ASC 842 for Healthcare: Audit Readiness Checklist

Complete Your ASC 842 Healthcare Lease Audit Successfully

The Challenge of Healthcare Lease Accounting Audits

Many healthcare entities find it hard to get ready for an ASC 842 audit. That is especially true of entities that manage large portfolios of medical equipment, facilities, and service contracts. Audit readiness takes careful work. The team has to collect the data, classify the leases, and get the financial reporting right under the new lease accounting standard.

Our ASC 842 guide walks through the full compliance framework and gives practical insights. This article offers an essential ASC 842 audit checklist for healthcare entities. It sets out the key steps to stay compliant and avoid the common traps in healthcare lease accounting.

Defining Healthcare Leases for ASC 842 Audit Purposes

What defines healthcare leases under ASC 842 for audit purposes? A lease is a contract, or part of one, that conveys the right to control the use of an identified asset for a period of time in exchange for consideration. That is the ASC 842 Glossary definition of a lease. ASC 842-10-15-3 applies it: a contract is or contains a lease if it conveys that right.

The agreement can be explicit or implicit, which reaches past the obvious equipment and facilities to service contracts that contain implicit leases.

The ASC 842 lease definition reaches across the whole healthcare entity. It covers everything from medical equipment and real estate to IT infrastructure and transport fleets.

Auditors will focus closely on two things. Has the entity accurately identified all leases, including embedded leases? And did it apply the accounting treatment properly?

That treatment generally requires lessees to recognize a right-of-use (ROU) asset and a corresponding lease liability on the balance sheet for nearly all leases with terms exceeding 12 months. The recognition requirement is at ASC 842-20-25-1, and the short-term lease election is at ASC 842-20-25-2.

Control has two limbs, and both must hold throughout the period of use (ASC 842-10-15-4). The first is the right to obtain substantially all the economic benefits from using the identified asset. The second is the right to direct its use. Many medical agreements are complex, so the entity needs a robust process to identify its leases.

Take a contract for mobile diagnostic imaging services. It might include a lease component for the imaging equipment itself, even if no one labeled it a lease. Auditors will probe how the entity separates lease components from non-lease components, and how it valued each.

This comes up often during audit reviews. When the file does not clearly document that split, serious questions can follow.

Preparing an ASC 842 Audit Readiness Checklist for Healthcare

Getting ready for an ASC 842 audit in healthcare takes a structured checklist. It should cover the documents, how accurate the data is, how sound the process is, and how well the internal controls work.

How should healthcare organizations prepare an ASC 842 audit readiness checklist? Start with a complete lease inventory. Next, validate the key lease data points and set clear accounting policies. Then document the significant judgments and run a pre-audit self-assessment.

That review finds and fixes possible issues before the auditor arrives. This head start is crucial to audit readiness at hospitals and other healthcare providers. From a controller’s view, getting ahead of these issues can take real pressure off the close.

ASC 842 Audit Checklist for Healthcare

This checklist gives healthcare entities a structured approach to an ASC 842 audit:

• Lease Identification and Completeness:
  • Confirm someone has reviewed all contracts, including service agreements, for embedded leases. Make sure procedures are in place to catch new leases as they arise.
  • Verify that a complete inventory of all lease agreements exists. It should include all modifications, renewals, and terminations.
  • Data Validation: Reconcile lease data in the lease accounting system or spreadsheets with the underlying lease agreements.
• Lease Classification:
  • Check that each lease classification (operating vs. finance) is accurate under the ASC 842 criteria.
  • Document the reasons for each classification, most of all for leases close to the finance lease thresholds.
• Measurement of ROU Assets and Lease Liabilities:
  • Verify that the initial recognition and subsequent measurement of ROU assets and lease liabilities are accurate. Initial measurement follows ASC 842-20-30-1 for the liability and ASC 842-20-30-5 for the ROU asset.
  • Confirm the discount rates used are appropriate, can be verified, and are applied the same way each time. That holds whether the rate is the implicit rate or the lessee’s incremental borrowing rate (IBR), per ASC 842-20-30-2 through 30-4. Where the implicit rate is not readily determinable, a lessee that is not a public business entity has another option. It may use a risk-free discount rate in place of its incremental borrowing rate. That is an accounting policy election by class of underlying asset, using a period comparable with the lease term (ASC 842-20-30-3).
  • For a medical equipment lease, confirm the liability is the present value of the lease payments not yet paid at commencement (ASC 842-20-30-1). Any incentive paid or payable to the lessee is netted out of the fixed payments first (ASC 842-10-30-5(a)).
  • Confirm initial direct costs, any prepaid lease payments, and any incentive already received are carried in the ROU asset, not the liability (ASC 842-20-30-5).
• Disclosure Requirements:
  • Prepare all quantitative and qualitative disclosures that ASC 842 requires. A full ASC 842 compliance guide lays out the standard behind them.
  • Make sure the lease disclosures agree with the financial statements.
• Internal Controls:
  • Document the internal controls over lease accounting, from initiation to reporting, and test whether they are effective.
  • Confirm appropriate segregation of duties.
• IT System Functionality:
  • Assess whether the lease accounting software or system supports ASC 842 requirements well enough and produces accurate reports.
  • Ensure data integrity between the system and the general ledger.
• Policy and Documentation:
  • Formalize lease accounting policies and procedures.
  • Keep the supporting documents for all significant judgments and estimates.

Completeness is where this usually breaks. Deloitte’s Roadmap: Leases puts it plainly: “A lessee’s failure to identify leases, including those embedded in service arrangements, is likely to lead to a financial statement error given that ASC 842 requires lessees to reflect all leases, other than short-term leases, on the balance sheet” (ASC 842-20-25-1 and 25-2).

Many companies struggle to pull together all their lease contracts. That is hardest for diverse assets like specialized healthcare equipment housed across many sites. This is one of the more common problem areas in practice.

Common Audit Risks Specific to ASC 842 in Healthcare

ASC 842 brings unique audit risks for healthcare entities. They lease many assets, and those assets are complex: above all specialized medical equipment and diverse real estate portfolios. What are the common audit risks specific to ASC 842 in healthcare? Common audit risks include:

• Failing to identify embedded leases within service contracts
• Lease and non-lease components determined incorrectly
• Choosing an improper discount rate
• Errors in lease term and option assessments
• Poorly documented key judgments and estimates

These issues can lead to material misstatements, and auditors will be looking for them.

Embedded Leases in Healthcare: A Significant Risk Area

A prominent audit finding for hospitals is the overlooked embedded lease. Take a service contract that gives a healthcare entity the right to use specific medical equipment or a designated space for a period. Even if no one labeled it a lease, it likely contains an embedded lease. Auditors will challenge whether the list of identified leases is complete.

Healthcare providers often sign agreements for diagnostic imaging services, equipment maintenance with dedicated spares, or outsourced lab services. In each case, the healthcare entity in effect controls specific assets (e.g., a particular MRI machine, a dedicated lab space).

To quickly assess whether a service contract contains an embedded lease, run your agreements through our free AI Lease Analyzer tool. Miss these embedded leases, and ROU assets and lease liabilities can be understated. That leads to material audit adjustments. Auditors often challenge this area, so it is critical to document the review process well.

Discount Rate Application in a Dynamic Environment

When should healthcare organizations update their lease discount rates for audit? Healthcare entities should take a critical look at their lease discount rates, and update them if needed, at certain points. Those are the lease commencement date (ASC 842-20-30-1), a lease modification that is not a separate contract (ASC 842-10-25-11), and any remeasurement of the lease liability. On a remeasurement, the lessee updates the rate unless the remeasurement falls into one of the three exceptions in ASC 842-20-35-5.

Auditors will verify that the incremental borrowing rates (IBR) used are appropriate. That depends on the lease term, the amount of the lease payments, the collateral, and the entity’s credit profile. The ASC 842 Glossary defines the IBR as the rate of interest a lessee would have to pay to borrow on specific terms. Those terms are a collateralized basis, a similar term, an amount equal to the lease payments, and a similar economic environment.

In practice, choosing the right discount rate can be complex, more so with many leases and varying terms. A wrong discount rate can sharply change the present value of lease payments. That misstates the ROU assets and lease liabilities. It often becomes a sore point during audits.

Data Completeness for Healthcare Lease Portfolios

Complete data for healthcare lease portfolios under ASC 842 is vital to a good audit outcome. How do I ensure data completeness for healthcare lease portfolios under ASC 842 during an audit? Data completeness takes a step-by-step approach:

• Inventory all contracts
• Pull all relevant data points for each lease
• Reconcile data across the separate sources
• Put robust lease data validation controls in place

Without complete and accurate data, you cannot rely on the ROU asset and lease liability calculations. The same goes for the required disclosures.

What lease data must be validated for healthcare audit readiness? For healthcare audit readiness, the critical lease data points to validate include:

• Lease term (including renewal and termination options)
• Lease payments (fixed, variable, residual value guarantees)
• Lease commencement date and expiration date
• Discount rate applied
• Underlying asset identification (e.g., specific serial numbers for medical equipment)
• Non-lease components and their allocation
• Any lease incentives or initial direct costs (ASC 842-10-30-5(a); ASC 842-10-30-9).

During the month-end close, accounting teams often feel pressure to process new leases fast. That can leave gaps in the data they capture. Manual processes, such as Excel spreadsheets, make this worse. They make data integrity hard to keep across a large portfolio.

Auditors will often ask for the support behind each lease, including the original contract, amendments, and payment schedules. If you cannot provide it or reconcile the differences, expect more audit scrutiny and possible findings. Our article on lease completeness testing procedures goes deeper on making sure your lease population is complete.

Key Internal Controls for ASC 842 Lease Accounting in Healthcare

Robust ASC 842 internal controls, once set up and kept up, are the base for accurate, reliable lease accounting in healthcare. What are the key internal controls for ASC 842 lease accounting in healthcare? Key internal controls include:

• Formal policies and procedures for identifying and abstracting leases
• A documented review and approval process for how leases are classified and measured
• Segregation of duties for lease management and accounting
• Lease data reconciled to the general ledger
• Discount rates and lease calculations validated at regular intervals

These controls help reduce the risk of error and fraud. Auditors will expect to see them in place and operating effectively.

Manual Process Limitations and Scalability Concerns

At scale, managing ASC 842 by hand gets hard, above all for healthcare systems with hundreds or thousands of leases. Many entities struggle to track lease modifications, reassessments, and new lease commencements with spreadsheets alone. This often results in:

1. Data Inconsistencies: Different versions of lease data across departments.
2. Lack of Audit Trail: Difficulty showing who changed lease data and when.
3. Calculation Errors: Amortization schedules and interest expense worked by hand are prone to human error.
4. Reporting Delays: A lot of time spent compiling data for financial reporting and disclosures, and even more during peak reporting periods.

Strong internal controls over financial reporting give reasonable assurance, not a guarantee, that the financial statements are free from material misstatement. The same limit applies to the audit itself. Grant Thornton’s comment letter on the PCAOB’s proposed AS 1000 asks that the standard “explain why absolute assurance is not attainable.”

Auditors will test the design and operating effectiveness of the controls over lease accounting. Our guide on implementing top 10 lease accounting internal controls has more on building robust controls.

Calculation Example: Initial Measurement of a Medical Equipment Lease

Scenario: A hospital leases a specialized MRI machine.

Calculation:

1. Lease Liability: Present value of the five lease payments not yet paid at commencement, paid in arrears (ASC 842-20-30-1) = $150,000 * 4.329 = $649,350. This figure uses the rounded factor; the unrounded factor of 4.329477 gives $649,422.
2. ROU Asset: Lease Liability + Initial Direct Costs - Lease Incentives received (ASC 842-20-30-5) = $649,350 + $10,000 - $5,000 = $654,350

Key Takeaway: Correct initial measurement depends on identifying all cash flows and applying the right discount rate. Small errors here carry through the whole life of the lease.

Q&A: Addressing Key Concerns for Healthcare Lease Audits

This section answers common questions from auditors and accountants about ASC 842 in healthcare.

Q: How to prepare for an asc 842 audit in healthcare?

A: To prepare for an ASC 842 audit in healthcare, start with a thorough pre-audit self-assessment. Compile a complete and validated lease inventory, and make sure the accounting policies and procedures are documented. Verify that all calculations are accurate, and confirm that all required financial statement disclosures are ready.

Q: What lease data must be validated for healthcare audit readiness?

A: To be ready for a healthcare audit, validate all the detailed data pulled from lease contracts against the source documents. This includes lease term, payment schedules, discount rates, initial direct costs, and lease incentives. It also includes the specific underlying asset details that support the recording of healthcare right of use assets. Auditors typically require evidence of this validation, often performed by an independent preparer and reviewer.

Q: Why does healthcare equipment leasing require specific ASC 842 controls?

A: Healthcare equipment leasing requires specific ASC 842 controls because medical equipment leases come in high volume, are specialized, and are modified often. Service contracts also carry an inherent risk of embedded leases. These controls make sure leases are identified, classified, measured, and reported accurately in the financial statements. They guard against misstatements in the ROU asset, the lease liability, and the required disclosures.

Q: How to audit embedded leases in medical service agreements?

A: To audit embedded leases in medical service agreements, review a sample of service contracts and look for implicit rights of use. Contracts for outsourced services or equipment maintenance deserve the closest look. This often takes forensic analysis of the contract language. The aim is to learn whether the healthcare entity controls an identified asset for a period.

Audit Findings and Common Errors for Hospitals

"What are common lease accounting audit findings for hospitals?" One common lease accounting audit finding for hospitals is a failure to identify embedded leases. These turn up most often in long-term service agreements for diagnostic equipment or facility management.

Other common issues are an incremental borrowing rate (IBR) that is not applied the same way each time and misclassified leases (e.g., treating a finance lease as an operating lease). Quantitative disclosures that are incomplete or wrong are another. Many hospitals also end up responding to ASC 842 audit findings on thin support for significant judgments. Lease term elections and the assessment of renewal options come up most.

Incomplete Documentation of Lease Modifications

Incomplete documentation of lease modifications is a frequent audit finding. Say a hospital extends a lease for an imaging center, or upgrades equipment within an existing lease.

When a modification is not a separate contract, the lessee reassesses the classification of the lease as of the modification’s effective date (ASC 842-10-25-9). For the modifications listed in ASC 842-10-25-11, it also reallocates the remaining consideration and remeasures the lease liability, using a discount rate determined at that date.

Extending the term of an existing lease is on that list (ASC 842-10-25-11(b)). The exception is exercising a contractual option to extend that is already in the contract. That case is a remeasurement under ASC 842-20-35-5 instead.

Often the accounting team records the financial impact well enough but fails to keep clear support that an auditor can follow. That support should show the timing, the terms, and the resulting adjustments to the ROU asset and lease liability. Without a clear audit trail, auditors find it hard to verify compliance.

Example: Consequences of Missing Embedded Leases

Consider a hypothetical hospital system with many contracts for outsourced pathology services. Each contract names specific lab equipment housed within the hospital and run by the service provider. Suppose the hospital obtains substantially all the economic benefits from using that equipment and has the right to direct its use. Both limbs of the control test are then met (ASC 842-10-15-4).

If the system treats those contracts purely as service agreements, the embedded leases go unrecognized. Correcting them later means recognizing ROU assets and lease liabilities that should have been on the balance sheet from commencement (ASC 842-10-15-3; ASC 842-20-25-1).

The illustration shows the risk when processes are decentralized and the lease identification protocols are too weak to catch embedded leases in healthcare.

Next Steps for Enhanced Healthcare Lease Accounting Compliance

To firm up your team’s ASC 842 compliance and keep audits smooth, keep watching and refining your lease accounting processes. Structured approaches and specialized tools can sharply reduce audit risk and streamline reporting. For deeper analysis and guidance, we highly recommend our full ASC 842 guide.

Related Articles

• ASC 842 Management Assertions: An Auditor's Perspective
• ASC 842 Pre-Audit Self-Assessment Checklist
• Responding to ASC 842 Audit Findings
• Auditing ASC 842 Lease Accounting: An Auditor's Guide