Question

Kapiti Ltd runs a successful chain of fashion boutiques, but has been experiencing significant cash flow problems. The directors are examining a proposal made by an accounting consultant that all the shops currently owned by the company be sold and either leased back or the businesses moved to alternative leased shops. The directors are keen on the plan but are puzzled by the consultant’s insistence that all lease agreements for the shops be ‘operating’ rather than ‘finance’ leases.

Meanwhile, Scarlett Ltd agreed to lease their 5 buildings to Kapiti Ltd.

The lease agreement details are as follows:

Length of lease	10 years
Commencement date	1 July 2020
Annual lease payment, payable 1 July each year commencing 1 July 2020 ($120000 x 5)	$600 000
Estimated economic life of the building	10 years
Annual Interest rate implicit in the lease	10%

The Chairman of the Board directed the Company Accountant to submit a detailed report on the above project.

Required

Explain, by reference to the requirements of AASB 117, why the consultant prefers operating to finance leases.                                                   

Answer 1

According to AASB 117, a lease is considered to be a finance lease if it transfers substantially all the risks and rewards incidental to ownership.

A finance lease (also known as a capital leaseor a sales lease) is a type of lease in which a finance company is typically the legal owner of the asset for the duration of the lease, while the lessee not only has operating control over the asset, but also some share of the economic risks and returns from the change in the valuation of the underlying asset. The consultant prefers operating to finance lease because :

• it's not cancel-able
• the lessor may or may not bear the cost of insurance, repair, maintenance, etc. Usually, the lessee has to bear all cost.
• the lessor may transfer ownership of the asset to the lessee by the end of the lease term
• the lessee has an option to purchase the asset at a price which is expected to be sufficiently lower than the value at the end of the lease period.