Sustain Your ASC 842 Lease Accounting Compliance

Effective continuous compliance: building sustainable lease accounting practices isn't just a nice-to-have anymore; it's a non-negotiable for organizations navigating the complexities of ASC 842. We've seen firsthand how companies grapple with maintaining accurate lease portfolios, ensuring proper financial reporting, and preparing for rigorous audits. The risk of a material misstatement or control deficiency due to inadequate lease accounting is significant. Without a robust, continuous approach, organizations run the risk of non-compliance, restatements, and, frankly, adverse audit opinions. Building sustainable lease accounting means we need to integrate systematic procedures, technology, and governance into our day-to-day operations. Here, we'll walk through how organizations can establish and maintain these crucial accounting frameworks. We often advise clients that they can maintain continuous ASC 842 compliance by embedding lease accounting processes within their operational workflows, leveraging specialized technology, and establishing strong internal controls, much like what you'd find in our guide for implementing lease accounting internal controls.

What Auditors Are Actually Looking For

When we approach an ASC 842 audit, our focus is squarely on key financial statement assertions: completeness, accuracy, and valuation. We need comfort that every contract meeting the definition of a lease has been identified and recorded appropriately. The completeness assertion, in particular, means we're verifying that all transactions and accounts that should be recorded have been included in the financial statements. This is often where things get tricky with leases, given their variety and sometimes hidden nature.

Auditors are going to scrutinize the methodologies used for lease identification testing, the judgments applied in determining lease terms, discount rates, and lease classification. For instance, Deloitte’s audit guidance often emphasizes the importance of a comprehensive lease inventory and a strong control environment around lease data capture and maintenance ¹. The audit process typically involves:

• Understanding the entity and its environment: This means digging into the nature of the entity's operations, its lease portfolio, and the IT systems used for lease management.
• Evaluating controls: We examine the design and implementation of internal controls over lease accounting, including those for identifying new leases, modifications, and terminations.
• Substantive testing: This includes recalculating lease liabilities and Right-of-Use (ROU) assets, reviewing disclosures, and performing cutoff procedures.
• Completeness procedures: This involves testing to ensure nothing's been left out. We ask, "what are the risks of incomplete lease population?" to make sure not all leases are omitted from the financial statements.

An inherent risk we often see is the omission of leases, especially for contracts that don't overtly appear to be leases at first glance.

✅ Best Practice: As auditors, we highly value transparent and well-documented lease accounting policies, supported by a robust system of internal controls and consistent application. That's what gives us comfort.

Key Risks and Failure Points

Organizations often hit several critical snags when trying to achieve and maintain continuous compliance: building sustainable lease accounting. Failing to mitigate these can lead to significant audit adjustments and, frankly, restatements. One primary risk we frequently encounter concerns ROU asset compliance with initial measurement and subsequent amortization.

• Incomplete Lease Portfolio: Many companies struggle to identify all contracts that contain a lease, particularly those embedded within service agreements or other operational contracts. This oversight often stems from a decentralized contract management process. If an identified asset being controlled by the lessee isn't captured, a material portion of the lease portfolio could be missing, impacting financial statements.
• Incorrect Lease Classification: Misclassifying finance leases as operating leases, or vice versa, leads to incorrect balance sheet and income statement presentations. This often arises from misinterpreting the criteria or errors in applying the five classification tests. We've seen this trip up many teams.
• Inaccurate Lease Data: Errors in lease data, such as incorrect lease terms, payment schedules, or discount rates, directly lead to miscalculations of ROU assets and lease liabilities. This can be exacerbated by manual data entry or reliance on disparate spreadsheets – a common pitfall.
• Failure to Address Lease Modifications: Lease modifications (e.g., changes in scope, term, or consideration) require specific accounting treatment under ASC 842. Incorrectly accounting for these changes can materially impact financial results, as detailed in our guide on lease accounting challenges. This is where many teams get tripped up.
• Lack of Internal Controls: Without strong internal controls over lease accounting, there's an increased risk of errors, fraud, and misstatement. This includes controls over data input, calculation reviews, and segregation of duties.

Calculation Example: Lease Liability Recalculation

Scenario: A company enters into a new lease for office space. The lease term is 5 years, with annual payments of $25,000, payable at the beginning of each year. The company's incremental borrowing rate (IBR) is 5%.

Key Takeaway: An auditor will undoubtedly re-perform this calculation to verify the initial lease liability recorded. Discrepancies can arise from incorrect lease terms, payments, or the chosen discount rate. A 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, and its initial measurement is directly linked to this liability.

⚠️ Risk Alert: A common audit finding we see relates to companies overlooking service contracts with embedded lease components, leading to material understatements of lease liabilities and ROU assets. An embedded lease refers to a lease component contained within a larger contract that may not be explicitly identified as a lease.

Practical Checklist for Sustainable Lease Accounting

Effective continuous compliance: building sustainable lease accounting really demands a systematic approach, often leveraging automation to ensure accuracy and timely reporting. This checklist provides a framework that controllers and accounting managers can use to implement robust lease compliance procedures.

Q: How can technology help with sustainable lease accounting? A: Honestly, technology, like specialized lease accounting software, is a game-changer. It automates calculations, centralizes lease data, streamlines modification accounting, and generates audit-ready reports, significantly reducing manual effort and error while improving compliance and efficiency. It really takes a lot of the headache out of it.

How Accounting Teams Should Validate Their Approach

Validation is absolutely key to knowing if your lease accounting process is achieving continuous compliance: building sustainable lease accounting effectively. Accounting teams have to establish repeatable verification steps and maintain comprehensive documentation to support their compliance efforts. This proactive approach not only ensures accuracy but also streamlines the audit process. The AICPA provides solid guidance on audit evidence and substantiation, which directly applies to supporting lease accounting balances ².

1. System-to-General Ledger Reconciliation: We recommend regularly reconciling balances from the lease accounting system (e.g., ROU assets, lease liabilities) to the general ledger. This should be done at least monthly to catch discrepancies early. Every variance needs to be explained and documented.
2. Data Integrity Checks: Perform periodic checks on the accuracy and completeness of data within the lease accounting system. This involves sampling new lease entries and significant lease modifications to confirm all critical fields are correctly populated.
3. Cross-Functional Reviews: Engage other departments (e.g., procurement, legal, real estate, operations) responsible for initiating or managing contracts to confirm the completeness of the lease inventory. This could mean reviewing relevant contract repositories or even expense accounts for unreported lease-like payments. For additional strategies, refer to year-end communication plans.
4. Reperformance of Key Calculations: While software automates calculations, accounting teams should periodically re-perform manual calculations for a sample of leases, particularly those with complex terms or significant modifications. This verifies the system's accuracy and helps strengthen internal control over financial reporting.
5. Documentation of Judgments: Any significant judgments—like the lease term for contracts with options or the determination of the incremental borrowing rate—must be thoroughly documented. This means including the rationale, data sources, and approval process. Reasonable people can disagree on an interpretation, but the support needs to be there.
6. Regular Policy Reviews: Make sure your internal lease accounting policies and procedures remain current and effectively address all aspects of ASC 842. We often see that changes in operations or new types of contracts necessitate updates.

💡 Key Takeaway: The completeness assertion is one of the most scrutinized areas in a lease accounting audit. Accounting teams really need to devote significant resources to demonstrating that all leases have been identified and recorded, especially concerning how to identify embedded leases in contracts. That's where a lot of the work is.

Common Mistakes and How to Avoid Them

Failing to achieve continuous compliance: building sustainable lease accounting controls often stems from several common errors we see repeatedly. Understanding these pitfalls and adopting best practices can significantly enhance an organization's lease accounting maturity and resilience. The most frequent audit findings, in our experience, often relate to the underlying data and processes.

Q: What documentation is required for continuous compliance: building sustainable lease accounting? A: You'll need detailed lease agreements, contract abstraction summaries, discount rate methodologies, impairment analyses, modification memos, lease versus buy analyses, financial statement disclosure checklists, and reconciliation reports between the lease system and the general ledger. The documentation requirements can feel overwhelming, but it's all necessary.

🚨 Critical: A leading Big Four firm reported that the most common reason for audit deficiencies in lease accounting was the failure to implement appropriate internal controls over the complete population of leases, especially for non-real estate assets. ⁴ We see this all the time.

What Strong Execution Looks Like in Practice

For public companies and private entities preparing for future scrutiny, lease accounting compliance is truly an ongoing journey. Strong execution of continuous compliance: building sustainable lease accounting translates into tangible benefits beyond just avoiding audit findings. It means having real-time visibility into your lease portfolio, confidence in your financial reporting, and the ability to adapt swiftly to changes.

In a well-executed lease accounting environment, accounting managers:

• Can generate accurate lease expense, ROU asset, and lease liability reports at any time, not just at quarter-end.
• Are proactive in identifying new leases and modifications, ensuring they're accounted for promptly, minimizing those painful retrospective adjustments.
• Have a clear audit trail for every lease entry, modification, and judgment made, which significantly cuts down on auditor inquiry time.
• Experience smoother quarter-end and year-end close processes related to lease accounting, avoiding those last-minute scrambles and restatements.
• Can easily provide data for budgeting, forecasting, and strategic decision-making because the lease information is reliable and accessible.

Consider a large multinational corporation with thousands of leases across various asset classes. With strong continuous compliance, they're using a centralized lease accounting platform that integrates with their ERP system. New contracts are automatically screened for embedded leases right at the procurement stage. Any contract identified as a lease is immediately abstracted into the system, and the accounting treatment is initiated. Lease modifications are routed through a workflow for approval and automated accounting updates. Monthly reconciliations are automated, with exceptions flagged for review. This level of maturity results in seamless audits, accurate financial statements, and eliminates the need for extensive manual effort at period-ends. That's the gold standard we aim for.

🎉 Success Story: Organizations with strong continuous compliance: building sustainable lease accounting processes report a reduction in audit hours dedicated to lease accounting by an average of 30-40%, alongside improved internal control effectiveness. That's a huge win.

Next Steps

Achieving continuous compliance: building sustainable lease accounting is an evolutionary process that requires dedication and strategic investment. We always advise clients to start by assessing their current lease portfolio and existing internal controls. Identify those gaps in your process for identifying, managing, and accounting for leases. Seriously consider leveraging technology to automate manual tasks and enhance data accuracy—it's worth the investment. Regularly train your team on ASC 842 updates and internal procedures. Proactive engagement with your auditors can also provide valuable insights into their expectations and help refine your approach to auditing ASC 842 lease accounting. Implement a phased approach, focusing first on critical areas like lease discovery and data integrity.

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