Lease Accounting Exposure Draft – Expense Presentation

In our posting earlier this month, we provided highlights of the May 2013 revised Exposure Draft jointly issued by the FASB and IASB proposing major changes to the manner in which lessees would account for their lease contracts. In that posting, we discussed the fact that leases would be classified based upon the nature of the asset being leased and the significance of both the period of the lease as compared to the remaining or total economic life of the leased asset and the present value of lease payments as compared to the fair value of the leased asset. Type A Leases, mainly comprising equipment, would have accelerated expense recognition and Type B Leases, mainly comprising property, would have straight-line expense recognition. However, there is another interesting consideration as it relates to the proposed manner in which expenses would be presented in the income statement of the lessee as compared to current GAAP accounting for operating leases.

For Type A Leases, the Exposure Draft proposes that the lease related expense be presented separately with respect to the interest component and the amortization component. For Type B Leases, the expense would be presented as a single line item as lease/rent expense.  This presents an interesting point with respect to an important financial statement metric (particularly for public companies), Earnings Before Interest, Taxes, Depreciation and Amortization (EBITDA). Interest and amortization on Type A Leases would be added back in the calculation of EBITDA while lease expense on Type B leases would not be. Therefore, while overall expense would increase in earlier years of the lease term for those entities that have a greater proportion of Type A Leases, EBITDA would also be higher by virtue of the add back of interest and amortization. The statement of cash flows would also be impacted. For Type B Leases, the lease expense would be a reduction in operating cash flow as is the case under current GAAP accounting for operating leases. For Type A Leases, cash payments for the principal portion of the lease payment would be classified as a financing activity. The result – operating cash flow would be higher for Type A Leases.

We are certain that these types of classification issues will result in a healthy discussion in the comment letters that the Boards receive and the outreach process that will be undertaken over the next few months.