Prevent and Correct Common ASC 842 Audit Adjustments
ASC 842, Leases, is hard even for seasoned accounting teams. Operating leases used to sit off the balance sheet, and now they go on it. That shift added new accounting work and calls for strong processes to stay compliant. So ASC 842 audit adjustments are now a key focus for controllers and accounting managers who want clean financial statements.
Auditors often see the same problem first: the lease data is not complete or not accurate at the start. That leads to adjustments during the audit cycle.
Strong controls and careful preparation can cut these adjustments sharply. In the end, many companies ask, "How can my company prepare for an ASC 842 audit?" Know the common pitfalls and put prevention steps in place early. Then your ASC 842 audit runs faster and ends with fewer findings.
For a complete breakdown, see our lease accounting guide.
Q: What are common ASC 842 audit adjustments?
A: Common ASC 842 audit adjustments most often relate to four areas. They are the completeness of the lease population, accurate lease classification, correct calculation of right-of-use (ROU) assets and lease liabilities, and proper disclosure. These adjustments often stem from missed embedded leases, errors in discount rates, or wrong amortization schedules.
The Four Assertions Auditors Test on Your Lease Balances
Auditors test lease balances the way they test any balance: through financial statement assertions. The main ones are completeness, accuracy, valuation, and presentation and disclosure. They want assurance that every lease transaction and balance is correctly reflected in the financial statements.
The completeness assertion is the auditor's objective to verify that all transactions and accounts that should be recorded have been included in the financial statements. This is especially hard for leases, because embedded leases can go unnoticed.
Auditors perform lease audit procedures to confirm that the lease population and the calculations are accurate. They review lease schedules, verify discount rates, and assess management's judgments.
Deloitte's Roadmap: Leases pairs the risk that not all leases are identified with a control over identifying the complete population of contracts to evaluate. It pairs the risk that contracts are wrongly captured as leases with a control over determining whether an arrangement meets the definition of a lease1.
Auditors often start by testing internal controls over the lease accounting process. They expect strong review procedures and segregation of duties.
Q: How do auditors test ASC 842 audit adjustments?
A: Auditors typically test ASC 842 audit adjustments by reviewing the supporting documents, such as lease agreements and amendments. They recalculate ROU assets and lease liabilities, check discount rates closely, and reconcile lease data to the general ledger.
This table sums up the key audit focus areas:
| Audit Assertion | Auditor Focus | Example Procedure |
|---|---|---|
| Completeness | All leases identified and recorded | Review contracts for embedded lease discovery, reconcile lease count. |
| Accuracy/Valuation | ROU assets and liabilities correctly calculated | Recalculate lease liabilities, verify discount rates, check amortization. |
| Classification | Leases correctly classified (operating vs. finance) | Review qualitative and quantitative criteria per ASC 842 guidance. |
| Presentation/Disclosure | Financial statement and footnote disclosures adequate | Compare disclosures to ASC 842 requirements, check for consistency. |
💡 Key Takeaway: The completeness assertion is one of the most closely examined areas in an ASC 842 audit. You must show a thorough process for finding every lease contract and lease component. Auditors often apply substantive testing procedures to confirm that recorded lease balances are accurate.
What Drives the Most Common Audit Adjustments
Several common pitfalls can lead to large ASC 842 audit adjustments. Know these risks so you can manage them ahead of time.
- Incomplete Lease Population: Many companies miss contracts that contain a lease, particularly small-dollar leases and service contracts with embedded leases. ASC 842 has no low-value exemption. A lessee that leaves a small lease off the balance sheet relies on materiality and its own capitalization threshold, not on an exemption in the standard2. The risk is material misstatement of both the balance sheet and income statement.
- Inaccurate Lease Classification: Classifying a finance lease as an operating lease (or vice versa) affects depreciation, interest expense, and the presentation of cash flows. ASC 842-20-25-5 and 842-20-25-6 set the two expense patterns, and ASC 842-20-45-5 sets the cash flow classification. It can also distort key financial ratios.
- Incorrect Discount Rate Determination: The discount rate has a large effect on the ROU asset and lease liability calculations. A lessee uses the rate implicit in the lease when that rate is readily determinable, and its incremental borrowing rate when it is not. A lessee that is not a public business entity may elect a risk-free rate in place of its incremental borrowing rate, by class of underlying asset (ASC 842-20-30-3). Errors can lead to material valuation adjustments.
- Errors in Lease Modification Accounting: Changes to lease contracts (e.g., extensions, terminations, scope changes) require specific accounting treatment under ASC 842. Getting that treatment wrong is a frequent source of adjustments.
- Inadequate Documentation: Lease judgments, calculations, and inputs (like discount rates or lease terms) need clear, thorough documentation. Without it, auditors struggle to verify balances, and findings can follow.
Right-of-use (ROU) asset is defined in the ASC 842 glossary as an asset that represents a lessee's right to use an underlying asset for the lease term. ASC 842-20-25-1 requires a lessee to recognize it, together with a lease liability, at the commencement date. Errors in its initial measurement or later amortization are common.
⚠️ Risk Alert: A common audit finding: companies overlook service contracts and supply agreements that may contain embedded leases. Miss these, and large ROU assets and lease liabilities can be left off the balance sheet. That has a big effect on the ROU asset audit. A common failure point is overlooking embedded leases in service contracts.
Calculation Example: Lease Liability Adjustment
Scenario: An entity never recognized a 5-year operating lease that commenced in the current year. The lease has annual payments of $10,000 (paid in arrears), with no prepaid rent, lease incentives or initial direct costs. The incremental borrowing rate is 5%. ASC 842-20-30-1(a) measures the lease liability at the present value of the lease payments not yet paid, discounted using the discount rate for the lease at commencement.
| Component | Value | Calculation |
|---|---|---|
| Annual Lease Payment | $10,000 | Given |
| Lease Term | 5 years | Given |
| Incremental Borrowing Rate | 5% | Given |
| Present Value Factor (5 yrs, 5%) | 4.32948 | Ordinary annuity factor (payments in arrears): (1 − 1.05−5) ÷ 0.05 = 4.32948. With payments in arrears, all five payments are not yet paid at commencement, so all five are discounted (ASC 842-20-30-1(a)). |
| Initial Lease Liability | $43,294.80 | $10,000 x 4.32948. Discounting each payment separately gives $43,294.77; the 3-cent difference is factor rounding. |
| Initial ROU Asset | $43,294.80 | Equal to the initial lease liability, because there are no payments at or before commencement, no lease incentives and no initial direct costs (ASC 842-20-30-5). |
Key Takeaway: This calculation shows a material omission that would require an audit adjustment. It is why a complete lease identification audit matters.
The omission affects the balance sheet. On the income statement, an operating lease produces a single lease cost, generally recognized on a straight-line basis over the lease term (ASC 842-20-25-6(a)). Amortization of the ROU asset and interest on the lease liability are the finance lease pattern (ASC 842-20-25-5).
Practical Checklist for Audit Readiness
Heading off ASC 842 audit adjustments takes a structured approach. This checklist sets out the key tasks for accounting teams.
Q: How do I avoid common ASC 842 audit adjustments?
A: To avoid common ASC 842 audit adjustments, do four things. Put a robust lease management system in place, and review lease contracts regularly for modifications. Use a proper discount rate method, and keep complete documentation. Proactive internal controls are paramount.
| Checklist Item | Description | Responsible Party | Status |
|---|---|---|---|
| 1. Comprehensive Lease Inventory | Confirm all contracts (including service agreements) have been reviewed for leases. | Lease Accountant, Mgmt. | Complete |
| 2. Lease Data Validation | Verify all lease data points (term, payments, residuals, options) are accurate and complete. | Lease Accountant | In Progress |
| 3. Discount Rate Justification | Document the methodology and inputs for the discount rate used for each lease, such as the incremental borrowing rate (IBR). Include the risk-free rate election and the classes of underlying asset it covers, if made. | Controller | Complete |
| 4. Lease Classification Review | Re-evaluate lease classification (operating vs. finance) for all leases, especially for adjustments. | Accounting Manager | Complete |
| 5. Substantive Calculation Review | Independently check ROU asset, lease liability, and amortization calculations. | Senior Accountant | In Progress |
| 6. Footnote Disclosure Preparation | Draft and review all required ASC 842 disclosures based on final lease data. | Controller | Complete |
| 7. Change Management Process | Establish and document processes for accounting for lease modifications and remeasurements. | Accounting Manager | In Progress |
This checklist aligns with our guide to completing an ASC 842 lease accounting audit.
✅ Best Practice: Companies that execute well review their leases every quarter. They catch changes early and head off issues that could lead to ASC 842 audit adjustments. Regular review keeps the lease accounting system current.
Reconciling Lease Schedules Before the Auditors Arrive
Good validation is more than data entry. It means critical review and reconciliation. Accounting teams must set up and document procedures that make their ASC 842 balances auditable.
For the specific requirements, see Topic 842 in the FASB Accounting Standards Codification (free registration required). Start with ASC 842-20-25-1 on recognition and ASC 842-20-30-1 on initial measurement.
- Reconciliation to General Ledger: Reconcile the detailed lease schedules to the general ledger accounts on a regular basis. That covers ROU assets, lease liabilities, interest expense, and amortization. Investigate and resolve every difference promptly.
- Completeness Check of Contracts: Put a control in place that reviews every new or renewed contract for a possible lease. This could be a keyword search of the contract database or a checklist for the procurement team. An embedded lease is a lease component inside a larger contract that may not be explicitly identified as a lease. Training staff to spot these can prevent common audit findings.
- Peer Review of Judgments: Have a senior member of the accounting team or an outside consultant review the significant lease judgments. Two examples are the lease term (considering options) and how the discount rate was applied.
- Use of Lease Software Features: Use lease accounting software to automate the calculations and produce standard reports. That cuts manual error and gives you consistent audit trails.
- Documentation of Assumptions: Document every significant assumption clearly (e.g., initial direct costs, residual value guarantees, lease incentives, the incremental borrowing rate). Record the basis for each one and the evidence that supports it. For more validation steps, see our lease documentation requirements.
TIP: Think like an auditor when you prepare your lease documentation, and the audit will run more smoothly. If the file does not let a reviewer re-perform the calculation from the contract, expect a request for more.
Embedded Leases and Discount Rates: The Costliest Errors
The table below pairs five common mistakes with what each means for the audit and the practice that helps avoid it.
| Common Mistake | Audit Implication | Best Practice to Avoid |
|---|---|---|
| 1. Failure to identify all embedded leases | Understatement of ROU assets and lease liabilities. Non-compliance with the recognition requirement in ASC 842-20-25-1. | Centralized contract review process including procurement and legal teams for embedded lease discovery. |
| 2. Incorrect discount rate application | Inaccurate valuation of ROU assets and lease liabilities, leading to material adjustments. | Documented IBR policy. Refresh the rate table for new leases. An existing operating lease keeps its commencement-date rate unless ASC 842-20-35-5 requires an update (ASC 842-20-35-3(a)). Involve valuation specialists if needed. |
| 3. Inadequate lease modification accounting | Errors in remeasurement of lease liabilities and ROU assets, impacting subsequent accounting. | Clear internal policies for tracking and accounting for renegotiations, extensions, and terminations. |
| 4. Lack of robust internal controls | Increased risk of errors going undetected, higher audit effort, potential for qualified opinion. | Implement segregation of duties, review controls, and automate where possible for lease accounting compliance. |
| 5. Insufficient supporting documentation | Difficulty for auditors to verify balances and judgments, leading to additional audit requests. | Maintain a complete, organized file for each lease, including contract, calculations, and judgments. |
Q: What documentation is required for ASC 842 audit adjustments?
A: Required documentation for ASC 842 audit adjustments includes the original lease agreements and any amendments. It also includes the ROU asset and lease liability calculations, the evidence behind the discount rates, and the detailed disclosures. Good documentation of internal controls is also critical. Many companies struggle with ROU asset measurement without proper documentation.
🚨 Critical: Without strong controls over ASC 842 audit adjustments, large audit adjustments can follow. So can material weaknesses in internal control over financial reporting. That hurts management's assessment of internal controls.
When the Audit Becomes Verification, Not Discovery
For companies that execute well on ASC 842 audit adjustments, the audit becomes verification, not discovery. These companies build lease accounting into their core financial processes. They do not treat it as a once-a-year task.
Consider a hypothetical multi-national retail company that runs a central lease management system. The system flags possible new leases from procurement data on its own. It calculates the lease accounting entries and tracks modifications in real time.
Before the audit, the accounting team does its own review with a checklist much like the auditor's. It also runs internal reconciliations. Then it hands the auditors a clean, organized PBC (Prepared by Client) list that includes:
- A complete lease population, reconciled to subsidiary ledgers.
- Detailed lease schedules for ROU assets and lease liabilities, with clear inputs.
- Documentation for discount rates, including the basis for the incremental borrowing rate.
- A memo that sets out the significant judgments and assumptions.
A head start like this can cut auditor questions, shorten fieldwork, and help keep material audit adjustments to a minimum. The aim is a cleaner audit, more confidence in financial reporting, and better lease accounting compliance.
Reducing Audit Adjustments in Your Next Cycle
To strengthen your ASC 842 compliance and cut future audit adjustments, focus on steady process improvement and knowledge sharing. Review your lease accounting policies and procedures on a regular basis, especially after a major business change or acquisition.
Train the people who touch leases, including procurement and legal staff. They need to understand embedded leases and the wider effect of lease accounting. Stronger internal controls always pay off in audit readiness.
Related Articles
- ASC 842 Audit Readiness Checklist
- Guides to Successfully Complete an ASC 842 Lease Accounting Audit
- Auditing ASC 842 Lease Accounting: An Auditor's Guide
- Preparing for ASC 842 Audits
Sources and further reading
Deloitte's Roadmap: Leases, Appendix D — Internal Control Over Financial Reporting. It lists the risk "All leases are not identified, in accordance with company policies" against the control "Identifying the complete population of contracts to evaluate." ↩
KPMG Handbook: Leases. It reproduces the Codification paragraphs cited on this page and explains, citing ASU 2016-02 BC421, why the FASB decided against a low-value asset exemption. ↩
