ANALYZING CREDITWORTHINESS FROM FINANCIAL STATEMENTS IN THE PRESENCE OF OPERATING LEASES

In 1976 the Financial Accounting Standards Board (FASB) issued its now infamous Statement of Financial Accounting Standard No. 13 "Accounting for Leases" , which provided new guidance for the accounting of various types of leasing arrangements. A significant component of this statement was the distinction made between "capital " leases and "operating " leases. A cottage industry soon arose that would design and structure leasing arrangements to meet the more favorable "operating " lease requirements. The success of these efforts was documented in a 2005 SEC staff study that showed some 96 percent ($1.25 trillion) of all future cash flow payments committed by U.S. corporations under leasing contracts is associated with operating leases. In present value terms this means that some $1 trillion in lease obligations is currently being unreported on the balance sheets of U.S. companies. The "success " (some would say abuse) of operating leases has led the SEC to recommend that the Financial Accounting Standards Board (FASB), in conjunction with the International Accounting Standards Board (IASB), to reconsider its accounting guidance for leases, a process that the FASB and IASB began undertaking in earnest in July 2006. It has become obvious that irregularities within lease accounting have become a critical issue when evaluating corporate financial statements, particularly those with large amounts of operating leases. Prior researchers, most notably Imhoff, Lipe, & Wright (1991, 1997), have examined different aspects of the impact that capitalizing operating leases would have on corporate financial statements. This paper examines how the current accounting treatment for operating leases, as well as the proposed changes, affects financial analysis, particularly with regards to the calculation of key financial ratios. A special focus is placed on various measures of a company's creditworthiness, particularly Altman's discriminant analysis model, or Z-score. Alternative methods for valuing operating leases are also examined.