Clash-ification of the Revenue and Lease Standards
My last week’s blog looked at the annual reports of several airline companies to assess the effect that leasing would have on their balance sheets. While looking at the annual report for Air Lease Corp I was surprised to see in their risk factors section the statement “our financial reporting for lease revenue may be impacted by a proposed new model for lease accounting.” The new lease changes usually focus on the balance sheet, but Air Lease Corp’s mention of revenue shifted my focus to the income statement.
The main worry with the new lease standard arises from the enormous amount of new lease liabilities and right of use assets that will appear as line items on the balance sheet. Line items on the income statement such as revenue, rent, interest and amortization expenses will also be affected. Small changes to these line items could lead to a greater impact than most realize. Let me explain how.
Corporations use financial planning as they carry out their reporting obligations and comply with accounting standards. Analysts, investors, and users of financial statements then measure and assess this performance. For example, they will look for changes in a company’s earnings before interest, taxes, depreciation and amortization (EBITDA). "EBITDA is one of, if not the most important measures that investors consider when a company is being bought or sold" said Joseph Ferriolo in Business News Daily. The slightest change to the EBITDA, down to a basis point, could impact a company’s value, analyst estimates, loan agreements, and a myriad of other performance based things tied to the EBITDA.
Leases affect EBITDA. As a lessee, there are two methods of recording a lease: operating or finance. “Each lease type has a specific income statement recognition pattern: straight-line for operating leases, and front-loaded for finance leases,” as noted in PwC’s article 10 minutes on the new US lease standard. “Lessees will record lease expense as a single line item for operating leases and amortization and interest expense for finance leases.” Therefore, if a lease is classified as a finance type, the lessee gets the benefit of increased interest and amortization expenses, which in turn, increases the EBITDA.
Under the current lease guidance, finance type leases show up on the balance sheet, whereas operating leases remain off the balance sheet. Companies looking to achieve a higher EBITDA through the classification of a lease as a finance type, also requires them to include the liability on the balance sheet. The addition of the liability often dissuades the company from classifying the lease as a finance type. That could change under the new lease standard. “[U]nder the new [lease] guidance, since all leases will be on balance sheet, companies may prefer that their leases be classified as finance leases” the PwC article says.
Classifying a lease as a finance type will not be simple. Companies can’t simply choose the easiest or most beneficial method for financial reporting. “Determining whether a contract includes lease and nonlease components, particularly when variable consideration exists, not only impacts the accounting guidance to follow, but also may affect the timing and amount of revenue to recognize,” said PwC’s Justin Frenzel in his highlight Lessor Accounting: the interaction of leasing and revenue. Those are the types of leasing contracts that concern many companies.
Investors, analysts, and users of financial statements need to be cognizant of the changes coming to financial statements. What may begin as a look into a company’s balance sheet may quickly turn into looking at a much bigger picture.
Unfortunately, that picture is still unclear, but with the effective date of revenue recognition and leasing standards quickly approaching, risks and uncertainty associated with the implementation could be disclosed in more company annual reports. Until then we are left to untangle the clash of the two standards one annual report at a time.
Continue the discussion at Bloomberg BNA Accounting LinkedIn.
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