Auditing Special Purpose Frameworks: Operating Expenses—Part 1

The financial reporting framework for Small and Medium Enterprises (SMEs) provides guidelines regarding the accounting treatment of operating expenses. As per the principles of framework expenses are recorded under accrual basis where the costs are accounted for in the similar period in which the related revenue is booked.

Operating expenses are normally recorded in the period they are incurred whereas intangible and tangible fixed assets are amortized and depreciated respectively over their respective useful lives.

Lease Accounting

The framework provides direction for lessees and lessors on how to account for finance and operating lease. The lease classification as finance or operating depends upon risks and rewards related to the asset. If all the significant rewards and risks have been transferred by lessor to lessee then the lease should be treated as finance lease and it can be judged from following criteria:

1. Lease through which the lessee gains all the significant economic benefits related to the asset leased and then it is considered as a finance lease. This would normally be the case if lease period is of more than 75% of asset’s useful life.

2. If the discounted present value of the future rentals is 90% or more of the market value of the asset at the start of the lease, then it will be treated as a finance lease.

3. Ownership is transferred or option to purchase the asset at substantially lower price is present at the completion of lease period.

Following is the additional criteria for lessors:

1. The lessor is expected to incur a significant cost which may decide whether rewards and risks are not transferred, thus precluding finance lease.

2. Lease receivable has same credit risks as other receivables.

Where all the risks and rewards are transferred to the lessee, it should be recorded as finance lease in the books of the lessee and lessor’s perspective it is a sale of asset or loan to lessee, depending upon the actual substance of the transaction.