For accounting purposes, leases are classified as either finance leases or operating leases.

The classification of a lease as an operating lease or a finance lease depends upon its economic substance.

A lease is classified as a finance lease if it transfers substantially all the risks and rewards incidental to ownership from the lessor to the lessee. A lease is classified as an operating lease if substantially all the risks and rewards incidental to ownership remain with the lessor.

The risks of asset ownership include those associated with unsatisfactory performance, obsolescence, idle capacity, losses in realisable value, uninsured damage and condemnation of the asset; the benefits include those obtainable from the use of the asset and gains in realisable value.

A finance lease is a form of borrowing. Only the Treasurer has the authority to borrow funds on behalf of the State. No other Minister or Head of Agency has the legislative authority to borrow funds, enter into finance lease agreements, or enter into any contract that involves the Agency in the borrowing of funds or guarantees borrowings by other parties.

Accordingly, agencies are only permitted to enter into operating leases.

Chart 1 Classification of a Lease (below) provides guidance on the accounting classification of lease arrangements. A lease that meets the following criteria will be classified as an operating lease:

Any implied terms or arrangements should be considered when determining the economic substance of a lease. For example, although a lease, or a sale and leaseback, may comprise only a minor portion of an asset’s economic life, the asset may be so essential that the lessee could not operate effectively without it. This implies either that the lease will be renewed or that the lessee will gain ownership of the asset, thus leading to classification of the lease as a finance lease.

Cancellable

Whether a lease is cancellable or non cancellable establishes the lessee’s right to uninterrupted use of the asset during the lease term. A cancellable lease is a lease which:

• does not require the permission of the lessor, and is not dependent upon the occurrence of some remote contingency to be cancelled;
• on cancellation, does not commit the lessee to enter into a further lease for the same, or equivalent, asset with the same lessor or a third party related to the lessor; or
• does not include a penalty of a magnitude that, in normal circumstances, could be expected to discourage cancellation.

Lease term means:

• the period of the lease; and
• any period of renewal of the lease flowing from an option, express or implied, which allows the lessee to renew the lease for a rental which, in relation to the expected fair rental of the asset at the date the option becomes exercisable, is low enough to make renewal of the lease appear, at the inception of the lease, to be reasonably assured.

Where a lease term commences within the last 25 per cent of the total useful life of the property the lease term criterion may become distorted in the later years of an asset’s life, and should not be applied.

The decision whether to lease or purchase an asset should be based upon a Business Case. The Business Case is developed to:

• gain approval to proceed with the asset acquisition;
• obtain resourcing for the asset acquisition; and
• document what the acquisition of the asset will accomplish and how this will be achieved.

Leasing also ensures that the lessor, as owner, bears the cost of changes in technology. This may be particularly important with information technology and other types of technical equipment.

The recommended methodology for use in preparing a Business Case is available at www.projectmanagement.tas.gov.au.

Whether purchasing or leasing an asset, an agency must comply with the Procurement requirements as set out in Part XI Procurement and Disposal.