What Auditors Do for ASC 842 Substantive Testing
Navigating the complexities of ASC 842 lease accounting presents significant challenges for controllers and accounting managers. Beyond initial implementation, the ongoing audit of these new standards requires meticulous preparation and a deep understanding of what external auditors actually examine. This article provides an in-depth look at ASC 842 substantive testing procedures: what auditors actually do, offering practical insights for ensuring compliance and a smooth audit process.
ASC 842 substantive testing procedures: what auditors actually do refers to the assurance process that all contracts meeting ASC 842's definition of a lease have been identified, evaluated, and recorded in the organization's financial statements. A key challenge we consistently see is the sheer volume of data and the judgment required, particularly for an ASC 842 audit that moved many leases from off-balance sheet to on-balance sheet. Auditors focus squarely on the completeness, accuracy, valuation, and classification of lease assets and liabilities. Our goal as auditors is to address the risk of material misstatement due to errors or omissions in lease accounting.
What Auditors Are Actually Looking For
Auditors approach lease audit procedures with a healthy dose of professional skepticism, particularly regarding the completeness and accuracy of an organization's lease population. We're primarily concerned with ensuring that all leases, including embedded leases, have been properly identified and accounted for under ASC 842. This involves a combination of inquiry, inspection, reperformance, and recalculation procedures. We don't just verify the numbers; we scrutinize the underlying judgments and documentation supporting those numbers. Understanding ASC 842 management assertions is critical for preparing robust audit evidence.
✅ Best Practice: Proactive engagement with your auditors, including sharing lease accounting policies and system outputs early, can significantly streamline the audit process and reduce those frantic, last-minute requests. We appreciate it when clients come prepared.
A common concern for auditors is what are the risks of incomplete lease population. Simply put, an incomplete population inevitably leads to understated right-of-use (ROU) assets and lease liabilities, which could easily result in a material financial statement misstatement. We'll often perform extensive procedures to confirm the completeness of records, extending beyond the accounts management initially provides.
Key Audit Focus Areas for ASC 842
| Audit Assertion | Auditor Focus Area | Example Procedure |
|---|---|---|
| Completeness | All leases, including embedded ones, are identified. | We'll review general ledger accounts for recurring payments; analyze expense accounts for potential lease payments; inquire about new contracts; and select a sample of vendor payments to review underlying contracts for lease components. |
| Existence | ROU assets and lease liabilities relate to actual leases. | We confirm the existence of underlying assets and lease agreements; we might even physically inspect leased assets if material and feasible. |
| Valuation | Lease assets and liabilities are correctly measured. | We recalculate the present value of lease payments using appropriate discount rates; verify variable lease payments and lease modifications; and assess any impairment of ROU assets. |
| Rights & Obligations | Entity has economic rights to ROU assets and obligations for lease liabilities. | We inspect lease contracts for terms, conditions, and ownership transfer provisions; and confirm lease commencement and expiration dates. |
| Presentation & Disclosure | Lease information is properly classified and disclosed. | We review financial statements and footnotes for compliance with ASC 842 disclosure requirements, including disaggregation of lease liabilities, weighted-average discount rates, and lease term. |
From our perspective, and as Deloitte's audit guidance also emphasizes1, significant audit effort is often placed on assessing the effectiveness of controls surrounding lease identification and data capture, given the inherent judgment involved. We consistently highlight the importance of reviewing the entity's policy for determining the discount rate and ensuring its consistent application.
Key Risks and Failure Points
We've seen several common pitfalls that can derail an ASC 842 audit, leading to unwelcome audit adjustments and increased audit fees. Understanding these risks upfront is essential for timely remediation.
- Undiscovered Embedded Leases: Many organizations, despite their best efforts, fail to identify lease components within service contracts—think outsourcing agreements, IT services, or transportation arrangements. This can significantly impact the completeness assertion. An embedded lease refers to a lease component contained within a larger contract that may not be explicitly identified as a lease, and it's a frequent finding.
- Incorrect Discount Rate Determination: Choosing an inappropriate incremental borrowing rate (IBR) or improperly applying the risk-free rate can lead to material misstatements in lease liabilities and ROU assets. Auditors will scrutinize the methodology and support for the determined rate rigorously.
- Inaccurate Lease Term Determination: Judgments regarding lease extensions, terminations, and purchase options directly affect the lease term and, consequently, the ROU asset and lease liability. Insufficient documentation or inconsistent application of these judgments is a frequent audit finding.
- Improper Lease Classification: While simpler under ASC 842, the distinction between finance and operating leases still requires careful consideration, especially for private companies that may still be applying the old classification criteria based on their transition method choice.
- Insufficient Documentation: A lack of clear, organized documentation for lease agreements, amendments, calculations, and the judgments made can severely impair an auditor's ability to verify balances. This inevitably leads to delays and additional auditor effort, which nobody wants.
- ROU asset audit challenges often arise from improper impairment assessments. When events or changes in circumstances indicate that the carrying value of an ROU asset may not be recoverable, an impairment test is required, and auditors will certainly review it.
⚠️ Risk Alert: A common audit finding, and one we see repeatedly, relates to companies overlooking service contracts that implicitly convey the right to control an identified asset, thus containing embedded leases. This directly impacts the completeness of the lease population.
Scenario Example: Undiscovered Embedded Leases Consider a manufacturing company that enters into a five-year contract with a logistics provider to manage its entire fleet of delivery vehicles. The contract specifies the number and type of vehicles, and the manufacturing company has the right to direct how the vehicles are used, without the logistics provider having substantive substitution rights. The company, perhaps understandably, accounts for this as an operating expense. During the ASC 842 substantive testing procedures: what auditors actually do phase, our team reviews a sample of large recurring expenses and flags this particular logistics contract. Upon reviewing the terms, the auditor identifies an embedded lease for the vehicles, requiring the company to recognize ROU assets and lease liabilities for approximately $2.5 million previously expensed. This materially impacts the balance sheet and results in an audit adjustment. This is where most teams get tripped up.
Practical Checklist for Substantive Testing
This checklist outlines critical steps for preparing for ASC 842 substantive testing procedures: what auditors actually do. Organizations must ensure they have robust processes and documentation in place to address each point. This helps in how to ensure lease completeness for ASC 842 compliance. For more detailed guidance, consider reviewing an ASC 842 audit readiness checklist.
| Checklist Item | Description |
|---|---|
| 1. Complete Lease Inventory | Ensure all leases, including embedded ones, are identified and recorded in a centralized system or spreadsheet. This is the foundation for avoiding what are the risks of incomplete lease population. |
| 2. Lease Data Verification | Confirm the accuracy of key lease data: commencement/expiration dates, payment schedules, options, lease incentives, and nonlease components. |
| 3. Discount Rate Justification | Document the methodology and support, including any comparable borrowing rates, used to determine the incremental borrowing rate (IBR) for each lease. |
| 4. Lease Term Determinations | Maintain clear rationale and documentation for assumptions made regarding renewal options, termination options, and purchase options. |
| 5. Lease Modification Accounting | Have a process for identifying and properly accounting for lease modifications, including remeasurements and reallocations. |
| 6. Impairment Assessment | Document any impairment assessments performed on ROU assets, including the triggering events and calculations. |
| 7. Disclosure Requirements | Prepare and review all required ASC 842 disclosures, ensuring they are comprehensive and accurate. |
| 8. Internal Control Documentation | Document internal controls over lease identification, data input, calculation, and reporting. While perhaps not direct substantive testing, auditors will absolutely review these controls. |
| 9. Journal Entry Support | Ensure all journal entries related to ROU assets, lease liabilities, and lease expenses are properly supported. |
💡 Key Takeaway: The completeness assertion is one of the most scrutinized areas in an ASC 842 audit. Auditors will go beyond simply reviewing the provided lease schedule to search for unrecorded leases; we've seen too many instances where that's been an issue.
How to identify embedded leases in contracts
Identifying embedded leases requires a systematic contract review process. The first step for embedded lease discovery is to review all service contracts and purchase orders, particularly those involving the use of specific assets. Q: How to identify embedded leases in contracts? A: Examine contracts for two key criteria: an identified asset (like a specific machine or a distinct portion of a building) and the right to control its use (e.g., the right to direct how and for what purpose the asset is used, or the right to obtain substantially all economic benefits from its use). If both exist, the contract likely contains an embedded lease. Accounting managers should work closely with procurement and legal departments for this review; it's a team effort.
How Accounting Teams Should Validate Their Approach
Accounting teams must proactively validate their lease identification audit processes and ASC 842 calculations before the audit begins. This internal validation process involves replicating auditor procedures to identify potential weaknesses or errors. 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 paramount for ASC 842.
Validation Steps and Evidence
- Reconciliation: Reconcile the lease population from your lease accounting software or spreadsheet to the general ledger. Trace current lease payments to the lease schedule and ensure all active leases are included.
- Sample Testing: Select a sample of lease contracts (both those identified as leases and those initially deemed non-leases) and perform detailed recalculations of the ROU asset and lease liability. Verify all input assumptions, especially the discount rate and lease term.
- Cross-Functional Review: Collaborate with procurement and legal to review contracts for embedded leases. We recommend implementing a quarterly or annual review cycle for new or modified contracts.
- Policy Compliance: Ensure that the entity's lease accounting policy is consistently applied across all leases and that any judgmental areas (e.g., lease term, IBR) are adequately supported.
- Data Integrity: Verify the integrity of data imported into your lease accounting software. We've seen firsthand how errors in data entry can cascade into significant financial statement misstatements.
- ROU Asset Reconciliation: Reconcile the 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, to the general ledger, ensuring proper depreciation and any impairment entries are recorded.
Calculation Example: Lease Liability Recalculation
Scenario: An auditor might re-perform the calculation for a sample lease to verify valuation.
| Component | Value | Calculation |
|---|---|---|
| Annual Lease Payment | $10,000 | From lease agreement |
| Lease Term | 5 years | From lease agreement, no options considered reasonably certain to exercise |
| Incremental Borrowing Rate | 5.00% | Company's determined IBR for a 5-year collateralized borrowing. Auditor confirms documentation. |
| Present Value Factor | 4.32948 | Present value of an annuity due factor for 5 periods at 5% (assuming payments in advance, as is common for leases). Calculation: [ (1 - (1 + 0.05)^-5) / 0.05 ] * (1 + 0.05) |
| Lease Liability | $43,295 | $10,000 * 4.32948 |
Key Takeaway: This re-calculation verifies the actuarial accuracy of the lease liability, a core component of ASC 842 substantive testing procedures: what auditors actually do. Auditors will verify the discount rate selection process and the present value calculation, so make sure your support is solid.
As the AICPA Audit Guide points out2, auditors emphasize the existence of sufficient and appropriate audit evidence to support management's assertions. This includes lease contracts, payment schedules, and management's judgmental assessments.
Common Mistakes and How to Avoid Them
Even well-intentioned companies can make errors during ASC 842 implementation and ongoing compliance. Understanding these pitfalls can help accounting teams fortify their processes and prepare for the ASC 842 substantive testing procedures: what auditors actually do controls.
| Common Mistake | Best Practice / Solution |
|---|---|
| Incomplete Contract Search | Implement a comprehensive, cross-functional process involving procurement, legal, and operations to identify all contracts. Use data analytics on expense accounts (e.g., looking for recurring payments not tied to fixed assets) to identify potential unrecorded leases. Regularly update a centralized lease inventory. This directly addresses the question of "how to ensure lease completeness for ASC 842 compliance." |
| Inaccurate Discount Rate Application | Develop and document a clear policy for determining the incremental borrowing rate (IBR). For private companies, if using the risk-free rate, ensure the election is properly documented and consistently applied. Consider obtaining formal quotes from lenders or engaging third-party specialists for IBR determination – it often pays off. |
| Failure to Account for Lease Modifications | Establish a robust process for tracking and accounting for lease modifications (e.g., changes in scope, term, or consideration) in a timely manner. Ensure appropriate remeasurements of the lease liability and ROU asset are performed and documented. This is where many companies get tripped up after the initial implementation. |
| Lack of Sufficient Documentation | Maintain a well-organized system for all lease agreements, amendments, supporting calculations (e.g., IBR determination, lease term analysis), and significant judgments. Auditors require a clear audit trail, and without it, you're looking at delays. What documentation is required for asc 842 substantive testing procedures: what auditors actually do includes lease agreements, payment schedules, IBR support, lease term analyses, and impairment calculations. |
| Misunderstanding Nonlease Components | Correctly identify and separate nonlease components (e.g., common area maintenance, insurance) from lease components. For operating leases, ensure practical expedient elections are consistently applied and documented. |
| Inadequate Internal Controls Over Lease Data | Implement strong internal controls, including segregation of duties, review processes, and system access controls, for lease data entry, calculation, and reporting. Auditors will test these controls if management relies on them, so don't overlook them. |
🚨 Critical: Failure to reliably track lease modifications can lead to material misstatements. This is often flagged as "what are common asc 842 substantive testing procedures: what auditors actually do audit findings" because while the initial lease accounting might be correct, subsequent changes are not properly recorded.
What Strong Execution Looks Like in Practice
Strong execution in lease accounting compliance for ASC 842 translates into a more efficient audit, fewer audit adjustments, and greater confidence in financial reporting. It mitigates the need for extensive auditor deep-dives and ensures adherence to accounting principles, which is what we all strive for.
Characteristics of a Well-Prepared Organization
- Centralized Lease Management System: Organizations leveraging specialized lease accounting software significantly streamline data management, calculations, and reporting, which drastically reduces manual errors.
- Proactive Contract Review: A disciplined process for reviewing all new and renewed contracts for lease components, ensuring timely identification and accurate accounting.
- Robust Internal Controls: Well-documented and operating internal controls over the entire lease accounting cycle, from initiation to disclosure. This is non-negotiable.
- Comprehensive Documentation: A readily available repository of all lease contracts, amendments, calculations, and judgments, easily accessible for auditors. This makes everyone's lives easier.
- Regular Lease Data Review: Periodic review and reconciliation of lease data and balances to the general ledger, identifying discrepancies before the audit team even steps in.
Q: How do auditors perform substantive testing for ASC 842 leases? A: Auditors perform substantive testing by first understanding the entity’s internal controls. If controls are deemed ineffective, they will increase the extent of substantive procedures. These involve detailed testing of transactions and balances, such as re-performing present value calculations, verifying lease terms, inspecting contracts for embedded leases, and confirming disclosures.
Next Steps
To enhance your organization's readiness for ASC 842 substantive testing procedures: what auditors actually do, we strongly recommend evaluating existing processes against the guidance provided here. Implementing robust controls and a systematic approach to lease identification and accounting will significantly de-risk your next financial statement audit.
Related Articles
- Auditing ASC 842 Lease Accounting: An Auditor's Guide
- Preparing for ASC 842 Audits
- ASC 842 Audit Adjustments: What to Expect
- Understanding ASC 842 Lease Accounting Impact on Company Performance
