ACCT 302 Week 7 Research Paper Example

Leases on the Balance Sheet: Accounting Rules, Incentives and Managers' Lease-or-Buy Choices

Introduction

For decades, a company could use an office tower, a fleet of aircraft or a chain of store buildings for most of their useful lives without reporting a liability for the payments it had promised to make. Operating leases appeared only in the notes. That ended when ASC 842 took effect for public companies in 2019: any lease longer than a year now places the payment obligation and the matching asset on the lessee's balance sheet (Spiceland et al., 2018). The standard changed reported numbers dramatically for retailers, airlines and restaurant chains. This paper asks a managerial accounting question about that change: did ASC 842 change what managers decide about leasing, from whether to lease at all to the terms they accept, or did it merely relocate existing obligations from the notes to the face of the statements? The evidence suggests that the underlying lease-or-buy economics did not change, but that managers responded to the standard where their incentives were tied to reported numbers, most visibly by shifting toward lease terms the standard leaves off the balance sheet.

Why Firms Lease

Leasing is not simply a way to hide debt. Eisfeldt and Rampini (2009) argue that leasing has a genuine economic advantage: because a lessor keeps ownership, it can take back equipment or property faster and more cheaply than a lender can seize pledged collateral, so leasing allows a firm to finance more of an asset's value than borrowing would. That advantage is most valuable to financially constrained firms, which in their analysis lease a larger share of their capital. Leasing also transfers some risks of ownership, such as the risk that an asset becomes obsolete or that its resale value falls, to a lessor that may be better able to bear them. None of these reasons depends on where the lease appears in the financial statements. If leasing decisions were driven only by these economics, a change in accounting should have left them untouched.

The Lease-or-Buy Decision as a Capital Budgeting Problem

Managerial accounting treats the lease-or-buy decision as a comparison of the present value of the cash flows under each alternative. Consider a composite regional grocery chain that needs a new refrigerated distribution center. It can buy the building for $4 million, financed with a loan at its 6 percent borrowing rate, or it can sign a ten-year lease calling for $520,000 at each year-end. Discounted at 6 percent with an annuity factor of 7.3601, the ten rent checks are worth about $3.83 million today. Before taxes and residual value, leasing is slightly cheaper. A full analysis would add the tax effects of depreciation and lease payments and the value of the building after ten years, which belongs to the chain only under the purchase option. Whichever way those adjustments fall, the decision rests on cash flows, discount rates and risks.

The adjustments can easily reverse the result. Suppose the chain expects the building to be worth $2.2 million after ten years. Discounted at 6 percent, using a single-sum factor of 0.5584, that residual value is worth about $1.23 million today, which lowers the effective cost of buying to roughly $2.77 million against $3.83 million for leasing. On those assumptions buying is the better choice by about $1 million. If instead the chain is uncertain about where its stores will be in ten years, the option to walk away at the end of the lease has value that a simple present value comparison does not capture, and a manager might rationally pay more to lease. These are the questions the decision should turn on: the residual value of the asset, the cost of capital, the tax position of the firm and the value of flexibility. The accounting classification of the lease is not among them, which is why any change in decisions after ASC 842 points to something other than the economics.

The new standard measures the lease almost exactly as this analysis does. Under ASC 842, the chain measures its lease obligation by discounting the payments still owed, using the lessor's implicit rate when it is known and otherwise the chain's own incremental borrowing rate, and books a matching right-of-use asset for the building, adjusted for items such as initial direct costs (Spiceland et al., 2018). The chain would therefore report a $3.83 million liability for the lease, close to the $4 million loan it would have reported if it had bought. Once the lease is on the balance sheet, the accounting finally shows what the capital budgeting analysis always knew: leasing a building for most of its life is a way of financing it. In a world where managers made decisions only on cash flows, that change in reporting would be irrelevant.

From ASC 840 to ASC 842

Under the previous standard, a lessee classified a lease as a capital lease, recorded on the balance sheet, only if it met one of four criteria, including a lease term of 75 percent or more of the asset's economic life or a present value of minimum lease payments of 90 percent or more of its fair value. Leases that fell short of these bright lines were operating leases and stayed off the balance sheet. Companies could structure leases to fall just short, for example by setting the present value of payments at 89 percent of fair value. ASC 842 removed that incentive for most leases by recognizing operating leases as well. It kept two classifications, finance and operating, which differ in the income statement: a finance lease reports amortization and interest separately, while an operating lease reports a single straight-line lease cost. It also left three items off the balance sheet: leases whose term is a year or shorter, payments that vary with usage or sales rather than with an index or rate, and certain renewal options that are not reasonably certain to be exercised.

Why Reported Numbers Still Matter to Managers

If the economics did not change, why might decisions change? Managerial accounting theory points to the ways reported numbers enter contracts and evaluations. Debt covenants often limit ratios such as debt to equity, bonus plans reward return on assets or earnings growth, and analysts and rating agencies compute debt ratios from reported liabilities. A standard that adds lease liabilities to the balance sheet can push a company closer to a covenant limit or lower its return on assets, even when nothing about its operations has changed.

Research on managers' leasing choices shows these incentives operate. Eaton et al. (2021) modeled the expected level of investment in leased assets and treated the unexplained portion as a proxy for inefficient investment. They found that leasing, unlike capital expenditures, appeared to be a channel through which managers could over-invest, even in firms with high-quality reporting and negative free cash flow. Unexpected lease investments were followed by faster sales growth but slower earnings growth for up to three years and were greeted by negative stock returns, yet they were associated with higher CEO compensation, driven mainly by the sales growth. The authors concluded that compensation contracts rewarding growth gave managers reason to expand through leases. If leasing had been a less visible way to invest under the old rules, recognizing leases on the balance sheet should make such investment easier for boards and investors to see and challenge.

Evidence on Lease Contracts After Adoption

The clearest evidence that managers changed their behavior concerns variable lease payments. Heese et al. (2025) note that ASC 842 allows variable payments based on usage or sales to remain off the balance sheet, partly on the assumption that such payments are hard to estimate. They found that variable lease expenses were common and substantial, and that they were about as persistent and predictable as fixed operating lease expenses while showing limited sensitivity to revenue, which suggests they were based on stable drivers rather than true variability. After adoption, companies reported lower minimum operating lease commitments and higher variable lease expenses, a pattern consistent with substituting variable leases for fixed ones. Recognizing the variable lease obligations would have increased reported debt by 7.1 percent on average, by the authors' conservative estimate, and neither equity betas nor credit ratings appeared to reflect them.

This is the response managerial accounting theory would predict. Where the standard left an opening, some managers moved through it, restructuring contracts so that payments that were economically fixed would appear variable. A grocery chain could, for example, negotiate a lower fixed rent with an added percentage of each store's sales. If the store's sales are stable, the chain's real obligation is almost unchanged, but its reported lease liability falls. The decision to lease did not change; the form of the lease did.

Evidence on Lenders and Markets

If recognition simply moved information from the notes to the balance sheet, sophisticated lenders should have been indifferent. Evidence suggests otherwise. Kusano and Yamashita (2026) took advantage of a setting in Japan where some companies used international standards and recognized operating leases under IFRS 16, while others used Japanese standards and only disclosed them. After IFRS 16 arrived, the recognizing group saw its short-term borrowing spreads narrow by more than the group that kept leases in the notes, which the authors interpret as a reduction in information risk. The decline was largest for firms with lower lease intensity. For managers, this finding cuts against the fear that recognition would raise borrowing costs. If lenders price recognized leases more favorably, the chain in the example may find that recognizing its distribution center lease lowers rather than raises the cost of its other borrowing.

Recognition also had a less expected consequence. Zhou and Fan (2025) found that companies affected by ASC 842 reported larger temporary differences between book and tax amounts, which is understandable since tax rules still treat most operating lease payments as rent while the books now carry lease assets and liabilities, and that these firms experienced greater capital market uncertainty, driven largely by the new book-tax differences. A standard intended to make leases more transparent added a new source of complexity for readers of the tax note, which illustrates how a reporting change can create costs no one designed.

Implications for Managers

Several implications follow for managers making leasing decisions. First, the lease-or-buy decision should still be made on cash flows, risks and the value of flexibility, using the present value analysis shown above; the accounting change does not alter which alternative creates more value. Second, managers should be cautious about restructuring leases to avoid recognition. Converting fixed payments into variable ones may lower reported liabilities, but if lenders and investors learn to estimate the hidden obligations, as Heese et al. (2025) suggest they eventually could, the reporting benefit will fade while the contract terms remain. Third, boards should review compensation plans that reward growth or return measures, since Eaton et al. (2021) show that such plans can encourage lease investment that does not create value. Fourth, managers should communicate with lenders about covenant definitions, because covenants written before ASC 842 may define debt in ways that suddenly include lease liabilities.

A fifth implication concerns the choice between finance and operating classification for leases that remain on the balance sheet. Both now carry a liability, but a finance lease splits its cost into amortization and interest, which are excluded from earnings before interest, taxes, depreciation and amortization, while an operating lease reports a single lease cost within operating expenses. A company evaluated on that earnings measure therefore looks better when its leases qualify as finance leases, the reverse of the old incentive to avoid capitalization. Managers and boards should recognize that this effect is purely presentational. A performance measure that changes when a lease is reclassified, while the cash paid each year stays the same, is measuring the accounting rather than the business, and incentive plans built on it can reward the wrong choices.

For a Christian manager, the lease decision also carries a moral dimension. Scripture observes that the borrower is servant to the lender (English Standard Version Bible, 2001/2016, Proverbs 22:7). A long-term lease is a commitment to pay, as binding as a loan, and ASC 842 makes that commitment visible. Structuring a contract so that an obligation appears smaller than it is may be legal, but it treats lenders and shareholders as people to be managed rather than served. Honest stewardship means making the lease-or-buy choice on its merits and letting the statements show its true weight.

Conclusion

Has ASC 842 altered managers' leasing choices? The economic case for leasing, rooted in debt capacity and the transfer of ownership risks, did not change, and a lease-or-buy decision made on present values should come out the same under either standard. What changed were the incentives tied to reported numbers, and managers responded where the standard allowed them to, shifting toward variable payments that remain off the balance sheet. Lenders, meanwhile, appear to have welcomed recognition, while the new book-tax differences added uncertainty for investors. The evidence has limits. The standard has been in effect for only a few years, much of the research uses short windows around adoption and the Japanese evidence comes from a different reporting system. Future research on whether variable lease substitution persists, and whether boards adjust compensation plans in response, will show whether ASC 842 changed managers' decisions in lasting ways or only redirected the familiar effort to keep obligations off the balance sheet.

References

Eaton, T. V., Nichols, C., Wahlen, J., & Wieland, M. (2021). Managers' investment decisions: Incentives and economic consequences arising from leases. Journal of Risk and Financial Management, 14(4), Article 165. https://doi.org/10.3390/jrfm14040165

Eisfeldt, A. L., & Rampini, A. A. (2009). Leasing, ability to repossess, and debt capacity. The Review of Financial Studies, 22(4), 1621-1657. https://doi.org/10.1093/rfs/hhn026

English Standard Version Bible. (2016). Crossway. (Original work published 2001)

Heese, J., Shin, A., & Wang, C. C. Y. (2025). Variable leases under ASC 842: First evidence on properties and consequences. Review of Accounting Studies, 30(3), 2218-2263. https://doi.org/10.1007/s11142-025-09899-z

Kusano, M., & Yamashita, T. (2026). Does recognizing operating leases influence loan spreads? Evidence from Japan. Journal of International Accounting Research, 25(2), 83-106. https://doi.org/10.2308/jiar-2024-015

Spiceland, J. D., Nelson, M. W., & Thomas, W. B. (2018). Intermediate accounting (9th ed.). McGraw-Hill Education.

Zhou, Y., & Fan, S. (2025). Lease accounting standard (ASC 842), temporary book-tax differences, and capital market uncertainty. Journal of Corporate Accounting & Finance, 36(4), 108-126. https://doi.org/10.1002/jcaf.22794