Case 4-9 Financial Statement Disclosure: Current accounting for leases requires that certain leases be capitalized. For capital leases, an asset and the associated liability are recorded. Whether or not the lease is capitalized, the cash flows are the same.
a. If one of the objectives of financial reporting is to enable investors, creditors, and other users to project future cash flows, what difference does it make whether we report the lease as a liability or simply describe its terms in footnotes? Discuss.
b. The efficient market hypothesis states that all available information is impounded in security prices. In an efficient capital market, would it make a difference whether the lease is reported as a liability or simply described in footnotes? Explain.
c. When there are debt covenants that restrict a company’s debt-to-equity ratio and when debt levels rise relative to equity, management may be motivated to structure leasing agreements so that they are not recorded as capital leases. Discuss this motivation in terms of agency theory.
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