Lease Expense Classification – the Impact is Broader than You May Think

By | July 24, 2013

The revised Exposure Draft on proposed Lease Accounting Changes issued in May 2013 (“the Revised ED”) contains provisions on expense classification that has broader implications than may be evident initially.

For Type B leases, principally leases of property (real estate), the proposed expense is classified as lease expense and the expense recognition pattern is straight-line, similar to the manner in which expense is generally recognized now. However, for Type A leases, principally equipment leases, the proposed expense is classified partly as interest and partly as amortization and the expense recognition is accelerated into the early years of the lease term.  Therefore, GAAP earnings under the Revised ED will be lower particularly for those companies that have significant equipment leases. However, EBITDA will be higher in those cases because interest and amortization can be added back to GAAP earnings to determine EBITDA.

So what are the broader implications to which I refer?  Does your company have employment, earn out or other similar agreements where the payments depend upon either GAAP earnings or EBITDA? If so, the payment calculations may be impacted by the proposed changes in expense classification and expense recognition pattern even though the economic results of the business have not changed. The proposed lease accounting changes may not be effective until 2017 but, to the extent that such agreements are being drafted now, it may be wise to insert provisions that future changes in expense classification or expense recognition pattern will be disregarded for purposes of the payment calculations made in accordance with the agreements. Why should payments be impacted by changes that do not affect the economic results or cash position of the business?