Understanding AASB Finance Leases

A finance lease, as defined under Australian Accounting Standards Board (AASB) 16, effectively transfers substantially all the risks and rewards incidental to ownership of an asset from the lessor to the lessee. This means that although the legal title remains with the lessor, the lessee is essentially treated as if they own the asset for accounting purposes.

Key Characteristics of a Finance Lease

Several criteria indicate whether a lease should be classified as a finance lease. AASB 16 does not prescribe rigid rules but rather provides indicators to be considered in totality. A lease is likely to be classified as a finance lease if any of the following circumstances exist:

• Transfer of Ownership: The lease transfers ownership of the asset to the lessee by the end of the lease term. This is the most definitive indicator.
• Bargain Purchase Option: The lessee has the option to purchase the asset at a price significantly below its fair value at the time the option becomes exercisable, and it is reasonably certain that the lessee will exercise this option.
• Major Part of Asset's Life: The lease term is for the major part of the economic life of the asset, even if title is not transferred. Generally, this is considered to be 75% or more of the asset's useful life.
• Present Value of Lease Payments: The present value of the minimum lease payments at the inception of the lease amounts to substantially all of the fair value of the leased asset. 'Substantially all' is typically interpreted as 90% or more.
• Specialized Asset: The leased asset is of such a specialized nature that only the lessee can use it without major modifications.

Accounting Treatment for Lessees

When a lease is classified as a finance lease, the lessee recognizes an asset (Right-of-Use Asset) and a lease liability on the balance sheet at the commencement of the lease. The initial measurement of both the asset and liability is usually at the present value of the lease payments.

Over the lease term, the lessee will:

• Depreciate the Right-of-Use Asset: The asset is depreciated over its useful life, or the lease term if that is shorter and ownership will not transfer.
• Amortize the Lease Liability: The lease liability is reduced as lease payments are made. Each lease payment is split between a reduction of the lease liability and interest expense. The interest expense is recognized in the profit or loss.

Impact on Financial Statements

Finance leases have a significant impact on a lessee's financial statements. The recognition of an asset and liability on the balance sheet increases both assets and liabilities. The depreciation expense and interest expense impact the profit or loss. Furthermore, the lease payments are classified as financing activities in the statement of cash flows.

Importance of Proper Classification

Correctly classifying a lease as either a finance lease or an operating lease (where the asset remains off-balance sheet under certain conditions) is crucial for providing a true and fair view of a company's financial position and performance. Misclassification can significantly distort key financial ratios and metrics, potentially misleading investors and other stakeholders.