This thesis examines the economic differences between financial statement disclosure and recognition of lease information. Motivated by renewed interest in the disclosure versus recognition issue, and the contentious nature of this issue in lease accounting, two key research questions are addressed: (1) is there an economic difference between lease recognition and footnote disclosure, and (2) what are the incentives for, and implications arising from, the adoption of the alternative forms of lease reporting? Employing contracting and risk-based valuation theories, the research questions are addressed by systematically modelling and testing management and investor responses to the introduction of mandatory lease disclosure and recognition rules contained in AAS17 Accounting for Leases and ASRB 1008 Accounting for Leases. Transition provisions in these standards, which permitted optional lease recognition, enable testing of changes in responses to different disclosure and recognition rules. Importantly, lease asset specificity is predicted to be a common factor in conditioning these responses.
From the management perspective, it is argued that recognition has adverse economic consequences. Hence, lease substitution (replacement of finance leases with off-balance sheet operating leases) is predicted to be the dominant response to avoid these consequences. However, greater lease asset specificity is predicted to be a constraining factor in managers' ability to restructure finance leases as operating leases, leading to a preference for other methods to avoid or mitigate the recognition consequences. These include the placement of finance leases in non-consolidated entities and the use of lease liability (asset) minimisation (maximisation) methods. From the investor perspective, it is argued that investors observe managers' responses and adjust equity risk valuations for the financial risk inherent in recognised and disclosed leases. As managers replaced finance leases with operating leases in the post-transition period, the average risk profile of firms' operating lease portfolios is expected to increase due to the inclusion of the more firm-specific finance leases. Therefore, due to changes in asset specificity, it is hypothesised that operating and finance lease portfolios are valued differently in the transition period, but not in the post-transition period.
Using primarily regression analysis, the models are tested over a wide study period (1985 to 1992) to capture the full range of responses and to allow for differences in asset specificity, macroeconomic factors and changes to consolidation rules. The results support all hypothesised responses. A preference for operating leases is clearly evident in managers' responses indicating that managers view lease recognition as costly relative to lease disclosure and are prepared to commit resources over an extended period of time to avoid or minimise the effects of lease recognition. Investors also appear to treat disclosed and recognised leases differently where the underlying nature of the assets varies. Where the nature of the disclosed or recognised assets indicates similar asset risk, as evident in the post-transition period, no differences in investors' valuations are evident.
By adopting a wide study period and controlling for asset specificity, the findings provide more comprehensive and integrated explanations of the incentives and responses to lease recognition and disclosure rules than reported in prior research. The findings also have important implications for standard setters and for their current review of the lease accounting standards. In particular, the findings highlight the failure of the 'risks and rewards' lease classification concept in achieving standard setters' objectives of financial statement recognition of long-term lease contracts.