ASC 842 Substantive Testing Procedures: What Auditors Actually Do

What Auditors Do for ASC 842 Substantive Testing

ASC 842 lease accounting poses real challenges for controllers and accounting managers. The work goes on past the first year. Each audit of the new standard takes careful preparation and a deep grasp of what external auditors actually examine. This article takes a close look at substantive testing of leases, with practical points to help you stay compliant and keep the audit smooth.

For a complete breakdown, see our ASC 842 compliance guide.

ASC 842 substantive testing procedures: what auditors actually do refers to testing the lease balances themselves rather than relying on controls. The auditor tests whether every contract meeting ASC 842's definition of a lease was identified, which is the completeness assertion. Auditors also test whether the recorded balances are right, and whether each lease is classified and disclosed correctly.

The sheer volume of data and the judgment required are what make the work hard. ASC 842-20-25-1 requires a right-of-use asset and a lease liability at commencement, including for leases that used to sit off the balance sheet. There is far more on the balance sheet to test than there was under ASC 840.¹

Auditors focus squarely on the completeness, accuracy, valuation, and classification of lease assets and liabilities. The auditor's goal is to address the risk of material misstatement due to errors or omissions in lease accounting.

The Substantive Procedures Auditors Run

Auditors bring a healthy dose of professional skepticism to lease audit procedures. They apply it most to the completeness and accuracy of an organization's lease population. Their main concern is that all leases, including embedded leases, have been properly identified and accounted for under ASC 842. To test that, they combine inquiry, inspection, reperformance, and recalculation procedures.

Auditors do not just verify the numbers. They also scrutinize the judgments and documentation that support those numbers. To prepare robust audit evidence, it is critical to understand ASC 842 management assertions.

✅ Best Practice: Engage with your auditors early, and share lease accounting policies and system outputs ahead of time. This can greatly streamline the audit and reduce those frantic, last-minute requests. Auditors appreciate it when clients come prepared.

A common concern for auditors is the risks of an incomplete lease population. Simply put, an incomplete population inevitably leads to understated right-of-use (ROU) assets and lease liabilities. That could easily result in a material financial statement misstatement.

Auditors will often perform extensive procedures to confirm that the records are complete. Those procedures extend beyond the accounts management first provides.

Key Audit Focus Areas for ASC 842

Lease identification and data capture involve inherent judgment. For that reason, auditors often put significant effort into assessing how well the controls around them work. They also review the entity's policy for determining the discount rate: the rate implicit in the lease when it is readily determinable, otherwise the incremental borrowing rate. The policy also covers any risk-free-rate election, which is made by class of underlying asset (ASC 842-20-30-3).

Where Substantive Testing Finds Problems

Several common pitfalls can derail an ASC 842 audit and lead to unwelcome audit adjustments and higher audit fees. You need to understand these risks up front to fix them in time.

• Undiscovered Embedded Leases: Many organizations try their best and still 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. It is a frequent finding.
• Incorrect Discount Rate Determination: ASC 842-20-30-3 sets an order. A lessee uses the rate implicit in the lease whenever that rate is readily determinable, and its incremental borrowing rate (IBR) when it is not. Choosing an inappropriate IBR can lead to material misstatements in lease liabilities and ROU assets, and so can misapplying the risk-free rate election. Auditors will take a hard look at the method and support behind the rate the company set.
• Inaccurate Lease Term Determination: Judgments about lease extensions, terminations, and purchase options directly affect the lease term (ASC 842-10-30-1). Through the lease term, they also affect the ROU asset and lease liability. Auditors often find that these judgments lack enough documentation or are applied unevenly.
• Improper Lease Classification: Classifying a lease as finance or operating requires careful thought, and it matters most for leases that commenced before adoption. An entity of any size that elected the package of practical expedients on transition did not reassess classification for expired or existing leases. Those leases carry their legacy classification forward (ASC 842-10-65-1(f)). Auditors check that the package was elected as a package, all three expedients or none, and that leases commencing after adoption were classified under ASC 842-10-25-2 through 25-3.
• Insufficient Documentation: A lack of clear, organized documentation can severely impair an auditor's ability to verify balances. That covers lease agreements, amendments, calculations, and the judgments made. This inevitably leads to delays and more auditor effort, which nobody wants.
• ROU asset audit challenges often arise from improper impairment assessments. Events or changes in circumstances may indicate that the carrying value of an ROU asset may not be recoverable. When they do, the ROU asset is tested for impairment under the long-lived asset guidance in ASC 360-10, and auditors will certainly review that test (ASC 842-20-35-9).

⚠️ Risk Alert: A common and repeated audit finding is that companies overlook certain service contracts. These contracts implicitly convey the right to control an identified asset, and thus contain 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. The manufacturing company has the right to direct how the vehicles are used, and the logistics provider has no substantive substitution rights.

The company, perhaps understandably, accounts for this as an operating expense. During the substantive testing of leases phase, the audit 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 (ASC 842-10-15-3).

That requires the company to recognize the lease liability it should have recorded at commencement, at the present value of the lease payments not yet paid (ASC 842-20-30-1). The balance today is the present value of the payments still unpaid, discounted at that commencement-date rate (ASC 842-20-35-3(a)). The right-of-use asset is measured off that liability (ASC 842-20-30-5). The roughly $2.5 million already run through operating expense is what put the contract on the audit team's sample list.

That $2.5 million is not itself the amount recognized; the recognized liability is the discounted remainder. The correction materially affects the balance sheet and results in an audit adjustment — the point where most teams get caught out.

Practical Checklist for Substantive Testing

This checklist outlines critical steps to prepare for substantive testing of leases. Organizations must have robust processes and documentation in place to address each point. This helps with how to ensure lease completeness for ASC 842 compliance. For more detail, consider reviewing an ASC 842 audit readiness checklist.

💡 Key Takeaway: The completeness assertion is one of the most scrutinized areas in an ASC 842 audit. Auditors will not simply review the lease schedule you provide. They will go beyond it to search for unrecorded leases, because unrecorded leases have been an issue too many times.

How to identify embedded leases in contracts

To identify embedded leases, you need a systematic contract review process. The first step for embedded lease discovery is to review all service contracts and purchase orders. Look most closely at those that involve the use of specific assets.

Q: How to identify embedded leases in contracts? A: Examine contracts for two key criteria. One is an identified asset, like a specific machine or a distinct portion of a building. The other is the right to control its use (ASC 842-10-15-3).

Control has two limbs, and ASC 842-10-15-4 requires both throughout the period of use. The customer must have the right to obtain substantially all of the economic benefits from use of the identified asset, and the right to direct its use. Fail either limb and there is no lease.

ASC 842-10-15-20 gives two routes to the direct-use limb. Under the first, the customer has the right to direct how and for what purpose the asset is used throughout the period of use.

The second route applies when those decisions are predetermined. It is met if the customer has the right to operate the asset, or to direct others to operate it in a manner the customer determines. That right must run throughout the period of use, with the supplier unable to change those operating instructions. It is also met if the customer designed the asset in a way that predetermines how and for what purpose it will be used (ASC 842-10-15-20(b)).

A contract with an identified asset and both limbs of control contains a lease. Accounting managers should work closely with procurement and legal departments on this review. It is a team effort.

How to Prepare for Substantive Testing

Before the audit begins, accounting teams must take the lead and validate their lease identification audit processes and ASC 842 calculations. To do this in-house, the team repeats the auditor's procedures to find possible weaknesses or errors.

The completeness assertion refers to an auditor's objective. The auditor verifies that all transactions and accounts that should be recorded have been included in the financial statements. This is paramount for ASC 842.

ASC 842's glossary defines the right-of-use (ROU) asset (ASC 842-20-20). An ROU asset is "an asset that represents a lessee's right to use an underlying asset for the lease term". For an operating lease, it is measured off the lease liability (ASC 842-20-35-3(b)).

Validation Steps and Evidence

1. 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 make sure all active leases are included.
2. Sample Testing: Select a sample of lease contracts. Include both those identified as leases and those first deemed non-leases. Then recalculate the ROU asset and lease liability in detail. Verify all input assumptions, especially the discount rate and lease term.
3. Cross-Functional Review: Work with procurement and legal to review contracts for embedded leases. Consider setting up a quarterly or annual review cycle for new or modified contracts.
4. Policy Compliance: Make sure the entity's lease accounting policy is applied consistently across all leases. Make sure any judgmental areas (e.g., lease term, IBR) are adequately supported.
5. Data Integrity: Verify that data imported into your lease accounting software is intact and correct. Errors in data entry can cascade into significant financial statement misstatements.
6. ROU Asset Reconciliation: Reconcile the right-of-use (ROU) asset to the general ledger. For a finance lease, amortize it on a straight-line basis, or another systematic basis if it better represents the lessee's consumption pattern (ASC 842-20-35-7). For an operating lease, there is no separate amortization line, since the ROU asset cost runs through a single lease cost (ASC 842-20-25-6(a)). Check any impairment entries (ASC 842-20-35-9).

Calculation Example: Lease Liability Recalculation

Scenario: An auditor might re-perform the calculation for a sample lease to verify valuation.

Key Takeaway: This re-calculation verifies the mathematical accuracy of the present value the company recorded as its lease liability (ASC 842-20-30-1). That check is a core part of substantive testing of leases. Auditors will verify how the discount rate was selected and the present value calculation, so make sure your support is solid.

Auditors work from evidence. That means the lease contracts themselves, the payment schedules, and the documentation behind management's judgments on lease term and discount rate.

Common Findings and How to Prevent Them

Even well-meaning companies can make errors when they implement ASC 842 and in ongoing compliance. Knowing these pitfalls can help accounting teams strengthen their processes and prepare for the substantive testing of leases.

🚨 Critical: Failure to reliably track lease modifications can lead to material misstatements. This is often flagged as "a subsequent-measurement finding" because while the initial lease accounting might be correct, subsequent changes are not properly recorded.

What a Clean Substantive Test Looks Like

Strong work on lease accounting compliance for ASC 842 leads to a more efficient audit, fewer audit adjustments, and greater confidence in financial reporting. It reduces the need for extensive auditor deep-dives. It also ensures the company follows accounting principles, which is what every team strives for.

Characteristics of a Well-Prepared Organization

• Centralized Lease Management System: Organizations that use specialized lease accounting software make data management, calculations, and reporting much smoother. That drastically cuts manual errors.
• Proactive Contract Review: A disciplined process to review all new and renewed contracts for lease components. It ensures leases are identified on time and accounted for accurately.
• 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 file of all lease contracts, amendments, calculations, and judgments that auditors can reach with ease. This makes everyone's lives easier.
• Regular Lease Data Review: The team reviews lease data and balances on a regular basis and reconciles them to the general ledger. That finds discrepancies before the audit team even steps in.

Q: How do auditors perform substantive testing for ASC 842 leases? A: Auditors start substantive testing by understanding the entity’s internal controls. If they deem the controls ineffective, they will increase the extent of substantive procedures. These procedures test transactions and balances in detail, such as re-performing present value calculations, verifying lease terms, inspecting contracts for embedded leases, and confirming disclosures.

Where to Go From Here on ASC 842 Testing

To get ready for substantive testing of leases, compare your existing processes with the points covered here. Robust controls and a systematic way to identify and account for leases will greatly de-risk your next financial statement audit.

Related Articles

• ASC 842 Audit: Guide to Compliance Evaluation
• Preparing for ASC 842 Audits
• ASC 842 Audit Adjustments: Common Corrections and Prevention
• How ASC 842 Lease Accounting Affects Key Performance Indicators