Question

Your audit client is in the construction industry. As such, the company has numerous fixed asset additions during the year, as well as a material expense for equipment rental. In your planning phase of the audit, you discover from conversations with the audit client's accounting personnel that there appears to be a lack of understanding on the correct accounting treatment for capital leases versus operating leases for equipment. Based upon this information, what relevant assertion(s) for fixed assets should you as the auditor be concerned about? Explain.

Answer 1

To answer this question, it is very important to know the definition of capital lease, Operating lease and how they operate, what are the key points to look at in terms of accounting.

If one have this above basic knowledge, then it would be very easy to answer the question.

Capital Lease: The name suggests itself that the ownership of the asset is transferred to the lessee. This type of lease is very similar to the assets purchased by way of paying EMI i.e, finance purchase, after the end of lease term, asset ownership might be transferred to the lessee.

Operating lease: This is very similar to renting property, Ownership is retained by the lessor and after the expiry of the lease, lessee has to transfer the possession of the property to the lessor.

How both of these leases work: Generally, the capital lease covers more than the estimated useful life of the asset, as the ownership is transferred, all expenses incidental to ownership (like maintenance, insurance, taxes) are also to be borne by the lessee. The operating lease term generally less than the useful life of the asset, since the ownership does not transfer, expenses incidental to ownsership are not transferred to lessee and are borne by lessor.

Accounting: In Capital lease, since the ownership is transferred, the asset has to be recognized in the balance sheet and the liability to pay of lease payments are also recognized in the balance sheet. Lessee can claim depreciaiton and Interest if any on the asset in his books of accounts. In Operating lease, Lease rentals are to be recognized in the Expenses side of Profit and loss account, no other accounting treatment is required for operating lease.

As an auditor, if the auditee staff does not have proper understanding of accounting for leases, I would check the following:

1. Study the lease agreement and understand what kind of lease.

2. After getting an idea of what type of lease it is, check whether the accounting treatment done is being correct or not? If it is a Capital Lease, check the balance sheet for the asset, if it is an operating lease check whether regular lease rentals are being debited in the profit and loss account.