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Risk Assessment Problems Resulting from the Misclassification of Leases

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The way leases are accounted for has been the subject of extensive criticism over many years, particularly their role in ‘off balance sheet’ financing. The accounting standard AASB 117 aims to prevent the potential risk assessment problems resulting from the misclassification of leases. In order for appropriate risk evaluations to be made, all the relevant information must be disclosed in the financial statements. The aim of the IAS and AASB 117 accounting standard is to ensure that leased assets in which all the risks and returns of holding the asset are transferred to the lessee upon the commencement of the lease are disclosed in the statement of financial position. This ensures that any judgements made about the performance of the company and therefore the risk to investors and creditors is based on accurate information. There have been incidences in the past where companies have attempted to mislead investors by leasing rather than purchasing assets and misclassifying them as operating leases, thus manipulating their financial statements. This essay will define leases and outline how they are accounted for, discuss the incentives for a company to misclassify leases and how this affects the accuracy of risk assessments, and discuss the effectiveness of the AASB117 standard in countering these practices.
A lease is defined as an agreement where the lessee acquires the right to use an asset from the lessor for an agreed period of time, in exchange for a series of payments (Deegan, 2012). The classification of a lease involves determining how it will be treated in the financial statements. An operating lease is a contract that conveys the right to use the asset to the lessee, but the rights of ownership remain with the lessor (Investopedia). Such a lease is not capitalized as an asset, but is treated as a rental expense. A financial lease is one that substantially

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