The following business situation, which commonly arises in practice, has been presented to your firm for advice. Tarzan Ltd (your client) has considerable assets and is earning strong profits but has limited cash reserves. Further, Tarzan Ltd has substantial long term borrowings. One of the conditions specified in the loan contracts with its major lender is that Tarzan Ltds debt to asset ratio, defined by the lender as the ratio of total liabilities to total assets, cannot exceed 75%. Breach of this condition triggers loan default.

Tarzan Ltd is considering a proposal from East Finance Ltd as a means of funding an expansion opportunity. The proposal under consideration by Tarzan Ltd is the sale-and-leaseback of existing land and building following an offer made from East Finance Ltd. The terms of the sale-and-leaseback proposal are as follows:

On 1 July 2017, East Finance Ltd would purchase land and building from Tarzan Ltd for $12,000,000. Tarzan Ltd would then lease back the land and building from East Finance Ltd, the terms of the contract for the lease back of the land and building being:

Term of the lease 10 years

Annual lease payments to be paid on the 1 July $1,500,000

First payment due 1 July 2017

Residual value of the land at the end of the lease $2,439,525 (not guaranteed by Tarzan Ltd)

Interest rate implicit in the lease 8%

Remaining useful and econimic life of Building 10 years

Tarzan Ltd measures land and buildings using the cost model. At the time of proposed purchase (1 July 2017), the relevant carrying amounts and fair values of the land and building are

	Carrying Amount	Fair Value
Land	$6,500,000	$8,400,000
Buliding	$2,500,000	$3,600,000

The building will be demolished at the end of the lease term (10 years), thus the residual value under the lease agreement is wholly attributable to the land but does not represent the estimated fair value of the land at the end of the lease. At the end of the lease, East Finance Ltd will sell the land for redevelopment and is certain of recovering the residual.

To assist with your analysis, Tarzan Ltd has provided you with forecast summary financial information as at 30 June 2017.

	30/6/2017
Current assets	$480,000
Non-current assets( includes land and buildings)	$14,500,000
Current liability	$410,000
Non-current liability	$10,675,200
Total equity	$3,894,800

East Finance Ltd has indicated to the directors of Tarzan Ltd that they believe the sale-and-leaseback arrangement would be classified as an operating lease suggesting, therefore, that the proposal would not influence their current lending contracts. However, Tarzan Ltd has reservations regarding the suggested classification of the transaction by East Finance Ltd and have sought advice from your accounting firm to assist them verify how the proposal should be treated to ensure compliance with Australian accounting regulations and in deciding if the proposal should be adopted.

Required to: Classify the lease is either operating lease or finance lease comply with International Accouting Standard. Please show your explanation and relevant accounting standard.