Company accounting

Lease Accounting

Lease accounting is one area that has attracted quite some controversy because of the potential for exploitation by companies. The classification of leases often proves difficult because lease indicators may not give similar implications. Finance leases give the lessee all the associated risks and rewards at inception. Any other lease is classified under operating leases. Specialised assets that are exclusively used by one entity are classified as finance leases and the lessor gets his return on investment from the lease payments (Edmonds et al, 2011). Non-specialised assets that can be sold or leased to other parties, with the financial risk going to the lessor, are generally treated as operating leases.

There are situations in which non-specialised assets can be converted to specialised category and vice versa (Jones, 2011). For example, an entity may lease some heavy equipment which has to be installed in its premises for many years. At the end of the lengthy lease period, the lessor may find it too expensive to facilitate the removal of such equipment. The conversion of a specialised asset into an operating lease requires that the equipment should still be functional at the end of the lease period but this might not be the case, with only the lessee finding value for it. In such situations, the lessee normally acquires such assets at the end of the lease period, either for free or pays some amount. When this happens the lease will now be considered a financial lease.

For assets that have been subject to multiple leases while still economically viable, the last lease before they are written off is treated as a finance lease (Edman, 2011). This is because the total amounts paid under the last lease may approximate the prevailing market valuation of the asset. Such a lease is unlikely to be extended, neither can the asset be bought a reasonable price because it is about to be written off. The last lease will only cover the remaining functional duration of the asset, and is thus treated as non-specialised.

According to IAS 17, the economic viability of an asset is the major determinant for classification as a finance lease. The multiple leases during the life of the asset are classified as operating leases because they form the basis for the lessor to recoup his investment in the asset (Edmonds et al, 2011). It follows that the last lease agreement before the asset is written off should not be treated any different since it is based on similar terms as the previous leases.

IAS 17 also provides that when assets are leased with payment of nominal rents, the agreement still qualifies as a lease. This is a form of operating lease because all the rent paid during the lease agreement are not enough to match the market value of the asset (Edman, 2011). For such agreements where rents are low, there is usually a premium paid upfront which amounts to a substantial portion of the assets fair value. For agreements with low rent and no upfront premium charged, it would appear the lessor is not keen on how the risks and rewards impact on his commercial interests.  Before such leases are classified, it is imperative to analyse the lessor’s intentions that drove him to enter into such terms (Lambert & Lambert, 2011).

‘Off-balance sheet financing’ refers to strategies used by companies to understate the extent of their liabilities when publishing their financial statements (Edman, 2011). Managers tend to use these strategies to navigate debt covenants according to the terms and conditions under which their firms have borrowed. Leasing represents the most commonly used device for off-balance sheet financing. Normal accounting practices require that equipment purchased on credit terms are listed as both assets and liabilities in the company’s accounts. However, accompany that enters into a lease transaction has the chance to avoid this requirement and simply list lease payments as expenses for the periods during which those payments are made. During this time, the entity is not particularly required to reflect these in their balance sheet.  Schedule 5 of the Corporations Regulations only makes provisions for disclosure in notes indicating the amount and time of these payments (Lambert & Lambert, 2011).

The interpretation of leases is largely dependent on professional judgment, leading lessees to seek ways of keeping off their lease liabilities from the balance sheet (Edman, 2011).  AAS 17 recognizes through an editorial note that it may not be appropriate for both the lessor and lessee to adopt the same classification. Under AASB 1008, a commentary points to a standard resulting from the identical classification of a lease by the lessor and lessee. In practice, the lessor and the lessee tend to classify lease differently, with lessees preferring ‘operating’ leases.

Leasing agreements fall under a broad category called executor contracts, which refer to contractual arrangements based on future performances by the contracting parties (Miller & Bahnson, 2010). For all executor contracts, access to a given asset is spread over a long period of time. There is no requirement for current reporting of future obligations under such contracts since the lessee will access the asset until a future date. The ordinary lease agreement is exempt from this situation. According to current accounting practice, both the asset and related liability must be indicated in the company’s balance sheet for assets purchased outright using a debt instrument (Miller & Bahnson, 2010).

Today, many organisations opt for asset leasing rather than direct purchase, partly because they will not be required to report the future lease obligation as a liability under current lease accounting (Doupnik & Perera, 2012). This presents one way of maintaining the company’s ability to acquire external financing. A good example is ICI Australia Ltd, which in 1980 announced a joint venture with the Australian Mutual Provident Society to develop an ethylene plant called Olefines Pty. Ltd. The arrangement was that ICI would lease the plant from Olefines for duration of seventeen years. Essentially, this arrangement enabled ICI to acquire an ethylene plant off-balance sheet, with a lease obligation of $4.9 million after one year and totalling to $499 million for the remaining life of the lease (Kangarluei et al, 2012).

There are situations where assets held under a finance lease are wholly or partially sub-let to another party based on the same terms and conditions. Leased accommodation premises may be shared by more than one entity. Usually, the lead entity leases the whole asset then invites others to re-lease part or all of it (Doupnik & Perera, 2012). The IAS 39 de-recognition requirements outline how such a situation is to be handled. The terms of the initial lease form the basis of its treatment as a finance lease. The other transactions between the lead entity and others have no bearing on how the lead entity honours the terms of the initial lease agreement (Miller & Bahnson, 2010). Even of the other entities fail to honour their agreement with the lead entity,  the lead entity is still obligated  to honour the  terms of the initial agreement.

According to IAS 17, contingent rents are treated as income/expenses rather than minimum lease payments for the period during which they apply (Elliott & Elliott, 2013). They are supposed to be paid as part of the lease payment but are pegged on some events happening in the future. Since such amounts are not decided when the lease is initially drawn, they are not counted as interest payments because there is no time link. Lessors go for contingent rent to cover for depreciation in the use of the asset while lessees try to cover a potential decrease in future sales (Carpenter & Mahoney, 2011).

There are leases that contain a clean break clause, which allows the lessee to discard the lease agreement after a certain period without being penalized (Miller & Bahnson, 2010). In such agreements, the lease term runs from the date the agreement is signed to the date when one party can break from the lease. It is not uncommon for such leases to include a termination clause, so that the lessor can get some compensation if the lessee decides to pull out of the agreement (Elliott & Elliott, 2013). However, this termination clause will not be considered when determining the lease terms.

The accounting loopholes in the determination of leases have been exploited to the detriment of users of financial statements. This is because they do not always present an honest outlook of lease transactions (Carpenter & Mahoney, 2011). The main issue of contention is the failure to recognize operating leases as giving rise to assets and liabilities. Many users of financial statements have been calling for changes in the accounting requirements to remedy this situation. This has led the IASB and FASB to propose new provisions that will see the listing of all lease agreements in company balance sheets as outlined in ED 2013/6 Leases. The AASB released similar proposals titled ED 242 (Doupnik & Perera, 2012).

ED 242 provides that an identified asset must be put in use in order for there to be fulfilment of the lease contract (Elliott & Elliott, 2013). However, this requirement is not applied if the supplier is allowed a substantive right to substitute the asset during the period of the lease contract. This provision already presents a potential loophole for contracts not to be classified as leases, as long the use of an asset is not relied upon to qualify fulfilment (Carpenter & Mahoney, 2011). If this happens, no right-of-use asset will be listed on the company’s balance sheet.

Under the new proposals, the lessee’s recognition of expenses and cash flows arising from a lease will be based on the potential economic benefits going to the lessee from the underlying asset (Miller & Bahnson, 2010). Most leases involving assets other than property will be classified as type A leases. Leases of land, property and buildings are classified as type B leases (Doupnik & Perera, 2012). In the same way, the lessor’s accounting will also depend on the expected benefits to be consumed by the lessee for the underlying asset.

Measurement of assets and liabilities related to a lease requires the lessor and lessee not to include most variable lease payments (Elliott & Elliott, 2013). Companies are required to make disclosures that enable users of financial statements to understand cash flow issues arising from leases (Carpenter & Mahoney, 2011).

Leasing is an important financing tool widely used in the business world, and is commonly used by organisations to stretch the legislative and taxation framework within a financial system (Carpenter & Mahoney, 2011). Several structured operating leases have been offered in the lease market over the years. This move was partly driven by the fact that accounting standards require finance leases to be capitalized onto company balance sheets. Operating leases, on the other hand, need not be in the balance sheet and are only disclosed using footnotes on the same (Elliott & Elliott, 2013). Nevertheless, new proposals seek to change this and put operating leases also on the balance sheet.

Previously, operating leases were mainly used by large corporations, especially U.S.-based companies. This has come to change over the years and many public and private sector lessees are now keen on using operating leases (Carpenter & Mahoney, 2011). They have become a common feature of the fleet leasing industry and form an integral component of fleet management. When using operating leases, the lessor usually hopes that after the expiry of the lease period, the asset will still be able to fetch a good price in the market (Elliott & Elliott, 2013).

The treatment of leases has for a long time been a source of controversy in the accounting profession (Miller & Bahnson, 2010). Essentially, operating leases do not end up as assets or liabilities while financial leases are considered an acquisition of assets on credit terms. This means that any business entering into financial lease will be required to list it on its balance sheet as both an asset and liability. Focus now shifts to interpretation of accounting standards to determine whether a particular contract amounts to a finance or operating lease (Elliott & Elliott, 2013).



Carpenter, B. W., & Mahoney, D. P. (2011). Expanding The Accounting Education Horizon: Sensitizing Students To The Profession’s Societal Obligations. Journal of Business & Economics Research (JBER)4(1).

Doupnik, T. S., & Perera, M. H. B. (2012). International accounting. New York: McGraw-Hill Irwin.

Edman, B. R. (2011). Leases: Off-Balance Sheet Financing and the Strive for Transparency Today.

Elliott, B., & Elliott, J. (2013). Financial accounting and reporting. Harlow: Pearson.

Edmonds, T. P., Tsay, B.-Y., & Olds, P. R. (2011). Fundamental managerial accounting concepts. New York: McGraw-Hill Irwin.

Henry, E., & Holzmann, O. J. (2011). Lease accounting project reaches exposure draft stage. Journal of Corporate Accounting & Finance22(2), 65-70.

Jones, M. (2011). Creative accounting, fraud and international accounting scandals. Chichester, West Sussex, England: John Wiley & Sons.

Kangarluei, S. J., Motavasel, M., & Sharifi, R. M. (2012). The Effect Of Off-Balance Sheet Financing On Profitability And Leverage Ratios. Editorial Note Words from the Board of Editor 2 Profile of Authors Included in this Number 3 Information for Contributors 55(1), 85.

Lambert, C., & Lambert, C. (2011). An investigation of earnings management through investments in associated companies: An Australian perspective. Journal of Business & Economics Research (JBER)1(7).

Miller, P., & Bahnson, P. (2010). Off-Balance-Sheet Financing: Holy grail or holey pail?.Accounting Today24(13), 16-17.


Leave a comment

Your email address will not be published. Required fields are marked *