Day 211 Leasing in accounting

Leasing in accounting

In current business environment, it is becoming more and more common for organizations to lease an asset instead of purchasing it. The reason for this change is because it would immensely reduce the pressure on company’s cash flow. Therefore, the fund can be used on further expansion or investments. According to AASB 117, the lease agreement is the ‘contract whereby the lessor conveys to the lessee in return for a series of payments the right to use an asset for an agreed period of time.’ In fact, we understand the definition of the asset is ‘controlled’ by the entity to generate future economic inflows'. Hence a firm needs to recognize an asset even though it is not entitled to the ownership. 

In order to identify whether a lease should be recorded as an asset, the accountants have to determine who is bearing the risks and rewards derived from the it. So we should define the term ‘financial lease’ when the agreement transfers substantially all the risks and rewards incidental to ownership of an asset to the lessee. In the contrast, the lessor retains the risks and rewards from ‘operating lease’. Fortunately, the AASB 117 has provided some convenient examples for accountants to distinguish different types of leases. To illustrate, if there will be a transfer of ownership or at a bargain purchase option( which substantially lower than the fair value) at the end of the lease term; When the lease term is over 75% of the expected useful life on the asset; If the present value of minimum lease payments is greater than 90% of the fair value; And the leased asset has unique nature which can only be utilized by lessee without major modification. Thereby under these scenarios, the lease should be classified as a finance lease. 

Asset under the finance lease should be capitalized at the amount of present value of minimum lease payments or the fair value of the asset, whichever is lower. It must appear as leased asset and leased liability on the lessee’s financial position corresponding to the AASB regulations. This is important since it has an impact over the company’s debt-asset ratio, thus it is required due to the prudential purpose.