Lease meaning :
- Lease is an agreement between the Lessor and the Lessee.
- It is for an agreed period of time for an agreed consideration.
Lessor transfers the right to use the property and Lessee transfers the consideration for that transfer of rights.
Why Lease Audit is required?
A lease audit is necessary for several reasons, and it plays a crucial role in ensuring that lease agreements are accurately documented and adhered to.
Here are some key reasons why lease audits are important:
Rent Payments :
Lease audits assist in making sure that the rent paid by the tenant is correct and compliant with the terms mentioned in the lease. Verifying the computation of basic rent, additional rent, and any other costs or fees is part of this.
Lease Terms :
Cost reduction :
Error Detection :
Risk Identification :
Types of leases in financial statement :
Leases for operations :
The lessor does not record the leased asset or debt on the balance sheet under operating leases. Rather, lease payments appear on the income statement as operational expenses.
Unless another systematic basis more illustrative of the pattern in which the benefit of the leased asset is consumed is deemed acceptable, the rental expenses related to operational leases are recognized evenly over the lease term.
Leases with financing :
Contrarily, under a finance lease, the lessor and lessee must both acknowledge the lease’s assets and liabilities on the balance sheet.The lessee records an asset at the beginning of the lease that represents the right to use the leased asset and a liability for the present value of future lease payments.The decrease of the lease burden and interest expense are divided into lease payments, with the interest component decreasing with time.
Accounting of both the leases in the books differ accordingly based on the entities turnover.
Conditions to identify whether the lease is financial or operation
If any one of the following conditions is satisfied then the lease is classified as financial.
Ownership Transfer : At the conclusion of the lease period, the lessee receives ownership of the asset.
Purchase Option : The lease gives the lessee the option to buy the asset at a predetermined price as long as it’s anticipated to be significantly less than fair value on the day the option becomes exercisable. A financing lease is indicated by the lessee’s reasonable certainty of exercising this option.
Lease Term : The majority of the asset’s economic life is covered by the lease. It is implied that the lessee is reaping the majority of the financial rewards from using the asset if the lease is for the majority of the lessee’s economic life.
Specialized Nature : Leased is of specified nature such that only the lessee can use it without major modifications being made.
Current Lease Payment Minimum’s Present Value : Excluding maintenance expenses, the present value of the minimum lease payments at the beginning of the lease equals or surpasses the fair value of the leased asset by a significant margin. A financial lease is indicated if the minimum lease payments’ present value approaches or surpasses the asset’s fair market value.
Accounting and Disclosure :
Financial Lease (Lessor's Perspective):
Initial Recognition :
The lessor recognizes the leased asset as a receivable at an amount equal to the net investment in the lease. The net investment in the lease is the aggregate of the minimum lease payments and any unguaranteed residual value accruing to the lessor.
Gross Investment in the Lease :
The gross investment in the lease is the sum of the minimum lease payments and any unguaranteed residual value accruing to the lessor. Initial direct costs incurred by the lessor are added to the gross investment in the lease.
Unearned Finance Income :
The difference between the gross investment in the lease and the cost of the leased asset is recognized as unearned finance income.
Recognition of Finance Income :
Finance income is recognized over the lease term, applying the interest rate implicit in the lease. Alternatively, when the interest rate implicit in the lease cannot be readily determined, the lessor uses its incremental borrowing rate.
Residual Value :
Any unguaranteed residual value accruing to the lessor is recognized as income when it becomes certain that it will not be subject to significant reversal.
Operating Lease (Lessor's Perspective) :
Initial Recognition :
The lessor continues to recognize the leased asset in its books.
The asset is depreciated in accordance with the lessor’s normal depreciation policy.
Lease Income :
Lease income from operating leases is recognized on a systematic and rational basis over the lease term.
Disclosures :
Finance Lease :
Disclose the gross investment in the lease and the unearned finance income. Disclose contingent rents recognized as income.
Operating Lease :
Disclose total contingent rents recognized as income.
Finance Lease (Lesse's Perspective) :
Initial Recognition :
The lessee recognizes a leased asset and a liability for future lease payments at the present value of the minimum lease payments. Initial direct costs incurred by the lessee and any initial direct costs incurred by the lessor on behalf of the lessee are added to the amount recognized as an asset.
Lease Liability :
The lease liability is reduced as lease payments are made, and interest is recognized on the outstanding lease liability using the interest rate implicit in the lease. If the interest rate cannot be readily determined, the lessee uses its incremental borrowing rate.
Depreciation :
The leased asset is depreciated over its useful life.
Finance Cost :
The interest on the lease liability is recognized as finance cost over the lease term.
Operating Lease (Lessee’s Perspective) :
Disclosures :
Finance Lease :
- Disclose the total of future minimum lease payments.
- Disclose the total of future minimum sublease payments expected to be received under non-cancelable subleases.
- Disclose the interest on the net investment in the lease.
- Disclose the depreciation on the leased asset.
Operating Lease :
Disclose the total of future minimum lease payments under non-cancelable operating leases for each of the following periods: not later than one year, later than one year and not later than five years, and later than five years. Disclose contingent rents recognized as an expense. Disclose the total of future minimum sublease payments expected to be received under non-cancelable subleases.
PKC play a crucial role in helping companies conduct lease audits by providing an independent and objective assessment of their lease agreements.
Here are some ways in which PKC assist companies in the lease auditing process :
Review of Lease Agreements :
PKC thoroughly examine lease agreements to understand the terms and conditions outlined in the contract. This includes rent payments, lease duration, renewal options, maintenance responsibilities, and any other financial and operational aspects specified in the lease.
Financial Analysis :
PKC perform a detailed financial analysis of lease-related transactions. This involves reviewing rent payments, operating expenses, and other financial data to ensure accuracy and compliance with the terms of the lease.
Expense Verification :
PKC verify the accuracy of expenses associated with the leased property. This may include scrutinizing invoices, receipts, and other supporting documents to confirm that expenses are in accordance with the lease agreement.
Compliance Assessment :
PKC assesses whether both the landlord and the tenant are in compliance with the terms of the lease. This includes identifying any potential violations and assessing adherence to financial and operational obligations.
Identification of Irregularities :
PKC are tasked with identifying any irregularities, discrepancies, or potential areas of concern within the lease agreements. This may include issues related to financial reporting, accounting practices, or other contractual obligations.
Author
Logitha S
