The essential difference between an operating and a finance lease is that in the former the benefits and costs of ownership remain with the lessor but with the latter they pass to the lessee. In other words, an operating lease is a hiring arrangement while a finance lease is a financing arrangement. The essential difference may be illustrated in another way. An operating lease is likely to exist if acquiring legal ownership of the property is not a viable option, for example because the lessee’s need for the resource is short-term. On the other hand, a finance lease is likely to exist if acquiring legal ownership is regarded as a possible way of obtaining the services provided by the property.
In summary, the capitalisation treatment will result in an increased debt ratio (implying higher financial risk, an increase in the rates of interest on debt, and a reduced credit rating) and lower return on total assets (implying inferior operating performance and possibly reduced management incentives such as bonuses).
Managers will not be indifferent to the choice between these treatments. They have strong incentives to favour the expense treatment and to ensure that leases are classified as operating leases. Empirical accounting research shows that following the introduction of accounting standards that mandated the operating/finance lease distinction, many lessees restructured their leases to ensure that they could be classified as operating leases and qualify for off-balance sheet treatment.
According to AASB 117, to determine whether a lease is a finance lease we must examine whether substantially all the risks and rewards incidental to ownership are transferred from the lessor to the lessee. Rewards of ownership of assets include the use of the asset and the benefit of any increased value of the asset. The lease clearly transfers the reward of use of the asset to the lessee, but only for a period equal to 40% of the asset’s expected useful life. The reward of any increase (or the risk of any decrease) in value remains with the lessor. This is indicated by the unguaranteed residual value. Risks of ownership include losses due to theft, damage or obsolescence; risks associated with declines in asset values. The risks of loss are transferred to the lessee, who is responsible for insuring the asset. A further indicator is the relationship between the present value of the lease payments and the fair value of the asset being leased. The present value of 24 monthly payments of $2 750 given a rate of interest of 0.5% is $62 048 (89.9% of fair value). Is this ‘at least substantially all’? A further issue in this case is that if the lessee cancels the lease he is liable to pay ($2 750 × 12 =) $33 000. This is a substantial penalty and, according to para. 11 of AASB 117, is an indicator that the lease could be classified as a finance lease. Overall, a majority of risks and rewards of ownership are transferred to the lessee, but not all. Given the incentives of lessee’s to classify leases as operating, it seems likely that this lease would be classified in that manner.
P12.5
Lessor’s Books: XYZ Company PV of lease payments = $15 000 + = $71 861 Given that this is a dealer or manufacturer lease, we assume that 10% is the market rate of interest, and there is no unguaranteed residual. Based on these assumptions, the journal entries would be as follows:

_________________________________________________________________ 1 July 2009 Lease receivables Dr $71 861 Cost of goods sold Dr 52 000 Sales Cr $71 861 Inventory Cr 52 000 _________________________________________________________________ 1 July 2009 Cash at bank Dr $15 000 Lease receivables Cr $15 000 _________________________________________________________________ 30 June 2010 Interest