Complete Your ASC 842 Pre-Audit Evaluation
A robust pre-audit self-assessment for ASC 842 compliance is critical for any entity seeking to navigate the complexities of lease accounting with confidence. The transition to ASC 842, Leases, has significantly changed how companies account for their leasing arrangements, moving most leases onto the balance sheet. This shift introduces new disclosure requirements, complex calculation methodologies, and increased scrutiny from auditors. An effective pre-audit self-assessment ensures that an organization has accurately applied ASC 842 and is prepared to withstand external audit procedures. It 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. Without a thorough self-assessment, organizations risk material misstatements, audit delays, and potential non-compliance findings, which can impact financial reporting and investor confidence. This proactive approach helps identify and rectify issues before they become costly audit exceptions, ensuring a smoother ASC 842 audit process and validating the comprehensiveness of financial disclosures.
What Auditors Are Actually Looking For
Auditors approach an ASC 842 audit with a focus on several key assertions, primarily completeness, accuracy, and presentation. They want to ensure that all leases have been properly identified and recorded, and that the financial statements accurately reflect the entity's lease obligations and rights-of-use. Under PCAOB auditing standards, auditors are required to assess management's application of complex accounting standards.
✅ Best Practice: Auditors expect a well-documented process for lease identification, classification, measurement, and disclosure. This includes detailed audit trails for every lease decision.
Specifically, auditors perform lease audit procedures to test:
- Completeness: Have all leases, including embedded leases, been identified?
- Accuracy: Are lease liabilities and right-of-use (ROU) assets correctly calculated and measured?
- Classification: Are leases properly classified as operating or finance leases?
- Disclosure: Are all required ASC 842 disclosures complete and accurate?
- Controls: Are internal controls over lease accounting design and operating effectively?
Big Four firms like Deloitte emphasize the importance of a transparent and well-controlled lease accounting process, highlighting that auditors will scrutinize the methodology used for identifying leases and determining key inputs such as discount rates 1. They expect to see evidence of robust internal controls surrounding the entire lease lifecycle.
Key Audit Focus Areas
| Audit Area | Auditor's Objective | Evidence Reviewed |
|---|---|---|
| Lease Identification | Verify all contracts containing a lease are captured | Contract inventory, contract review policies, system outputs |
| Lease Classification | Confirm correct operating vs. finance lease determination | Lease schedules, classification templates, management judgments |
| Measurement | Assess accuracy of ROU assets and lease liabilities | Discount rate support, payment schedules, remeasurement calculations |
| Disclosure | Ensure compliance with ASC 842 disclosure requirements 2 | Financial statement footnotes, MD&A, management representations |
| System & Controls | Evaluate effectiveness of lease accounting system and related controls | System access logs, control narratives, exception reports |
Q: How do auditors test pre-audit self-assessment for ASC 842 compliance?
A: Auditors will typically review the organization's self-assessment documentation, test key controls identified during the assessment, and sample calculations and judgments to confirm their accuracy and completeness, comparing outcomes to ASC 842 requirements.
Key Risks and Failure Points
Failing to conduct a thorough pre-audit self-assessment exposes organizations to significant risks. One of the most prevalent is the incomplete identification of the lease population. When asking "what are the risks of incomplete lease population?", the answer involves not only financial misstatement but also a breakdown in internal controls and potential restatements.
⚠️ Risk Alert: A common audit finding relates to companies overlooking service contracts with embedded leases, leading to understated lease liabilities and ROU assets.
Here are concrete risks and why they matter:
- Incomplete Lease Identification: This is perhaps the greatest risk. If contracts containing leases are missed, the entire ASC 842 financial reporting will be incomplete and inaccurate. This directly impacts the completeness assertion, which refers to an auditor's objective to verify that all transactions and accounts that should be recorded have been included in the financial statements.
- Incorrect Discount Rate Application: Choosing the wrong incremental borrowing rate, or failing to properly document inputs, can lead to material miscalculations of lease liabilities and ROU asset audit values. Right-of-use (ROU) asset is defined as an asset that represents a lessee's right to use an underlying asset for the lease term under ASC 842.
- Embedded Lease Oversight: Many non-lease contracts contain an identified asset and control over its use. Forgetting embedded lease discovery can lead to significant omissions. An embedded lease refers to a lease component contained within a larger contract that may not be explicitly identified as a lease.
- Inadequate Documentation: A lack of clear, auditable documentation for judgments (e.g., lease term, optional payments, discount rates) makes it difficult for auditors to verify management's conclusions, leading to extensive audit questions and potential adjustments.
- Ineffective Internal Controls: Poorly designed or non-operating controls over the lease accounting process can result in calculation errors, data integrity issues, and a higher risk of material misstatement.
Example Scenario: Missed Embedded Leases
Scenario: A manufacturing company has a contract with an IT vendor for managed services. The contract specifies that the vendor will provide dedicated servers located at the client's premises, which the client has the right to control how they are used, including changing operating parameters. The accounting team initially classified this solely as an IT service expense.
| Component | Issue | Audit Impact |
|---|---|---|
| Contract Review | No formal process for embedded lease review | Significant gap in completeness. |
| Lease Identification | Dedicated servers not identified as an asset | Understated ROU assets and lease liabilities. |
| Financial Reporting | Expensed services rather than capitalized | Misstated balance sheet, income statement, and statement of cash flows. |
| Total Impact | Material Misstatement | Required audit adjustments, potential restatement, control deficiencies identified. |
Key Takeaway: Proactive contract review for embedded leases is essential. This often involves cross-functional collaboration with procurement and legal departments.
Practical Checklist for Pre-Audit Self-Assessment
To effectively prepare for an ASC 842 audit, organizations should follow a structured approach. This pre-audit self-assessment for ASC 842 compliance involves a detailed review of processes, contracts, and calculations.
💡 Key Takeaway: A comprehensive pre-audit self-assessment helps to proactively identify and resolve potential issues, dramatically reducing audit efforts and findings.
What should I include in my ASC 842 audit readiness checklist?
A robust ASC 842 audit readiness checklist should cover lease identification, classification, measurement, and disclosure. It should also assess internal controls and documentation practices. This structured review aligns with guidance on how to ensure lease completeness for ASC 842 compliance.
Pre-Audit Self-Assessment Checklist
| Checklist Item | Action Required | Documentation / Evidence |
|---|---|---|
| 1. Lease Population Completeness | Develop and execute a plan for comprehensive contract review. | Contract inventory, review log, embedded lease policy. |
| 2. Lease Data Capture | Ensure all critical lease data points are accurately captured in a central system. | Lease abstract templates, lease accounting system data. |
| 3. Lease Classification Review | Re-evaluate all leases for proper operating vs. finance classification. | Classification matrix, narrative of judgments. |
| 4. Discount Rate Validation | Document methodologies for determining incremental borrowing rates. | Rate calculations, external support for rates, internal policy. |
| 5. ROU Asset & Lease Liability Calculation | Verify calculations for initial measurement and subsequent remeasurements. | Lease schedules, reconciliation to GL, calculation models. |
| 6. Journal Entry Verification | Confirm all lease-related journal entries are accurate and timely. | JEs, supporting workings, recurring entry schedules. |
| 7. Disclosure Preparation | Draft and review all required ASC 842 financial statement disclosures. | Disclosure checklist, draft footnotes, management review. |
| 8. Internal Control Assessment | Evaluate design and operating effectiveness of controls over lease accounting. | Control narratives, process flowcharts, control testing results. |
| 9. Policy & Procedures Updates | Ensure lease accounting policies and procedures reflect ASC 842 requirements. | Updated accounting policies, training materials. |
Referencing an ASC 842 close process checklist can further enhance the comprehensiveness of your self-assessment.
How Accounting Teams Should Validate Their Approach
Validation is key to the effectiveness of a pre-audit self-assessment for ASC 842 compliance. It goes beyond simply completing a checklist; it involves rigorous testing of the output and underlying processes. For lease identification audit purposes, accounting teams must provide verifiable proof that their methodology is sound.
🚨 Critical: Failure to sufficiently validate the lease population or key calculations is a frequent cause of auditor findings and adjustments.
Validation Steps and Documentation
- Reconciliation to General Ledger (GL): Reconcile lease accounting system outputs to the general ledger accounts for ROU assets, lease liabilities, interest expense, and amortization. Any discrepancies must be investigated and resolved. This step often reveals errors related to data entry or system configuration.
- Sample Testing of Lease Data: Select a representative sample of leases, including those with complex features or significant values, and re-perform calculations for initial measurement, modifications, and remeasurements. This ensures the accuracy of underlying data and the application of accounting policy.
- Review of Key Judgments: Document and critically review all significant judgments made, such as lease term, optional periods, discount rates, and the assessment of identified assets and control (crucial for how to identify embedded leases in contracts). This includes challenging the assumptions behind these judgments. The FASB ASC 842-10-15 outlines criteria for identifying a lease.
- Cross-functional Interviews: Interview personnel in procurement, legal, and operations to understand their contract management processes and to identify any potential leases not captured by the central accounting function. This is especially important for identifying embedded leases.
- Benchmarking Disclosures: Compare draft ASC 842 disclosures against public filings of peer companies to ensure completeness and industry-standard presentation. This aligns with requirements for ASC 842 disclosure requirements.
- Control Walkthroughs: Perform walkthroughs of key internal controls related to lease accounting to ensure they are designed appropriately and are operating as intended. This also provides evidence of control effectiveness to auditors.
For additional resources on robust validation processes, organizations can consult guides on how to ensure lease completeness for ASC 842 compliance, specifically focusing on audit readiness.
Common Mistakes and How to Avoid Them
Even with diligent efforts, certain pitfalls commonly hinder an effective pre-audit self-assessment for ASC 842 compliance controls. Understanding these mistakes helps in proactive avoidance, benefiting the overall lease accounting compliance effort.
📢 Warning: Many companies underestimate the time and resources required for a comprehensive pre-audit self-assessment, leading to rushed efforts and missed issues.
Q: What documentation is required for pre-audit self-assessment for asc 842 compliance?
A: Required documentation includes a complete lease contract inventory, lease abstracts, classification narratives, discount rate policies, remeasurement calculations, general ledger reconciliations, and draft financial statement disclosures.
Common Mistakes vs. Best Practices
| Common Mistake | Explanation / Impact | Best Practice |
|---|---|---|
| 1. Underestimating Complexity | Believing ASC 842 is only a balance sheet presentation change. | Recognize the comprehensive impact on systems, processes, and people; allocate sufficient resources. |
| 2. Inadequate Lease Inventory | Relying on existing fixed asset lists or general ledger accounts. | Conduct a thorough, bottom-up review of all contracts across the organization with legal and procurement input. |
| 3. Manual Spreadsheets for Calculations | High risk of error, lack of audit trail, difficult to manage remeasurements. | Implement a specialized lease accounting software solution for automated calculations and reporting. |
| 4. Ignoring Embedded Leases | Missing leases within service or supply contracts. | Establish a formal process for identifying and reviewing all contracts for embedded leases. |
| 5. Lack of Cross-Functional Collaboration | Accounting team working in isolation from procurement, legal, and operations. | Foster regular communication and joint review processes between relevant departments. |
| 6. Poor Documentation of Judgments | Arbitrary lease terms or discount rates without clear rationale. | Document all significant judgments, including assumptions, inputs, and rationale for audit review. |
| 7. Delayed Disclosure Preparation | Waiting until year-end to draft footnotes. | Prepare disclosures quarterly or semi-annually to identify data gaps early. |
Q: What are common pre-audit self-assessment for ASC 842 compliance audit findings?
A: Common audit findings include undisclosed embedded leases, incorrect discount rate application, errors in calculating ROU assets or lease liabilities, and insufficient documentation of management's judgments, highlighting the need for vigilance.
For further insights into avoiding these common errors, reviewing resources like the top 10 year-end lease accounting challenges can be highly beneficial.
What Strong Execution Looks Like in Practice
Organizations that excel in their pre-audit self-assessment for ASC 842 compliance demonstrate specific characteristics that streamline the external audit process. Strong execution results in fewer auditor questions, fewer audit adjustments, and ultimately, a more efficient and less stressful audit cycle.
✅ Best Practice: Proactive engagement with auditors and a transparent, well-documented process are hallmarks of strong lease accounting compliance.
A well-executed self-assessment means that the accounting team has already anticipated auditor questions and prepared the necessary evidence. This includes:
- Comprehensive Lease Data: A centralized, accurate, and up-to-date repository of all leases and their critical data points.
- Automated Calculations: Utilizing lease accounting software for accurate and auditable calculations of ROU assets, lease liabilities, interest, and amortization.
- Robust Internal Controls: Implementing and consistently operating controls over lease data input, classification, measurement, and reporting.
- Detailed Documentation: All judgments (e.g., lease term, discount rates, short-term lease elections) are clearly articulated and supported.
- Proactive Issue Resolution: Identifying and resolving discrepancies or complex accounting issues before the auditors arrive.
Example: A Pre-Assessment Success Story
A multinational manufacturing firm implemented an ASC 842 software solution and dedicated a cross-functional team to its pre-audit self-assessment for ASC 842 compliance. They began six months before their year-end audit, reviewing all contracts, identifying embedded leases, and documenting key judgments.
- Outcome 1: They discovered 15 previously unrecorded embedded leases in service contracts, leading to a several million-dollar adjustment to ROU assets and lease liabilities, which was corrected prior to audit.
- Outcome 2: Their auditors noted the completeness and accuracy of the lease data and supporting documentation.
- Outcome 3: The total audit hours for lease accounting decreased by 20% compared to the previous year's audit, saving both time and audit fees.
This firm's success underscores that strong execution in lease accounting compliance involves not just technical application but also a strategic approach to preparation and ongoing management.
Next Steps
To further enhance your pre-audit self-assessment for ASC 842 compliance and develop a robust audit readiness strategy, consider evaluating your current processes against industry best practices. Continuously training your team on ASC 842 complexities and leveraging appropriate technology can significantly improve efficiency and accuracy. Proactive engagement with auditors early in the process can also provide valuable insights and minimize last-minute surprises.
Related Articles
- Preparing for ASC 842 Audits
- Auditing ASC 842 Lease Accounting: An Auditor's Guide
- Guide to Successfully Complete an ASC 842 Lease Accounting Audit
- Passing Your ASC 842 Audit
