Auditing leases: completeness, measurement and disclosure

In this lesson you will

Design completeness procedures that find unrecorded and embedded leases
Test lease term and discount rate as accounting estimates under AU-C 540
Recompute lease balances and roll forward each class
Tie lease disclosures to the general ledger and lease schedule

Where the risk sits

Lease balances fail in three ways: a lease is missing, a recorded lease is measured wrong, or the disclosures do not agree with the books. Completeness is the assertion that gets the least testing, because the client's lease schedule is built from the leases the client knows about.

Completeness procedures

Run more than one of these, because each catches a different gap:

Disbursement scan. Sort the vendor payment listing for recurring fixed payments (monthly, same amount, same payee) to landlords, equipment finance companies, fleet providers and related parties. Agree each to the lease schedule or to a documented conclusion that no lease exists.
Contract read. Read significant service, supply, logistics, data center and outsourcing contracts for specified assets the client controls (Lesson 2).
Related parties. Compare the related party list to the lease schedule. A building owned by the shareholder with no written lease is a common miss. The ASU 2023-01 expedient for common control leases (private companies and not-for-profits that are not conduit bond obligors) relies on written terms, so without a written lease it is unavailable unless management documents the terms before the statements are issued.
Fixed asset and location review. Compare the client's operating locations and significant equipment to owned assets and recorded leases.
Minutes and inquiries. Board minutes, management inquiries and legal letters can reveal new commitments, especially leases signed but not yet commenced, which are disclosed.

Testing the estimates

Lease term and discount rate are accounting estimates. Under AU-C 540 you assess inherent risk with reference to estimation uncertainty, complexity and subjectivity, then respond.

Lease term. For leases with renewal options, test management's reasonably certain analysis against the contract-based, asset-based, entity-based and market-based factors in 842-10-30-2, such as leasehold improvement spend, relocation cost, renewal rates against market, and how central the location is. Look for inconsistency, such as a renewal excluded from the lease term while leasehold improvements are depreciated over the renewal period.
Discount rate. Test the incremental borrowing rate to evidence: recent secured borrowings, bank quotes or a documented build-up. For a risk-free election, agree the rate to Treasury yields of matching term at commencement and confirm the class-level election is disclosed (ASU 2021-09).
Retrospective review. Compare prior-year term judgments with what happened, such as options exercised that were excluded.

Recomputation and rollforward

For a sample of new and modified leases, agree inputs to the signed agreement and recompute the liability and ROU asset. For the population, roll forward each class from opening balance through additions, modifications, payments, interest or straight-line cost, impairment and terminations to closing. Agree payments to cash disbursements. Test classification for new leases.

Disclosures

Tie the required amounts to the schedule and general ledger: finance lease cost split between amortization and interest, operating, short-term and variable lease cost, cash paid split by operating and financing cash flows, noncash additions, weighted-average remaining term and discount rate (842-20-50-4), and the maturity analysis reconciled to the liability (842-20-50-6). Confirm each policy election is stated. The lease disclosure checklist covers the full list.

Controls

For a client with many leases, understand the lease process: who identifies new contracts, who determines term and rate, and who reviews the schedule. The fixed asset and lease RCM lists typical controls and test steps.

Worked example

An unrecorded equipment lease at Cobalt Machining, LLC

During the disbursement scan for Cobalt Machining, LLC, the senior finds 12 payments of $9,500 to an equipment finance company. The lease schedule has no matching entry. The controller explains the CNC machine was "rented" in January and the payments go to repairs expense.

The senior obtains the agreement: a 36-month lease, monthly payments in arrears, no purchase option, a machine with a 10-year life and a fair value of $650,000. Cobalt's incremental borrowing rate is 6 percent (0.5 percent monthly).

Classification: 3 of 10 years and a present value well below 90 percent of fair value. Operating.

Initial liability: $9,500 x 32.8710 = $312,275. After 12 payments the liability is about $214,300 (24 remaining payments discounted at 0.5 percent). The ROU asset equals the liability, since no prepaid, incentive or initial direct cost exists.

Conclusion: both balances are understated by about $214,300. The income statement effect is a reclassification from repairs to lease cost. The senior proposes the entry, evaluates the control deficiency in lease identification, and expands the disbursement scan to other finance companies.

Self-check

Answer each question before you open the answer.

Why is a disbursement scan more effective than inquiry for lease completeness?
Show answer
Inquiry relies on management knowing which contracts are leases. A scan of recurring fixed payments surfaces arrangements management did not identify, including embedded and related party leases.
What inconsistency would you look for when testing lease term?
Show answer
Leasehold improvements depreciated over a renewal period that management excluded from the lease term. The two judgments rest on the same expectation and should agree.
Which lease disclosure requires a reconciliation to the balance sheet liability?
Show answer
The maturity analysis of undiscounted cash flows, which is reconciled to the lease liabilities (842-20-50-6).

Sources

Back to the syllabus

Standards are paraphrased from the primary sources listed above; read the source before relying on a requirement. This lesson is training material, not professional advice. Report an error