Audit of leases, the audit objectives and audit program to be prepared while auditing the lessee obligation

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

For further reference, read also :

• The right way to classify a lease
• How is the treatment of land and buildings lease transaction ?
• Effect of operating and finance leases on lessee financial statements and key financial ratios

WHY We Need to Know the Client's Business ?

Obtaining an understanding of the client’s business is key to an effective and efficient audit. It enables us not only to tailor our work to meet the individual facts and circumstances of each client, but also to carry out that work and to evaluate our findings in an informed manner. Our knowledge of the client’s business also helps us to develop and maintain a positive professional relationship with the client.

International Standards on Auditing (ISA) 315 states that the auditor should obtain an understanding of the entity and its environment, including its internal control, sufficient to identify and assess the risks of material misstatement of the financial statements whether due to fraud or error, and sufficient to design and perform further audit procedures.

Understanding the entity is an iterative process, continuing throughout the entire duration of the audit.

Prior the accepting an audit engagement, we should obtain a preliminary knowledge of the industry and of the ownership, management and operations of the entity to be audited.

Detailed information is required at the planning stage of our audit to enable us to plan our work adequately. We need to understand the nature of client’s business, its organization, its method of operation and the industry in which it is involved. This understanding enables us to appreciate which events and transactions are likely to have a significant effect on the financial statements.

Specifically, such an understanding helps us to :

• Identify the areas of high risk where we should concentrate our audit effort
• Maximize efficiency in other areas of audit significance
• Assess the potential for use of analytical procedures, by enabling us to identify the information which we can use to make predictions and comparisons
• Obtain an understanding of the internal control structure
• Assess the inherent and control risks in the key areas of audit significance
• Develop an audit strategy enabling us to obtain the necessary audit evidence in the most effective and efficient manner possible.

Knowing the client’s business helps us in a number of ways both during the conduct of the audit, and when we come to complete our work.

This includes, for example, helping us in :

• Recognising errors in the financial statements
• Asking the right questions and evaluating the reasonableness of the answers we receive
• Making judgements about the appropriateness of the client’s accounting principles, policies and procedures
• Identifying unusual or unexpected transactions and related party transactions
• Interpreting the results of audit tests and evaluating their effect
• Carrying out appropriate procedures to review events occurring after the balance sheet date
• Carrying out an overall review of the financial statements.

Knowledge of the client’s business and the industry in which it operates is essential also to the development of a positive relationship and it helps us as follows :

• In understanding the management’s philosophy and aspirations for the business
• Understanding the business strategy and plans
• Providing relevant and practical business advice to the client
• Identifying areas in which the client might benefit from other professional services which we provide.

ISA 315 states that :

• the auditor should obtain an understanding of relevant industry, regulatory, and other external factors including the applicable financial reporting framework
• the auditor should obtain an understanding of the nature of the entity
• the auditor should obtain an understanding of the entity's selection and application of accounting policies and consider whether they are appropriate for its business and consistent with the applicable financial reporting framework and accounting policies used in the relevant industry
• the auditor should obtain an understanding of the entity's objectives and strategies, and the related business risks that may result in material misstatement of the financial statements
• the auditor should obtain an understanding of the measurement and review of the entity's financial performance.

Each year, the auditor's understanding of the entity should be updated and details of significant changes documented (Hrd) ***