Understanding ASC 842 Audit Readiness Checklist: A Complete Guide

Preparing for an ASC 842 audit requires meticulous planning and a deep understanding of the standard's nuances. Without proper preparation, organizations face significant risks of audit findings, financial restatements, and delays. This guide provides an ASC 842 audit readiness checklist to help controllers, accounting managers, and auditors navigate the complexities of lease accounting compliance. ASC 842 audit readiness checklist is defined as the assurance that all contracts meeting ASC 842's definition of a lease have been identified, evaluated, and recorded in the organization's financial statements. A proactive approach to compliance not only streamlines the audit process but also ensures the accuracy and completeness of financial reporting. This comprehensive preparation helps companies proactively address potential issues, such as what are the risks of incomplete lease population, before they become audit deficiencies. How do I get my company ready for an ASC 842 audit? By systematically reviewing lease agreements, establishing robust internal controls, and validating accounting treatments against professional standards, companies can achieve successful audit outcomes.

What Auditors Are Actually Looking For

Auditors approach ASC 842 engagements with a focus on specific financial statement assertions as outlined by the Public Company Accounting Oversight Board (PCAOB) and the American Institute of Certified Public Accountants (AICPA). Their primary objective is to obtain sufficient appropriate audit evidence to support their opinion on the fairness of the financial statements. This involves evaluating controls, testing data integrity, and assessing the appropriateness of accounting judgments. ¹

💡 Key Takeaway: The completeness assertion is one of the most scrutinized areas in an ASC 842 audit, as auditors want assurance that all lease obligations are recognized.

Auditors perform lease audit procedures to confirm that organizations have properly applied the Financial Accounting Standards Board (FASB) Accounting Standards Codification (ASC) 842, Leases. This includes verifying the identification of all leases, correct classification, accurate measurement of right-of-use (ROU) assets and lease liabilities, and appropriate financial statement disclosures. Understanding what auditors look for in ASC 842 is crucial for effective preparation.

Q: how do auditors test asc 842 audit readiness checklist? A: Auditors typically test an ASC 842 audit readiness checklist by selecting a sample of leases, reviewing underlying contracts, re-performing calculations for ROU assets and lease liabilities, and evaluating the design and operating effectiveness of related internal controls. They also reconcile lease data to the general ledger and financial disclosures.

Here's an overview of key audit focus areas:

Big Four firms, such as Deloitte, emphasize the importance of a complete lease population and robust controls over data integrity. ² They often use data analytics to identify potential omissions or inconsistencies in lease data. The completeness assertion refers to an auditor's objective to verify that all transactions and accounts that should be recorded have been included in the financial statements. This is particularly challenging for leases given the potential for contracts to contain embedded leases.

Key Risks and Failure Points

Failure to adequately prepare for an ASC 842 audit presents several significant risks that can lead to material misstatements, prolonged audit timelines, and increased audit fees. These risks often stem from a lack of systematic processes and comprehensive documentation.

⚠️ Risk Alert: A common audit finding relates to companies overlooking service contracts with embedded leases, impacting lease completeness and accuracy.

• Incomplete Lease Population: The most paramount risk is the failure to identify all lease arrangements. Many service or supply contracts may contain an embedded lease, which refers to a lease component contained within a larger contract that may not be explicitly identified as a lease. Auditors conducting an ROU asset audit will scrutinize the process of lease identification, including controls designed to capture these less obvious leases.

• Incorrect Lease Classification: Misclassifying a finance lease as an operating lease, or vice versa, directly impacts the balance sheet and income statement presentations. This often occurs due to misapplication of the ASC 842 criteria, such as incorrect assessment of the lease term or present value of lease payments.

• Inaccurate Measurement of ROU Assets and Lease Liabilities: Errors in determining the discount rate, lease term, or variable lease payments lead to incorrect initial and subsequent measurement. A typical error is using an unsupported incremental borrowing rate or failing to update it for lease modifications.

• Insufficient Documentation: Lack of comprehensive documentation for significant judgments—such as determining reasonably certain renewal options or the incremental borrowing rate—prevents auditors from validating management's assertions. This can lead to qualified audit opinions or extensive auditor requests.

• Failure to Implement Robust Controls: Without adequate internal controls over the lease accounting process, from contract inception to financial reporting, the risk of error increases exponentially. Auditors will test these controls, and deficiencies will lead to expanded substantive testing. For example, a PwC report highlights the importance of internal controls over data input and calculation accuracy. ³

Calculation Example: Initial Lease Liability

Scenario: A company enters into a 5-year lease agreement for office space with annual payments of $10,000, payable at the beginning of each year. The company's incremental borrowing rate is 5%.

Key Takeaway: This calculation demonstrates the importance of accurately determining the lease term, payment amount, and discount rate. Auditors will re-perform this type of calculation, so supporting documentation for each input is critical.

Practical ASC 842 Audit Readiness Checklist

What is ASC 842 audit readiness checklist under ASC 842? It's a structured list of tasks and validations designed to ensure an organization's lease accounting records and processes comply with ASC 842 requirements, allowing for an efficient and clean audit. Organizations should create an ASC 842 audit readiness checklist controls specifically designed for their environment.

ASC 842 Audit Readiness Checklist

✅ Best Practice: Organizations actively leveraging lease accounting software tend to have smoother audits due to automated calculations and audit trails. Implementing effective internal controls is paramount.

How Accounting Teams Should Validate Their Approach

Accounting teams play a critical role in validating the accuracy and completeness of their ASC 842 implementation. This involves more than just running reports; it requires a systematic review process that mirrors an auditor's skepticism. Lease identification audit goes beyond simple contract review to ensure that control assessments are accurate.

1. Reconcile Lease Data to Cash Payments: Compare total lease payments recorded in the lease sub-ledger or system to actual cash disbursements for leases. This helps identify unrecognized leases or discrepancies in payment schedules.
2. Sample Testing and Re-performance: Select a sample of leases across different asset types and re-perform the initial measurement calculations for the ROU asset and lease liability. Verify discount rates, lease terms, and payment components. This is a critical step in how to ensure lease completeness for ASC 842 compliance.
3. Review Embedded Lease Identification Process: Scrutinize the process used for embedded lease discovery. This includes reviewing a sample of non-lease contracts (e.g., service agreements, supply contracts) to confirm that the criteria for a lease were properly assessed. The AICPA offers guidance on auditing lease accounting, emphasizing discovery.
4. Validate Discount Rate Inputs: Ensure all inputs used to determine the incremental borrowing rate (IBR) are documented and supported. For example, verify that the credit rating used aligns with the company's actual rating, and the yield curve data matches the effective date of the lease.
5. Perform Roll-forwards and Reconciliations: Prepare a lease liability and ROU asset roll-forward schedule from the beginning of the period to the end, reconciling it to the general ledger balances. Investigate any discrepancies.
6. Disclosure Checklist Completion: Use an ASC 842 disclosure checklist (e.g., from a Big Four firm or a professional organization) to ensure all required quantitative and qualitative disclosures are present and accurate in the draft financial statements.

🚨 Critical: Failure to identify embedded leases can result in material misstatement and significant audit findings, particularly regarding the completeness assertion.

Common Mistakes and How to Avoid Them

Preparing for an ASC 842 audit can be fraught with pitfalls. Recognizing these common mistakes and implementing proactive strategies to avoid them is vital for a smooth audit process.

Q: what documentation is required for asc 842 audit readiness checklist? A: Required documentation typically includes a complete lease inventory, lease abstracts, classification memos, IBR methodology, amortization schedules, modification logs, GL reconciliations, and draft financial statement disclosures. Maintaining proper lease management documentation is key.

A frequent oversight is underestimating the effort required for initial data collection and abstraction. This often leads to errors in ROU asset audit procedures as auditors encounter incomplete or inconsistent information, requiring extensive follow-up. This can directly result in what are common asc 842 audit readiness checklist audit findings appearing on an audit report.

What Strong Execution Looks Like in Practice

Strong execution of an ASC 842 audit readiness checklist results in a streamlined audit process, mitigated compliance risks, and improved financial reporting accuracy. It's not just about passing the audit, but about achieving robust lease accounting compliance that stands up to scrutiny.

An organization demonstrating strong execution will have:

• A Comprehensive Lease Inventory: Every contract containing a lease, whether explicit or embedded, is identified, abstracted, and centrally managed within a lease accounting software. This ensures complete coverage.
• Documented Policies and Procedures: Clear, written policies for lease identification, classification, measurement (including IBR determination), and modification accounting are in place and consistently followed. These policies include the definition of control for specific assets as per FASB ASC 842-10-15.
• Effective Internal Controls: Automated and manual controls are in place and operating effectively to ensure data integrity, prevent errors, and provide a clear audit trail. This covers everything from contract intake to journal entry posting.
• Proactive Auditor Engagement: Management communicates significant judgments and provides requested documentation to auditors well in advance of fieldwork. Potential issues are discussed and resolved proactively, minimizing surprises.
• Accurate and Timely Financial Reporting: Draft financial statements and disclosures are prepared accurately, reconcile to underlying data, and are ready for auditor review without significant adjustments.

📝 Tip: Companies that successfully transition often view ASC 842 as an opportunity to enhance financial data quality and improve internal processes.

For example, a mid-sized manufacturing company, committed significant resources in 2023 to standardize its lease contract abstraction and implemented a new lease accounting system. By early 2024, they had completed 100% of their lease abstracting, documented their IBR methodology based on 2023 market data, and conducted an internal review using their ASC 842 audit readiness checklist. This allowed them to provide their auditors with a complete, well-organized data room by Q3, resulting in their fastest and cleanest ASC 842 audit to date, with zero material findings. This proactive strategy also helped them get ahead of year-end lease accounting challenges.

Next Steps

To effectively prepare for your next audit, start by reviewing your current lease portfolio and assessing the completeness of your data. Consider leveraging technology to streamline lease management and ensure compliance with ASC 842. Regular internal reviews and self-audits using a robust ASC 842 audit readiness checklist can significantly improve your chances of a successful audit.

Related Articles

• Preparing for ASC 842 Audits: Building a Reliable Lease Accounting Trail
• Demystifying Lease Audits: A Guide for Accountants and Auditors
• Passing Your ASC 842 Audit: Key Steps to Success
• New Lease Accounting Standard Implementation Challenges