Accounting for Leases: Information Signal or Earnings Management? Evidence from Italian Listed Companies

Since the G4+1 special report (1996), the reform of accounting for leases has been a central topic in the agenda of standard setters and regulators. Currently, the IASB and the FASB have issued the Exposure Draft (ED) Leases that requires for lessee to apply only one accounting model, the ‘right of use of assets’. The new approach aims at overcoming two main controversial features of the existing accounting treatment of IAS 17. First, it is argued that operating lease does not reflect relevant information since it omits to recognize rights and obligations arising from the lease agreements. Second, the choice of accounting treatment (operating versus finance) can be motivated by incentives to manipulate earnings trough creative compliance. Based on a sample of Italian listed companies, this study examines whether managers’ choice between finance and operating lease reflects the economic substance of the transaction or it is affected by incentives for earnings management. We find that managers tend to adopt operating leasing to reduce the probability of violating debt covenants. In addition, following the signaling theory we posit that companies may prefer to capitalize lease than to disclose it, in order to avoid any potential users’ adverse selection. However, the latter relationship is not supported for Italy.