According to a recent study from Jonathan A. Milian and E. Jin Lee at Florida International University, recognition of operating leases as a result of ASC 842, Leases, caused a significant one-time negative equity market reaction when 2019 quarterly earnings releases came out after companies first recognized leases.
The study, titled “Did the Recognition of Operating Leases Cause a Decline in Equity Valuations?” analyzed returns of stocks for over 2,000 companies during several trading day intervals around their earnings announcements or their recording of leases. It found companies with significant operating leases had significant increases in both assets and lease liabilities, which negatively impacted ratios like debt-to-equity, return on assets, and current ratios.
Although operating lease commitments had previously been disclosed in notes to annual financial statements and there was no change in the companies’ economics, risks, or cash flows, the study proposes investors were not previously adjusting for the use of operating leases before adoption of ASC 842 as might have been expected. The accounting change was incorrectly interpreted as new information that made reporting companies with more operating leases appear riskier because their financial ratios looked worse.
The study noted retailers that have significant use of operating leases in their operations—among them, Urban Outfitters, Foot Locker, Abercrombie & Fitch, and Dick’s Sporting Goods—reported the most abnormal stock returns when they announced their earnings.
According to the study, incorrectly categorizing operating lease liabilities as debt rather than long-term liabilities may have contributed to this reaction. AMC Entertainment Holdings’ CEO cited this as a possible reason his company’s stock price experienced a 50 percent drop and an increase in shorting of AMC shares.
Milian told the Wall Street Journal that changes in other accounting standards that result in recording amounts on balance sheets that were previously only required to be disclosed in notes to financial statements could negatively affect stock returns. He stated that while such changes made it easier for investors to use financial statements, companies could be hurt in the near-term.
This study provides a good reminder to companies and their boards that investors and analysts do not like surprises. It seems, however, given the long periods most major new accounting standards have for implementation, along with required SEC SAB 74 disclosures by public companies about the potential impact of significant accounting changes in periods before they are adopted, companies should have ample time to prepare their investors, analysts, and lenders about what changes are coming and when.
There may always be short-term stock price reaction to accounting news, but the good news to be gleaned from this study is: It was one-time and short-lived.