While performing analytical procedures on Merrill Traders, Inc., the auditor discovered a substantial increase in lease expense and a corresponding decrease in both the fixed-asset accounts and related depreciation. On further inquiry, the auditor discovered that a substantial amount of equipment and one piece of property were sold to an outside leasing company. The company then leased the property back and leased similar equipment from the lessor. The controller shows the auditor that the lease was contractually constructed so that it would not be considered a sale and leaseback. The proceeds of the sale were used to pay down long-term debt. The auditor is puzzled that economically there appears to be no change in the company’s operations, but it may have incurred higher future costs because the lease agreement terms do not appear to be as economically favorable as did the past ownership. For example, the company leases equipment for three years when the expected life is five years, but is responsible for all maintenance on the equipment.

Required
a. What role do substance vs. form decisions play in the audit of a client and in a situation such as that described?
b. What audit procedures should be performed to finish the analysis of the lease expense account?