Question

Discuss why the FASB issued ASU2016-2 and describe how leased assets and lease liabilities are reported on the balance sheet and the income statements based on ASU2016-2. Your description should include the reporting of the leased assets and lease liabilities on the balance sheet and the lease expenses on the income statement.

Answer 1

The primary objective to issue new guidance by FASB was to address the off-balance-sheet financing concerns related to lessees’ operating leases as (SFAS) No. 13, Accounting for Leases, only required entities with capital leases to report a lease liability and asset on the balance sheet.

With updation of this lease standard it removes the bright-line lease classification criteria that companies used to avoid capitalization of leases and hide the lease liabilities but the new ASU requires lessees to recognize assets and liabilities for virtually all finance (known as capital leases in SFAS No. 13) and operating leases and thereby results in a more faithful representation of the rights and obligations arising from leases and improves understanding and comparability of lessees’ financial commitments regardless of the manner they choose to finance the assets used in their businesses.

Reporting in Balance Sheet

Lessee Model

The new standard requires lessees to recognize on the balance sheet at lease commencement both:

• A right-of-use (ROU)  asset, representing the lessee’s right to use the leased asset over the term of the lease; and,

• A lease liability, representing the lessee’s contractual obligation to make lease payments over the term of the lease. The lease liability is initially recorded at an amount equal to the present value of the remaining lease payments4 due over the lease term, discounted at the rate implicit in the lease

On the other side of the balance sheet, the ROU asset is initially recorded at an amount equal to: • The initial lease liability; plus • Any lease payments made at or before lease commencement; plus • Any initial direct costs incurred by the lessee; less • Any lease incentives received from the lessor.

The subsequent measurement of the ROU asset depends on the type of lease.

The new lease standard requires lessees to classify all leases – except for short-term leases accounted for off balance sheet – as either an operating lease or a finance lease. Therefore, a lease would be classified as a finance lease  if any of the following criteria are met otherwise an operating lease.

“The lease transfers ownership of the underlying asset to the lessee by the end of the lease term.”

• “The lease grants the lessee an option to purchase the underlying asset that the lessee is reasonably certain to exercise.”

“The lease term is for the major part of the remaining economic life of the underlying asset.”

• “The present value of the sum of the lease payments and any residual value guaranteed by the lessee . . . equals or exceeds substantially all of the fair value of the underlying asset.”

• “The underlying asset is of such a specialized nature that it is expected to have no alternative use to the lessor at the end of the lease term.”

For finance leases, the ROU asset is accounted for similarly to how property, plant, and equipment (PP&E) is recorded; in each subsequent reporting period it is depreciated on a straight-line basis.

For operating leases, the periodic change in the carrying amount of the ROU asset is used to achieve a straight-line lease expense in the income statement.

Lessor Model

The leases standard requires a lessor to use the classification criteria discussed below to classify a lease, at its commencement, as a sales-type lease, a direct financing lease, or an operating lease.

Sales-type leases shall be accounted for by the lessor as follows:

a. The minimum lease payments (net of amounts, if any, included therein with respect to executory costs such as maintenance, taxes, and insurance to be paid by the lessor, together with any profit thereon) plus the unguaranteed residual value (as defined in paragraph 5(i)) accruing to the benefit of the lessor shall be recorded as the gross investment in the lease

b. The difference between the gross investment in the lease in (a) above and the sum of the present values of the two components of the gross investment shall be recorded as unearned income.

c. The present value of the minimum lease payments (net of executory costs, including any profit thereon), computed at the interest rate implicit in the lease, shall be recorded as the sales price. The cost or carrying amount, if different, of the leased property, plus any initial direct costs (as defined in paragraph 5(m)), less the present value of the unguaranteed residual value accruing to the benefit of the lessor, computed at the interest rate implicit in the lease, shall be charged against income in the same period.

Direct Financing Leases

a. The minimum lease payments (net of amounts, if any, included therein with respect to executory costs such as maintenance, taxes, and insurance to be paid by the lessor, together with any profit thereon) plus the unguaranteed residual value accruing to the benefit of the lessor shall be recorded as the gross investment in the lease.

b. The difference between the gross investment in the lease in (a) above and the cost or carrying amount, if different, of the leased property shall be recorded as unearned income. The net investment in the lease shall consist of the gross investment less the unearned income.

Operating Leases

a. The leased property shall be included with or near property, plant, and equipment in the balance sheet. The property shall be depreciated following the lessor's normal depreciation policy, and in the balance sheet the accumulated depreciation shall be deducted from the investment in the leased property.

b. Rent shall be reported as income over the lease term as it becomes receivable according to the provisions of the lease. However, if the rentals vary from a straight-line basis, the income shall be recognized on a straight-line basis unless another systematic basis is found.

c. Initial direct costs shall be deferred and allocated over the lease term in proportion to the recognition of rental income.

Reporting in Income Statement

Finance Lease Operating Lease

Lessee • Interest expense (Lease liability) • Total lease expense

• Amortization expense (ROU asset)   

Lessor • Interest income (Net investment in lease) • Rental/lease income