AUDITING

ASSIGNMENT 3, Lecturer: Le Phuong Thao, MBA

Trinh Hoai Minh Hieu

BAFNIU 13 160

Nguyen Hoang Mai

BAFNIU 13 054

Vu Thi Thanh Hai

BAFNIU 13 022

Le Thi Ngoc Yen

BAFNIU 13 114

Cao Thanh Hang

BAFNIU 13 025

WHAT IS OPERATING LEASE & FINANCE LEASE?

a. Definition:
Under IAS 17 Lease, a lease is classified as finance lease if it transfers substantially all the risks
and rewards of ownership, and gives rise to asset and liability recognition by the lessee and a
receivable by the lessor. Another name of finance lease is capital lease. Meanwhile, a lease is
classified as operating lease if it results in expense recognition by the lessee with the asset
remaining recognized by the lessor.
Whether a lease is a finance lease or an operating lease depends on the substance of the transaction
rather than the form. Situations that would normally lead to a lease being classified as a finance
lease include the following:
the lease transfers ownership of the asset to the lessee by the end of the lease term
the lease term is for the major part of the economic life of the asset, even if title is not
transferred
at the inception of the lease, the present value of the minimum lease payments amounts to
at least substantially all of the fair value of the leased asset
the leased assets are of a specialized nature such that only the lessee can use them without
major modifications being made
if the lessee is entitled to cancel the lease, the lessor's losses associated with the cancellation
are borne by the lessee
gains or losses from fluctuations in the fair value of the residual fall to the lessee
the lessee has the ability to continue to lease for a secondary period at a rent that is
substantially lower than market rent
All other leases are operating leases.
b. Accounting by lessees:
Finance leases
Operating leases
Following principles should be applied in the
Following principles should be applied in the
financial statements of the lessees:
financial statements of the lessees:
At commencement of the lease term,
For operating leases, the lease
finance leases should be recorded as
payments should be recognized as an
an asset and a liability at the lower of
expense in the income statement over
the fair value of the asset and the
the lease term on a straight-line basis,
present value of the minimum lease
unless another systematic basis is
payments (discounted at the interest
more representative of the time
rate implicit in the lease, if
pattern of the user's benefit [IAS
practicable, or else at the entity's
17.33]
incremental borrowing rate) [IAS
17.20]
Finance lease payments should be
apportioned between the finance
charge and the reduction of the
outstanding liability (the finance
charge to be allocated so as to
produce a constant periodic rate of
interest on the remaining balance of
the liability) [IAS 17.25]
The depreciation policy for assets
held under finance leases should be
consistent with that for owned assets.
If there is no reasonable certainty that
the lessee will obtain ownership at the
end of the lease the asset should be
depreciated over the shorter of the
lease term or the life of the asset [IAS
17.27]
c. Accounting by lessors:
Finance leases
The following principles should be applied in
the financial statements of lessors:
At commencement of the lease term,
the lessor should record a finance
lease in the balance sheet as a
receivable, at an amount equal to the
net investment in the lease [IAS

Operating leases
The following principles should be applied in
the financial statements of lessors:
Assets held for operating leases
should be presented in the balance
sheet of the lessor according to the
nature of the asset. [IAS 17.49] Lease
income should be recognized over the

17.36]
The lessor should recognize finance
income based on a pattern reflecting a
constant periodic rate of return on the
lessor's net investment outstanding in
respect of the finance lease [IAS
17.39]

d. Sale and leaseback transactions:

Finance leases
For a sale and leaseback transaction that
results in a finance lease, any excess of
proceeds over the carrying amount is
deferred and amortized over the lease term.
[IAS 17.59]

e. Disclosure lessees:
Finance leases [IAS 17.31]
carrying amount of asset
reconciliation between total
minimum lease payments and their
present value
amounts of minimum lease payments
at balance sheet date and the present
value thereof, for:
o the next year
o years 2 through 5 combined
o beyond five years
contingent rent recognized as an
expense
total future minimum sublease
income under noncancellable
subleases
general description of significant
leasing arrangements, including
contingent rent provisions, renewal or
purchase options, and restrictions
imposed on dividends, borrowings, or
further leasing
f. Disclosure lessors:
Finance leases [IAS 17.47]
reconciliation between gross
investment in the lease and the
present value of minimum lease
payments
gross investment and present value of
minimum lease payments receivable
for:

lease term on a straight-line basis,

unless another systematic basis is
more representative of the time
pattern in which use benefit is derived
from the leased asset is diminished
[IAS 17.50]

Operating leases
For a transaction that results in an operating
lease: [IAS 17.61]
If the transaction is clearly carried out
at fair value - the profit or loss should
be recognized immediately
If the sale price is below fair value profit or loss should be recognized
immediately, except if a loss is
compensated for by future rentals at
below market price, the loss it should
be amortized over the period of use
If the sale price is above fair value the excess over fair value should be
deferred and amortized over the
period of use
If the fair value at the time of the
transaction is less than the carrying
amount a loss equal to the
difference should be recognized
immediately [IAS 17.63]
Operating leases [IAS 17.35]
amounts of minimum lease payments
at balance sheet date under
noncancellable operating leases for:
o the next year
o years 2 through 5 combined
o beyond five years
total future minimum sublease
income under noncancellable
subleases
lease and sublease payments
recognized in income for the period
contingent rent recognized as an
expense
general description of significant
leasing arrangements, including
contingent rent provisions, renewal or
purchase options, and restrictions
imposed on dividends, borrowings, or
further leasing

Operating leases [IAS 17.56]

amounts of minimum lease payments
at balance sheet date under
noncancellable operating leases in the
aggregate and for:
o the next year
o years 2 through 5 combined
o beyond five years

o
o
o

the next year

years 2 through 5 combined
beyond five years
unearned finance income
unguaranteed residual values
accumulated allowance for
uncollectible lease payments
receivable
contingent rent recognized in income
general description of significant
leasing arrangements

contingent rent recognized as in

income
general description of significant
leasing arrangements

DEPRECIATION METHODS
In Vietnam and under VAS, companies may choose a number of depreciation methods, which
comply with the Circular No. 45/2013/TT-BTC dated April 25, 2013 of the Ministry of Finance

1. Straight-line depreciation method:

The fixed assets in the enterprises are depreciated by the straight-line depreciation method as
follows:
Annual average rate of depreciation = Primary price of fixed assets / Time of depreciation
Monthly average rate of depreciation = Annual average rate of depreciation / 12 months.
In case the time of depreciation or the primary price of the fixed assets changes, the enterprise have
to re-determine the average rate of depreciation of the fixed assets by taking the Residual value in
the accounting book divided by the time of depreciation re-determined or remaining time of
depreciation (determined as the difference between the time of depreciation registered minus the
time of depreciation) of the fixed assets.
The rate of depreciation for the final year of the time of depreciation of fixed assets is determined as
the difference between the primary price of fixed assets and the accumulated depreciation made to
the preceding year of the final year of those fixed assets.
For example: Company A purchases a fixed asset (new 100%) with the invoice price of 119 million
dong, a purchase discount of 5 million dong, the shipping cost of 3 million dong, the cost of
installing and test run of 3 million.
a. Technical life service is 12 years, the time of depreciation of fixed assets is 10 years, the fixed
assets are put into use on January 01, 2013.
Primary price of fixed assets = 119 million 5 million + 3 million = 120 million dong
Annual average rate of depreciation = 120 million : 10 years = 12 million/year
Monthly average rate of depreciation = 12 million dong : 12 months = 1 million dong/month
Annually, the enterprises shall deduct 12 million dong of the cost of depreciation of fixed assets into
the business costs.
b. After 5 years of use, the enterprises shall upgrade their fixed assets with a total cost of 30 million
dong, the utilization time re-evaluated is 6 years (increasing 1 year compared with the utilization
time initially registered). The date completed and put into use is January 01, 2018.
Primary price of fixed assets = 120 million dong + 30 million dong = 150 million dong
Depreciation deducted = 12 million dong (x) 5 years = 60 million dong
Residual value in accounting book = 150 million dong - 60 million dong = 90 million dong
Annual average rate of depreciation = 90 triu ng : 6 years = 15 million dong / year
Monthly average rate of depreciation =15.000.000 ng : 12 months =1.250.000 dong/ month

AUDITING ASSIGNMENT 3

/22/2016

2. Adjusted reducing balance method:

1. Content of the method:
Annual rate of depreciation of fixed assets = Residual value of fixed assets x Accelerated rate
Accelerated rate = Rate of depreciation by straight-line method x Adjustment Coefficient
Rate of depreciation by straight-line method = 1/ Time of depreciation of fixed asset * 100

Time of depreciation of fixed assets

Adjsutment coefficient
(time)

Up to 4 years ( t < 4 years)

1,5

Over 4 to 6 years (4 years t 6 years)

2,0

Over 6 years (t 6 years)

2,5

For the last years, when the annual rate of depreciation determined by the reducing balance method
above mentioned is equal to ( or lower) the average rate of depreciation between the Residual value
and remaining number of years of utilization of fixed assets, then from that year, the rate of
depreciation is calculated by the Residual value of the fixed assets divided by the remaining number
of years of utilization of fixed assets.
The monthly rate of depreciation is equal to the yearly deducted depreciation divided by 12 months.
Example
Company A has purchased a new device producing electronic components with the primary price of
50 million dong. The time of depreciation of fixed assets determined is 5 years.

Annual rate of depreciation of fixed assets by the straight-line method is 20%.

Accelerated depreciation rate by the reducing balance method is equal to 20% x 2

(adjustment coefficient) = 40%

Annual rate of depreciation of the above fixed assets is determined in the following
table:
Unit: Dong

Year

Residual
value of fixed
assets

Way to calculate
annual depreciation
of fixed assets

Annual rate of
depreciation

Monthly rate of
depreciation

Year-end
accumulated
depreciation

50.000.000

50.000.000 x 40%

20.000.000

1.666.666

20.000.000

30.000.000

30.000.000 x 40%

12.000.000

1.000.000

32.000.000

18.000.000

18.000.000 x 40%

7.200.000

600.000

39.200.000

10.800.000

10.800.000 : 2

5.400.000

450.000

44.600.000

10.800.000

10.800.000 : 2

5.400.000

450.000

50.000.000

AUDITING ASSIGNMENT 3

/22/2016

Rate of depreciation of fixed assets from the 1st year to the 3rd year is calculated by the Residual
value of fixed assets multiplied by the accelerated depreciation rate(40%).
From the 4th year onwards, annual rate of depreciation is equal to the Residual value of fixed assets
(in the beginning of the 4th year) divided by the remaining number of years of utilization of fixed
assets (10.800.000 : 2 = 5.400.000). [Because in the 4th year: the rate of depreciation by reducing
balance method (10.800.000 x 40%= 4.320.000) is lower the average rate of depreciation between
the Residual value and remaining number of year of utilization of fixed assets (10.800.000 : 2 =
5.400.000)].

3. Method of depreciation based on volume:

Based on the technical-economic records of the fixed assets, the enterprises shall determine the
total amount and volume of products made according to the design capacity of fixed assets, referred
to as the output by capacity design
Based on the actual situation of production, the enterprise shall determine the actual amount and
volume of products made monthly, annually of the fixed assets.

Monthly rate of depreciation

= Amount of products monthly made x Average rate of depreciation for a unit of product
Average rate of depreciation for a unit of product
= Primary price of fixed assets / Output by design capacity

In the United States and under US.GAAP, companies may use a number of depreciation methods,
as follows:

1. Activity method
(units of use or production).
2. Straight-line method.
3. Decreasing-charge methods (accelerated)
(3a) Sum-of-the-years-digits.
(3b) Declining-balance method.
4. Special depreciation methods
(4a) Group and composite methods.
(4b) Hybrid or combination methods

AUDITING ASSIGNMENT 3

/22/2016

1. Activity Method (Variable-Charge Or Units-Of-Production Approach)

The activity method assumes that depreciation is a function of use or productivity, instead of the
passage of time. A company considers the life of the asset in terms of either the output it provides
(units it produces) or an input measure such as the number of hours it works. Conceptually, the proper
cost association relies on output instead of hours used, but often the output is not easily measurable. In
such cases, an input measure such as machine hours is a more appropriate method of measuring the
dollar amount of depreciation charges for a given accounting period.
Depreciation charge
=(Cost - Salvage value) x Hours this year/ Total estimated hours
The major limitation of this method is that it is inappropriate in situations in which depreciation is a
function of time instead of activity. For example, a building steadily deteriorates due to the elements
(time) regardless of its use. In addition, where economic or functional factors affect an asset,
independent of its use, the activity method loses much of its significance. For example, if a company is
expanding rapidly, a particular building may soon become obsolete for its intended purposes. In both
cases, activity is irrelevant. Another problem in using an activity method is the difficulty of estimating
units of output or service hours received. In cases where loss of services results from activity or
productivity, the activity method does the best to record expenses in the same period as associated
revenues. Companies that desire low depreciation during periods of low productivity, and high
depreciation during high productivity, either adopt or switch to an activity method.

2. Straight-Line Method
The straight-line method considers depreciation as a function of time rather than a function of usage.
Companies widely use this method because of its simplicity. The straight-line procedure is often the
most conceptually appropriate, too. When creeping obsolescence is the primary reason for a limited
service life, the decline in usefulness may be constant from period to period
Depreciation charge
=(Cost - Salvage value) / Estimated service life
The major objection to the straight-line method is that it rests on two tenuous assumptions. (1) The
assets economic usefulness is the same each year, and (2) the maintenance and repair expense is
essentially the same each period. One additional problem that occurs in using straight-lineas well as
some othersis that distortions in the rate of return analysis (income/assets) develop

AUDITING ASSIGNMENT 3

/22/2016

3. Decreasing-Charge Methods or Accelerated Depreciation Methods.

The decreasing-charge methods provide for a higher depreciation cost in the earlier years and lower
charges in later periods. Companies should charge more depreciation in earlier years because the asset
is most productive in its earlier years. Furthermore, the accelerated methods provide a constant cost
because the depreciation charge is lower in the later periods, at the time when the repair and
maintenance costs are often higher.
There are two decreasing-charge methods:
(3a) Sum-of-the-Years-Digits.
The sum-of-the-years-digits method results in a decreasing depreciation charge based on a decreasing
fraction of depreciable cost (original cost less salvage value). Each fraction uses the sum of the years as
a denominator (5 + 4 + 3 + 2 + 1 = 15). The numerator is the number of years of estimated life
remaining as of the beginning of the year. In this method, the numerator decreases year by year, and
the denominator remains constant (5/15, 4/15, 3/15, 2/15, and 1/15). At the end of the assets useful
life, the balance remaining should equal the salvage value.

(3b) Declining-Balance Method.

The declining-balance method utilizes a depreciation rate (expressed as a percentage) that is some
multiple of the straight-line method. For example, the double-declining rate for a 10-year asset is 20
percent (double the straight-line rate, which is 1/10 or 10 percent). Companies apply the constant rate
to the declining book value each year. Unlike other methods, the declining-balance method does not
deduct the salvage value in computing the depreciation base. The declining-balance rate is multiplied
by the book value of the asset at the beginning of each period. Since the depreciation charge reduces
the book value of the asset each period, applying the constant-declining balance rate to a successively
lower book value results in lower depreciation charges each year. This process continues until the book
value of the asset equals its estimated salvage value. At that time, the company discontinues
depreciation.

AUDITING ASSIGNMENT 3

/22/2016

4. Special Depreciation Methods

Sometimes companies adopt special depreciation methods. Reasons for doing so might be that a
companys assets have unique characteristics, or the nature of the industry.
(4a) Group and Composite Methods
Companies often depreciate multiple-asset accounts using one rate. Two methods of depreciating
multiple-asset accounts exist: the group method and the composite method. The choice of method
depends on the nature of the assets involved. Companies frequently use the group method when the
assets are similar in nature and have approximately the same useful lives. They use the composite
approach when the assets are dissimilar and have different lives. The group method more closely
approximates a single-unit cost procedure because the dispersion from the average is not as great. The
computation for group or composite methods is essentially the same: find an average and depreciate
on that basis. Companies determine the composite depreciation rate by dividing the depreciation per
year by the total cost of the assets

The group or composite method simplifies the bookkeeping process and tends to average out errors
caused by over- or under depreciation. As a result, gains or losses on disposals of assets do not distort
periodic income. On the other hand, the unit method (depreciation of single assets) has several
advantages over the group or composite methods. (1) It simplifies the computation mathematically. (2)
It identifies gains and losses on disposal. (3) It isolates depreciation on idle equipment. (4) It
represents the best estimate of the depreciation of each asset, not the result of averaging the cost over a
longer period. As a consequence, companies generally use the unit method.
(4b) Hybrid or Combination Methods

In addition to the depreciation methods already discussed, companies are free to develop their own
special or tailor-made depreciation methods. GAAP requires only that the method result in the
allocation of an assets cost over the assets life in a systematic and rational manner.

AUDITING ASSIGNMENT 3

/22/2016

WHAT IS THE MEANING OF RATIOS IN SLIDE 25? WHY ARE THEY

USED FOR ANALYTICAL PROCEDURES?

Total cost of plant assets

Annual output dollars ( pounds , other units )

This ratio represents the average cost of the Property, Plant, and Equipment (PPE) per dollar or unit of
output. This means that auditors use it to estimate how much the cost of PPE was contained for one
unit or dollar of produced goods. They use this ratio for analytical procedure because the result can be
regarded as a benchmark to observe if there is a significant change in average cost of PPE per unit from
year to year. For example, if the result in year 2015 increases significantly in comparison with that of
year 2014, the auditors can figure out there might be an overstate in total cost of PPE or the production
units (output dollars) cannot catch up with the increase in PPE. This might be because the company
did not write-off any expired costs (insurance expense) in the cost of PPE (when it was actually
expired) or the company acquired more PPE or they buy another insurance for PPE in year 2015.

Total cost of plant assets

Cost of goods sold

This ratio represents the relationship between total cost of PPE and cost of goods sold. The result of
the ratio tells us that how much dollar from cost of PPE in one dollar cost of goods sold. This was used
for analytical procedures as a benchmark to compare the PPE cost of this year to previous years. For
example, if

Total cost of PPE

Cost of goods sold

is too high compared with the previous year, the company might

overstate the cost of the PPE or understate the cost of goods sold or reduce their production level.
Based on this ratio, auditors can figure out if the company is manipulating the cost of PPE by not
deleting the assets that has been fully depreciated yet or they are not efficient in operating business.
Comparison of repairs and maintenance expense on a monthly basis and from year to year.
This means that auditors will compute and use the average monthly repairs and maintenance expense
of previous year as a benchmark to compare with this years monthly repairs expense.
This is one of the methods commonly used in analytical procedure because if there is a significant
difference in the amount of monthly repairs and maintenance expense from year to year, the auditors
know that they have to investigate the story behind those changes. For example, if the monthly repairs
and maintenance expense of this year increase significantly compared with last year, there might result
from one of the following circumstances. Firstly, if revenues increase, the output increases, meaning a
lot of equipment (PPE) broke down or it broke down frequently, which makes repair expense
increases. Secondly, it might be because the accountants has classified in the wrong account. Or
thirdly, it was because the machine was out of date so it broke down frequently. In this case, the value
of PPE has reduced and the company must reconciliate the cost of PPE on balance sheet or write off
the assets in accordance with regulations.
Comparison of acquisitions for the current year with prior years.
This can be used in analytical procedure because auditors could use acquisitions value in the previous
year as a benchmark to compare the acquisition value of this year to see if it is reasonable or not. For
example, if acquisition value of this year increases significantly compared to the previous year,
auditors will have to investigate why it was like that. It may be because many old machines broke
down, so the company has to buy more PPE. In this case, that company should revaluate the value of
PPE or write off some machines that cannot be used anymore. Besides, the auditors may investigate to
see if the company actually purchases more machines or they just overstate the value of PPE to have
more depreciation tax shield.

AUDITING ASSIGNMENT 3

/22/2016

e. Comparison of retirements for the current year with prior years.

This is used in analytical procedures by checking with depreciation expense account. If the company
records retirements of PPE, they must, at the same time, write off the depreciation for that machine
(asset). Therefore, if the retirement of this year significantly increases compared to the previous year
but the depreciation remains unchanged, auditors will know there was something wrong in that
situation. They have to investigate where that much depreciation expense comes from. That may
results from the wrong depreciation method of the company or their intentional purpose of keeping
depreciation of retired asset to gain depreciation tax shield for their own benefits.

THE MEANING OF THE RATIO OF DEPRECIATION EXPENSE TO TOTAL

COST OF PLANT (PPE)?
The depreciation expense to total cost of property, plant and equipment ratio often gives important
clues on how quickly a company is replacing its fixed assets, indicating the company's ability to
generate enough cash to replace aging equipment.
Depreciation to Fixed Assets Ratio = Depreciation / (Tangible Fixed Assets - Land)
Generally, low ratios are desirable, while an increase to this ratio over time can be indicative of a
problem. When the ratio is high, the company may take an aggressive approach to depreciation,
expensing asset costs over short time, resulting in a rapid rise in depreciation expense relative to the
age of the assets. However, if the ratio is less than prior years and few assets have been disposed of,
the auditor might be concern that depreciation has not been taken completely on some assets. Hence,
auditor should compute this kind of ratio and compare it to prior yearss ratios or a benchmark to spot
any significant suspicions and determine whether additional audit procedures should be performed.