the International Accounting Standards Board. At their joint meeting on February 28–29, 2012, the

two Boards discussed this method as an alternative to the straight-line and present value alternatives

already under consideration.

UAA amortization views the lessee’s amortization expense from the perspective of the

compensation required by the lessor for the lessee’s use of the underlying asset during the lease

period. From this perspective, the lessee’s right-of-use asset amortization has two components. The

first component is compensation to the lessor for consuming part of the underlying asset, and is

computed as the straight-line amortization of the portion of the lessor’s underlying asset value that

is consumed during the lease period. This component is referred to as ‘‘consumption of asset.’’ The

second component is compensation to the lessor for the opportunity cost of being unable to use the

unconsumed portion of the lease asset during the lease period. This is computed as the increase in

value each year of the lessor’s end-of-lease residual value in the underlying asset, and is referred to

as ‘‘residual accretion.’’Table 7 presents results from applying UAA amortization to the example used in Table 1 and

the main text under different scenarios. In each scenario, we assume a ten-year lease with annual

payments of $1,000 at the end of each period, and an incremental borrowing rate for the lessee of 7

percent, so that the present value of the lease liability and asset at inception of the lease is $7,024.

To apply the underlying asset approach requires an estimate of the portion of the underlying asset

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Accounting HorizonsMarch 2013

TABLE 7

Example of the Underlying Asset Approach Amortization Method

Panel A: Lease is Years 41–50 of 50-Year Asset Life

Year of Lease

1 3 5 7 9

Cash Inflow 1,000 1,000 1,000 1,000 1,000

Consumption of Asset 702 702 702 702 702

Residual Accretion 0 0 0 0 0

Income before Interest 298 298 298 298 298

Beginning Book Value � SL Amort 7,024 5,619 4,214 2,809 1,404

Rate of Return 4.2% 5.3% 7.1% 10.6% 21.2%

Panel B: Lease is Years 31–40 of 50-Year Asset Life

Year of Lease

1 3 5 7 9

Cash Inflow 1,000 1,000 1,000 1,000 1,000

Consumption of Asset 357 357 357 357 357

Residual Accretion 250 286 328 375 429

Income before Interest 393 357 315 268 214

Beginning Book Value � SL Amort 7,024 5,792 4,486 3,093 1,603

Rate of Return 5.6% 6.2% 7.0 8.7% 13.3%

Panel C: Lease is Years 1�10 of 50-Year Asset Life

Year of Lease

1 3 5 7 9

Cash Inflow 1,000 1,000 1,000 1,000 1,000

Consumption of Asset 47 47 47 47 47

Residual Accretion 474 543 622 712 815

Income before Interest 479 410 331 241 138

Beginning Book Value � SL Amort 7,024 5,948 4,730 3,349 1,781

Rate of Return 6.8% 6.9% 7.0% 7.2% 7.8%

Panel D: Lease is for Land That Does Not Depreciate

Year of Lease

1 3 5 7 9

Cash Inflow 1,000 1,000 1,000 1,000 1,000

Consumption of Asset 0 0 0 0 0

Residual Accretion 508 582 666 763 5,730

Income before Interest 492 418 334 237 127

Beginning Book Value � SL Amort 7,024 5,971 4,767 3,387 1,808

Rate of Return 7.0% 7.0% 7.0% 7.0% 7.0%

(continued on next page)

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Accounting HorizonsMarch 2013

that is consumed during the lease period. Throughout our example, we do this by assuming that the

fair value of the underlying asset to the lessor is determined by extending the terms of the lease to

the entire life of the asset. In the first three panels of Table 7, we assume the asset has a total life of

50 years and that the lessor values the asset at each point in time on the basis of leasing the asset at

$1,000 per year for the remaining years of its life. We then vary which ten-year period during that

50-year life is the lease period for the example lease, and this varies the portion of the remaining life

of the underlying asset that is consumed during the lease period. In the last panel of Table 7, we

assume the lease is for land that does not have a finite life, so that the portion of the asset’s value

consumed during the lease period is zero.

In Panel A, we assume that this lease is for the last ten years of the life of an underlying asset’s

50-year life. Under these circumstances, the portion of the remaining underlying asset consumed by

the lessee during the lease period is 100 percent and the lessor’s end-of-lease residual value in the

underlying asset is zero, so that the consumption of the asset is equal to (7,024� 0)/10¼ 702 each

year and residual accretion is zero. Panel A of Table 7 reports rates of return for UAA amortization

under these circumstances that are exactly the same as those reported in Panel A of Table 1 for

straight-line amortization for the same lease.

In Panel B, we assume that the lease is for years 31–40 of the underlying asset’s 50-year life.

Under these circumstances, the value of the underlying asset at the beginning (end) of the lease is

the present value of a 1,000 annuity discounted at 7 percent for 20 (ten) years and is equal to 10,594

(7,024). This results in consumption of the underlying asset that is equal to (10,594� 7,024)/10¼357 each year, and residual accretion that is equal to (7,024/(1.07)n)(0.07), where n is the number

of periods remaining in the lease, and is equal to 250 in the first year. The rate of return presented in

Panel B for year 1 (9) for this scenario is larger (smaller) than in Panel A, indicating movement

TABLE 7 (continued)

Each panel of this table presents an example of the Underlying Asset Approach (UAA) method of amortizing right-of-use lease assets. In all four examples, the lessee pays $1,000 at the end of each of ten years, and uses an incrementalborrowing rate of 7 percent to compute the value of the lease asset and liability at inception of the lease, which are bothequal to $7,024. The net cash inflows from the leased asset are expected to be equal to the lease payments in both timingand amount, so that the lease is a zero net present value investment.Consumption of Asset is the straight-line amortization of the portion of the underlying asset’s value consumed during thelease, and is equal to the difference between the asset’s value at inception of the lease and at termination of the lease,divided by the length of the lease. The asset’s value at inception and termination of the lease is determined by replacingthe length of the lease in the calculation of the present value of the lease payments with the remaining life of the asset atthe beginning and end of the lease, respectively.Residual Accretion is the product of the present value of the residual value of the underlying asset and the incrementalborrowing rate used to discount the lease payments (7 percent in this example).In Panel A, the lease is for the last ten years of an asset with a total expected life of 50 years. The asset’s residual value atthe end of the lease is zero, so that consumption of asset is equal to 7,024/10¼ 702 each year, and residual accretion isequal to (0/(1.07)n)(0.07)¼ 0, where n is the number of periods remaining in the lease.In Panel B, the lease is for years 31–40 of an asset with a total expected life of 50 years. The asset value at the beginning(end) of the lease is the present value of a 1,000 annuity discounted at 7 percent for 20 (10) years, and is equal to 10,594(7,024). Consumption of asset is equal to (10,594� 7,024)/10¼ 357 each year. Residual accretion is equal to (7,024/(1.07)n)(0.07), where n is the number of periods remaining in the lease, and is equal to 250 in the first year.In Panel C, the lease is for years 1–10 of an asset with a total expected life of 50 years. The asset value at the beginning(end) of the lease is the present value of a 1,000 annuity discounted at 7 percent for 50 (40) years and is equal to 13,801(13,332). Consumption of asset is equal to (13,801� 13,332)/10¼ 47 each year. Residual accretion is equal to (13,332/(1.07)n)(0.07), where n is the number of periods remaining in the lease, and is equal to 474 in the first year.In Panel D, the lease is for land that does not depreciate, so that the asset value at the beginning (end) of the lease is thepresent value of a 1,000 perpetuity discounted at 7 percent, and is equal to 14,286 (14,286). Consumption of asset isequal to (14,286 � 14,286)/10 ¼ 0 each year. Residual accretion is equal to (14,286/(1.07)n)(0.07), where n is thenumber of periods remaining in the lease, and is equal to 508 in the first year.

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Accounting HorizonsMarch 2013

away from the straight-line amortization results presented in Panel A of Table 1 and toward the

present value amortization results presented in Panel B of Table 1.

This movement is more evident in Panel C of Table 7, where we assume that the lease is for

years 1–10 of the asset’s 50-year life. Under these circumstances, the value of the underlying asset

at the beginning (end) of the lease is the present value of a 1,000 annuity discounted at 7 percent for

50 (40) years, and is equal to 13,801 (13,332). This results in consumption of the underlying asset

equal to (13,801 � 13,332)/10 ¼ 47 each year, and residual accretion equal to (13,332/

(1.07)n)(0.07), which is 474 in the first year. The rate of return presented in Panel C for year 1 (9)

for this scenario is much larger (smaller) than for straight-line amortization in Panel A, and is much

closer to the results for present value amortization presented in Panel B of Table 1.

Finally, in Panel D of Table 7, we assume that the lease is for land that does not have a finite

life. Under these circumstances, the value of the underlying asset at the beginning and end of the

lease is the present value of a 1,000 perpetuity discounted at 7 percent, and is equal to 14,286. Thus,

consumption of the underlying asset is (14,286� 14,286)/10¼ 0 each year, and residual accretion

is (14,286/(1.07)n)(0.07), which is 508 in the first year. The rates of return presented in Panel D for

this scenario in all years are identical to those presented in Panel B of Table 1 for present value

amortization.

In summary, the Underlying Asset Approach to amortization of the right-of-use lease asset is a

weighted-average of straight-line amortization and present value amortization, and this combination

is more (less) weighted toward straight-line amortization as the portion of the lessor’s underlying

asset consumed during the lease period increases (declines).28

28 Although we do not report details to save space, we find the same relationship among the three alternativeamortization methods when the lease is a positive net present value investment as in Panels C and D of Table 1.

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