# Audit of Lease Transactions

## Core Concept

A lease grants the right to use an asset (to the lessee) in exchange for lease payments/rent (paid to the lessor).

```

Lessor ──[Right to use asset]──► Lessee

Lessee ──[Lease payments / Rent]──► Lessor

```

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## Types of Lease

### A. Finance Lease

Definition: Substantially all risks and rewards incidental to ownership are transferred to the lessee.

#### Indicators — if ANY of these are present, it is a Finance Lease:

Indicator	Detail
(a) Bargain purchase option	Right to purchase asset at a reduced price at end of lease term
(b) Long lease term	Term covers substantially all of the asset's useful life
(c) Specialised asset	Asset is of a specialised nature — usable only by the lessee
(d) PV test	PV of minimum lease payments ≈ Fair Value of the asset at inception
(e) Expense bearing	Lessee bears all expenses — insurance, maintenance, etc.

#### Accounting by Lessee (Finance Lease):

Recognise the asset on the lessee's balance sheet
Charge depreciation on the asset
Recognise interest expense (finance cost) on the lease liability
Lessee enjoys the tax benefit of depreciation
Lease term is generally ≈ 75% of useful life

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### B. Operating Lease

Risks and rewards remain with the lessor
Lessor claims depreciation (retains ownership benefits)
Lessee treats lease payments as operating expense in the P&L
Asset remains on lessor's balance sheet

Feature	Finance Lease	Operating Lease
Risks & rewards transfer	To lessee	Remain with lessor
Depreciation claimed by	Lessee	Lessor
Lessee P&L charge	Depreciation + Interest	Lease rental (operating exp)
Asset on balance sheet	Lessee	Lessor

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## Audit Procedures — Lessor

1. Objective clause: Check the leasing company's charter/objective clause permits leasing activity

2. Credit analysis procedure: Verify whether the company has a documented procedure to assess creditworthiness of the lessee, covering:

Commitment under the lease
Past track record of the lessee
Collateral security offered

3. Examine the Lease Agreement and note the following:

(i) Description of equipment and location of installation
(ii) Amount, tenure of lease, date of payment, late charges, deposit
(iii) Whether equipment is to be returned to lessor at end of term
(iv) Whether the agreement prohibits subletting

4. Ensure invoice is retained safely

5. See Board Resolution authorising the director to execute the lease agreement

6. See copies of insurance policy obtained by lessor for the leased asset

7. Examine acceptance letter from lessee confirming the asset has been received

8. Examine the lease proposal form submitted by the lessee requesting the equipment

Worked example

### Example 1

Scenario: ABC Ltd. leases specialised machinery to XYZ Ltd. for 8 years. The machinery has a total useful life of 10 years. The PV of minimum lease payments is ₹9.5 lakh against the fair value of the asset of ₹10 lakh. Classify this lease.

Answer: This is a Finance Lease. Two strong indicators are present:

Lease term (8 years) = 80% of useful life → covers substantially all of the asset's life
PV of minimum lease payments (₹9.5 lakh) ≈ Fair Value (₹10 lakh) → PV test satisfied

XYZ Ltd. (lessee) must recognise the asset, charge depreciation, and recognise interest expense.

### Example 2

Scenario: A company leases office space for 3 years under a straightforward rental agreement. The building's estimated useful life is 60 years. There is no purchase option. Classify this lease.

Answer: This is an Operating Lease. The lease term (3 years) covers only 5% of the asset's useful life — far short of 'substantially all.' No indicators of a finance lease are present. The lessee will expense lease payments as operating costs; the lessor retains the asset on its balance sheet and claims depreciation.

### Example 3

Scenario: As the auditor of a leasing company (lessor), you are examining a large lease transaction. What key document should you examine to confirm the lessee requested and accepted the asset?

Answer: You should examine two documents:

1. The lease proposal form submitted by the lessee requesting the equipment — confirms the lessee initiated the arrangement

2. The acceptance letter from the lessee — confirms the asset was actually received and is in use

⚠️ Common exam mistakes

Assuming all long-term leases are finance leases — classification depends on transfer of risks and rewards, not just duration
In an operating lease, stating that the LESSEE claims depreciation — it is the LESSOR who claims depreciation in an operating lease
In a finance lease, recording only depreciation in the lessee's books and forgetting the INTEREST EXPENSE component on the lease liability
Confusing the indicators of a finance lease as cumulative — even ONE indicator being present is sufficient to classify a lease as a finance lease
Forgetting to check the Board Resolution when auditing a lessor — it is required to authorise the director to execute the lease agreement

Reference: — AS 19 — Leases (ICAI)

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Audit of Lease — Finance Lease vs Operating Lease

Worked example

⚠️ Common exam mistakes