For accounting and financial reporting purposes, an entity as the lessee has two alternatives in classifying a lease : (1) Operating Lease, (2) Finance Lease. The proper classification of a lease is determined by the circumstances surrounding the leasing transaction. According to IAS 17 : Leases, whether a lease is a finance lease or not will have to be judged based on the substance of the transaction, rather than on its mere form. If substantially all of the benefits and risks of ownership have been transferred to the lessee, the lease should be classified as a finance lease. Besides, IAS 17 also stipulates that substantially all of the risks or benefits of ownership are deemed to have been transferred if a lease transaction meets any one of criteria as prescribed in para. 10 and para. 11 of IAS 17.
While conducting an audit of lease transaction, the auditor shall take notes of the following principal objectives :
- Determine that all finance leases are recorded in the balance sheet with appropriate classification of the leased asset and the obligation
- Ascertain that depreciation expenses and interest expense relating to finance leases and rent expense on operating leases have been calculated and reported properly in the income statement
- Ascertain that footnote disclosure of finance lease and operating lease obligations are adequate and are in compliance with the disclosure requirements of IAS 17
The auditing procedures related to lessee obligations consist principally of a careful examination and study of the lease documents to determine the substance of the transaction and the proper accounting treatment. During the examination of the lease agreements, the auditor normally prepares a summary of the terms and provisions of each lease for his or her permanent file working papers documentation.
Then, how the auditor should prepare his or her audit program in relation with the audit of lease transaction ?
An audit program for lease obligations would include the following steps :
- Examine lease agreements and prepare a summary of key terms and pertinent data for the permanent file
- Determine that leases have been properly classified as either finance leases or operating leases using the criteria of IAS 17
- For capitalized leases, check the present value computations and determine the appropriateness of the discount rate used
- Determine that lease payments and expenses included in the accounts are in agreement with the provisions of the lease contracts
- Determine that executory costs to be paid by the lessee (property taxes, insurance, etc.) have been properly accrued and included in expenses
- Determine that any additional contingent rents payable have been accrued (such contingent rents may result from escalation clauses, gross receipts, provisions, etc.)
- Ascertain that footnote and balance sheet disclosures are in accordance with IAS 17
Source : Accountants’ Handbook – Lee.J.Seidler and D.R.Carmichael
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