Leases are agreements that grant the right to use an asset, usually for a period of time, in exchange for payment. As a result of the lease agreement, lessees and lessors must recognize lease assets and liabilities on their balance sheets.
In order to ensure that leases are accounted for correctly and in compliance with International Financial Reporting Standards (IFRS), it is important to conduct an audit of leases.
This technical article will provide an overview of audit procedures for leases under IFRS 16, including recognition, measurement, and disclosure of leases, as well as audit risks and considerations.
Accounting Under IFRS 16
IFRS 16, which came into effect on January 1, 2019, establishes a new accounting standard for leases. The standard requires lessees to recognize a right-of-use asset and a lease liability on their balance sheets, while lessors must recognize a lease receivable.
The recognition, measurement, and disclosure of leases under IFRS 16 differ from previous accounting standards and require a new approach to lease accounting.
Lessees must recognize a right-of-use asset, which is the amount of the lease liability adjusted for any prepaid or accrued lease payments and lease incentives.
The lease liability represents the obligation to make future lease payments. Lessees must also measure the lease liability at the present value of the future lease payments, discounted using the lessee’s incremental borrowing rate.
In addition, lessees must disclose key information about their leases, including the lease term, the amount of the lease liability, and the nature of the underlying asset.
Lessees must also provide a reconciliation of the right-of-use asset and the lease liability, as well as an explanation of any significant changes in the balance of these items during the period.
Audit Risks and Considerations
There are several audit risks and considerations associated with leases under IFRS 16, including:
- Misclassification of leases: Lessees may misclassify leases as operating leases instead of finance leases, which can result in incorrect recognition of lease liabilities and right-of-use assets.
- Mismeasurement of lease liabilities: Lessees may use incorrect discount rates or lease payment schedules when measuring the present value of lease liabilities, leading to incorrect amounts being recognized.
- Non-compliance with IFRS 16 disclosure requirements: Lessees may fail to disclose key information about their leases, including the lease term, the amount of the lease liability, and the nature of the underlying asset.
- Incorrect recognition of lease incentives: Lessees may recognize lease incentives incorrectly, leading to over- or under-recognition of lease liabilities and right-of-use assets.
- Incomplete or incorrect lease contract information: Lessees may have incomplete or incorrect information about the terms of their leases, which can result in incorrect recognition of lease liabilities and right-of-use assets.
- Lease modifications: Lessees may modify the terms of their leases, which can result in the need to reassess the lease liability and right-of-use asset.
- Lease renewals: Lessees may renew the terms of their leases, which can result in the recognition of new lease liabilities and right-of-use assets.
- Impairment of right-of-use assets: Lessees may recognize impairment losses on right-of-use assets, which can result in reductions in the balance of these assets.
- Depreciation of right-of-use assets: Lessees may depreciate right-of-use assets over the lease term.
Audit Assertions:
Audit assertions are the underlying representations and information that management has made regarding the financial statements and related information. For lease transactions, the following audit assertions are relevant:
- Existence: The underlying assets subject to the lease agreement exist and are under the control of the lessee.
- Rights and Obligations: The lessee has the right to use the underlying asset and is obligated to pay the rent under the lease agreement.
- Accuracy: The lease terms, including rent payments and lease classification, are accurately represented in the financial statements.
- Completeness: All leases have been recorded in the financial statements.
- Valuation: The lease liabilities are correctly measured and recorded in the financial statements.
Walkthrough Testing:
Walkthrough testing is a type of substantive audit procedure that involves tracing transactions from source documents to the financial statements. For lease transactions, the following walkthrough testing procedures can be performed:
- Review lease agreements to ensure that the terms and conditions match the information recorded in the financial statements.
- Compare lease payment schedules to rent payments recorded in the general ledger to verify the accuracy of rent payments.
- Verify that the lease liabilities are recorded in the correct accounts and are accurately calculated.
- Confirm that the correct lease classification has been applied in accordance with IFRS 16.
Test of Control:
Test of control is a type of substantive audit procedure that involves evaluating the design and effectiveness of internal controls related to lease transactions. The following test of control procedures can be performed:
- Review internal controls over the preparation and approval of lease agreements.
- Evaluate the accuracy of lease rent calculations and payments by testing a sample of transactions.
- Verify that proper lease classification is performed in accordance with IFRS 16.
- Ensure that lease liabilities are accurately recorded in the general ledger and reconciled to the lease agreement.
By performing these audit procedures, auditors can obtain reasonable assurance that lease transactions have been accurately recorded, processed, and reported in accordance with IFRS 16.
Substantive Audit Procedures
Substantive Audit Procedures are a set of audit tests performed by auditors to obtain evidence that supports the accuracy and completeness of the financial statements.
These procedures help the auditors to form an opinion on the financial statements and provide assurance to the stakeholders that the financial statements are free from material misstatements. In the context of leases, the substantive audit procedures for leases involve the following steps:
- Obtain an understanding of the entity’s leasing activities and lease agreements: The auditor must obtain an understanding of the entity’s lease agreements, including the terms and conditions, lease payments, and the nature of the underlying assets. This information can be obtained from the lease agreements, management, or from the entity’s lease accounting department.
- Review lease agreements for compliance with IFRS 16: The auditor should review the lease agreements to ensure that they are in compliance with the requirements of IFRS 16, which sets out the accounting requirements for leases. The auditor should also review the lease agreements to determine if any significant terms and conditions have changed during the year.
- Test the accuracy of lease recognition: The auditor should test the accuracy of the lease recognition process, including the identification of leases, the determination of lease and non-lease components, and the calculation of lease liabilities and right-of-use assets.
- Evaluate the accuracy of lease classification: The auditor should evaluate the accuracy of the lease classification as either finance or operating leases. This is an important step because the accounting treatment of leases depends on their classification.
- Test the accuracy of lease amortization: The auditor should test the accuracy of the amortization of the right-of-use assets, including the calculation of the amortization rate, the calculation of the lease liability, and the reassessment of lease terms.
- Evaluate the impairment of right-of-use assets: The auditor should evaluate the impairment of right-of-use assets, including the calculation of the impairment loss and the assessment of the recoverability of the right-of-use assets.
- Evaluate the accuracy of lease payments: The auditor should evaluate the accuracy of the lease payments, including the calculation of the lease liability and the classification of lease payments as principal or interest.
- Evaluate the accuracy of lease liability and right-of-use asset disclosures: The auditor should evaluate the accuracy of the disclosures related to the lease liability and right-of-use assets, including the lease term, the present value of lease payments, and the residual value of the right-of-use assets.
- Review the entity’s lease portfolio: The auditor should review the entity’s lease portfolio, including the types of leases, the nature of the underlying assets, and the lease term.
- Evaluate the entity’s lease portfolio for trends and patterns: The auditor should evaluate the entity’s lease portfolio for trends and patterns, including changes in lease terms and lease payments, the age of the underlying assets, and the entity’s lease portfolio size.
By performing these substantive audit procedures, the auditor can obtain sufficient evidence to support the accuracy and completeness of the entity’s lease accounting under IFRS 16 and provide assurance to stakeholders that the financial statements are free from material misstatements.
