Value relevance of the earnings impact of lease capitalization

We investigate value relevance of the earnings impact of the Statement of Financial Accounting Standards No. 13 (SFAS 13). SFAS 13 requires committed long-term leases to be capitalized as assets and liabilities along with recognition of depreciation expense and interest charges. This requirement tends to have adverse effects on risk, debt ratios, and earnings numbers. Previous research finds significance of capital lease information through its impact on risk and debt ratios from a balance sheet statement perspective. Unlike previous studies, we evaluate the value relevance of SFAS 13 from an income statement prospective. SFAS 13 requires a restatement of prior year's income for the SFAS 13 effect when adopting the standard. Thus, we measure earnings impact of SFAS 13 for the year (t) prior to the adoption as the difference between the restated earnings minus the reported earnings of year t. The earnings impact of SFAS 13 can be reasonably inferred from the footnote disclosure in year t due to the disclosure requirement of Accounting Series Report No. 147. Based on the efficient market hypothesis, the disclosed earnings impact of SFAS 13 of year t should be reflected in the stock price of year t. We employ a return-earnings model to investigate whether the market participants incorporate earnings impact of SFAS 13 in the assessment of market value of firms. We do not find significant value relevance for the earnings impact of SFAS 13 using the traditional linear model. However, we find evidence supporting value relevance for the earnings impact of SFAS 13 using nonlinear models but only when the earnings impact is large. In addition, based on a rank-adjusted earnings model developed in this paper, we find that the earnings impact of SFAS 13 has larger value relevance than do the pre-SFAS No. 13 earnings. While our main objective is to evaluate the value-relevance of earnings caused by SFAS 13, our paper also contributes to an extensive investigation of the performance of different return-earnings models and to the development of a rank-adjusted earnings model.