The role of leasing in UK corporate financing decisions, accounting treatment and market impact

Abstract

Leasing provides a significant source of finance across UK firms. Historically, its use has been attributed to favourable tax treatment and 'off-balance sheet' accounting, both of which have been eroded over time. The present day determinants of leasing have received limited investigation, and prior research has focused on the use of finance leases in isolation from overall corporate financing decisions. This seems inappropriate given the predominant and prolific use of operating leases (Beattie, Edwards and Goodacre, 1998), and evidence to suggest that lease and debt finance appear to be at least partial substitutes (Beattie, Goodacre and Thomson, 2000). Further, proposals issued by the Accounting Standards Board in late 1999 look set to essentially remove the current 'off-balance sheet' accounting treatment of operating leases. If accounting treatment is in any way responsible for the current use of operating leases, these proposals are likely to have a significant impact on the future role of leasing. In response, the present study. investigated both the current role of leasing in the wider context of corporate financing decisions, and its future role in light of the new proposals for lease accounting. Two separate surveys of UK quoted industrial companies were undertaken to investigate corporate financing and leasing decisions and views and opinions on lease accounting reform. Findings are based on a response of 23% (198 completed questionnaires) and 19% (91 completed questionnaires) respectively. OLS regression analysis was also employed for a sample of 159 UK quoted industrial companies, to establish the existence of an 'offbalance sheet' advantage to operating leases from a market perspective. Findings suggest that UK firms appear more likely to follow Myers' (1984) suggestion of a modified pecking order of capital structure when determining their debt, including leasing, levels. Investment nd dividend payout dictate the need for external finance, and debt including leasing is internally rather than externally constrained. On average, internal reserves followed by straight debt appear preferable to leasing. However, the benefits and costs associated with all sources of finance are likely to be considered when additional finance is required. Although tax and 'off-balance sheet' advantages to leasing remain, they do not appear to dominate the leasing decision in the current climate. Avoiding large capital outlay and cash flow considerations appear of paramount importance in the decision to lease all asset types. Findings suggest that the preference for leasing over other forms of debt is not anticipated to change in response to the new proposals for lease accounting. However, the new approach may not be without consequence. Where possible, financial statement preparers are likely to take reactionary steps to minimise balance sheet obligations. At the very least, this could involve exercising any opportunity to manipulate the new accounting treatment. It may extend to reduced investment and a decline in levels of debt financing, including leasing. Although operating lease obligations appear to be currently taken into account in the UK market's assessment of equity risk, the accuracy with which they are taken into account remains unclear. Therefore, the revaluation of securities in the wake of the new proposals becoming mandatory is not beyond the realms of possibility. The present study provides a holistic analysis of corporate financing and leasing decisions in UK firms. It provides a valuable contribution to the capital structure debate. It would seem inappropriate for future capital structure research to focus on proving alternative static trade-off and pecking order theories. Future research would benefit from a reconciliation of the two. The present study highlights the difficulties in analysing corporate financing and leasing decisions, by establishing that they are complex, multidimensional and essentially situation-specific. The present study also has important implications for policy makers. In addition to the potential economic consequences, findings appear to suggest that certain features of the new proposals fall short of developing into a high quality lease accounting standard. Further consideration by policy makers from alternative perspectives appears necessary.