Understand Lease Accounting Control Weaknesses & Fixes
Control deficiencies in lease accounting: common findings are a significant concern for controllers, accounting managers, and auditors, particularly in the post-ASC 842 environment. Inadequate internal controls can lead to material misstatements, increased audit scrutiny, and potential non-compliance with accounting standards. 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. For lease accounting, this means ensuring every lease agreement, both explicit and embedded, is properly identified and recorded. Failure to adequately manage these controls can result in substantial financial reporting risks, directly impacting financial statement accuracy and audit outcomes. This article explores common control deficiencies in lease accounting, their impact on ASC 842 controls, and how organizations can strengthen their processes to achieve lease accounting compliance. We will also address what auditors specifically look for and how accounting teams can validate their approaches to ensure lease completeness for ASC 842 compliance.
What Auditors Are Actually Looking For in Lease Accounting
Auditors meticulously examine an organization's lease accounting processes, focusing on the design and operating effectiveness of internal controls. Their objective is to gain reasonable assurance that lease liabilities and right-of-use (ROU) assets are accurately presented on the financial statements. This involves not only substantive testing of balances but also a thorough evaluation of controls preventing or detecting material misstatements. Per PCAOB auditing standards, auditors are required to assess control risk as part of their audit planning1.
✅ Best Practice: Robust lease controls procedures should span the entire lease lifecycle, from identification and abstraction to remeasurement and financial reporting.
Auditors apply a risk-based approach, often starting with understanding the overall control environment and then drilling down into specific areas prone to error. A primary focus is on the completeness of the lease population.
Q: How do auditors test control deficiencies in lease accounting: common findings?
A: Auditors often perform roll-forwards from prior periods, review contract populations, scrutinize expense accounts for lease-like payments, and interview personnel to understand the lease identification process. They will also look for evidence that contracts are consistently reviewed for embedded leases, a common source of deficiencies. What are the risks of incomplete lease population? An incomplete lease population directly leads to understated lease liabilities and ROU assets, creating a material misstatement on the balance sheet and affecting financial ratios.
Auditor Focus Areas in Lease Accounting Controls
| Focus Area | Audit Objective | Common Evidence Examined |
|---|---|---|
| Completeness | All leases are identified and recorded. | Contract databases, expense account analysis, vendor lists |
| Accuracy | Lease terms, payments, and calculations are correct. | Lease abstracts, amortization schedules, payment records |
| Classification | Leases are correctly categorized (finance/operating). | Lease classification checklists, expert reviews |
| Presentation/Disclosure | Financial statements meet ASC 842 requirements. | Footnote disclosures, financial statement line items |
| Authorization | Leases are approved at appropriate levels. | Approval matrices, signed contracts, procurement policies |
PwC, in their guidance on lease accounting, emphasizes the importance of a centralized lease accounting system and robust data governance to ensure accuracy and completeness2. Auditors seek proof that management has established policies and procedures for identifying new leases, modifications, and terminations. This includes reviewing lease abstracting processes and reconciliations between the lease accounting system and general ledger.
Key Risks and Failure Points
Implementing ASC 842 presented significant challenges, and many organizations continue to grapple with establishing effective controls. 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. Deficiencies in controls over these assets and their corresponding liabilities introduce several key risks:
- Incomplete Lease Population: Failing to identify all lease agreements, including those that are verbal or embedded within service contracts. This is a common source of control deficiencies in lease accounting: common findings.
- Inaccurate Data Abstraction: Errors in abstracting critical lease terms (e.g., lease term, payment amounts, discount rates) from contracts, leading to incorrect calculations of ROU assets and lease liabilities.
- Improper Lease Classification: Misclassifying finance leases as operating leases or vice-versa, impacting financial ratios and debt covenants.
- Lack of Segregation of Duties: Insufficient separation between lease contract negotiation, data input into the lease system, and general ledger posting, increasing the risk of fraud or error.
- Failure to Account for Lease Modifications: Not properly recognizing lease modifications, such as extensions, contractions, or terminations, in a timely and accurate manner.
- Inadequate Review and Reconciliation: Absence of periodic reviews of lease data against source documents and reconciliation between the lease sub-ledger and the general ledger.
⚠️ Risk Alert: A common audit finding relates to companies overlooking service contracts for embedded leases, leading to significant understatement of lease obligations.
Scenario Example: Unidentified Embedded Leases A manufacturing company enters into a service contract for third-party logistics (3PL) to manage its warehouse and distribution. The contract specifies that the 3PL provider must use a particular warehouse facility, dedicated to the manufacturing company's products, for a fixed term of five years. The manufacturing company has the right to direct the use of the warehouse (e.g., product placement, shipping schedules) and directly benefits from its use. This arrangement contains an embedded lease. If the company's internal controls do not include a systematic review of service contracts for such provisions, this embedded lease will likely remain unidentified, leading to an understatement of the ROU asset and lease liability on the balance sheet. This directly impacts ROU asset controls.
Practical Checklist for Effective Lease Accounting Controls
Implementing a structured approach to lease accounting controls is crucial for compliance and audit readiness. This checklist helps ensure that key areas are addressed. An embedded lease refers to a lease component contained within a larger contract that may not be explicitly identified as a lease. Identifying these is a critical control.
Lease Accounting Control Checklist
| Control Area | Specific Control Activity | Frequency | Responsible Party | Documentation Required |
|---|---|---|---|---|
| 1. Lease Identification | Centralized contract repository reviewed for all new agreements. | Ongoing/Monthly | Contract/Procurement Teams | Index of contracts, review logs |
| 2. Embedded Lease Discovery | Review all service contracts for implicit lease components. | Quarterly | Lease Accounting Team | Embedded lease assessment forms, contract analyses |
| 3. Data Abstraction | Standardized lease abstracting template and dual-review process. | As-needed | Lease Accounting Team | Completed abstracts, reviewer sign-offs |
| 4. Lease System Input | Data entry into lease software reconciled to abstracted data. | As-needed | Lease Accounting Specialist | System input reports, reconciliation logs |
| 5. Classification & Accounting | Application of ASC 842 classification criteria (5 tests). | As-needed | Lease Accounting Team | Classification checklists, accounting memos |
| 6. Modifications | Process to identify and apply accounting for lease changes. | Ongoing | Lease Accounting Team | Modification logs, revised amortization tables |
| 7. Reconciliations | Monthly reconciliation of lease system to general ledger. | Monthly | Lease Accounting Manager | Reconciliation reports, variance explanations |
| 8. Disclosure Management | Quarterly review of all required ASC 842 footnote disclosures. | Quarterly | Financial Reporting Team | Disclosure checklists, supporting schedules |
💡 Key Takeaway: Consistent application of standardized procedures is key to mitigating control deficiencies in lease accounting: common findings controls.
This checklist aligns with our ASC 842 internal control framework and emphasizes proactive management. How to identify embedded leases in contracts? Start by training procurement and legal teams to recognize "right-to-use" language within broader service agreements. Implement a formal review process for all significant contracts, not just those explicitly labeled as leases. Consider using AI-powered contract analysis tools to flag potential embedded leases, which aids in embedded lease discovery.
How Accounting Teams Should Validate Their Approach
Effective validation ensures that the implemented controls are operating as intended. Accounting teams are responsible for not only designing these controls but also for monitoring their effectiveness. This often involves self-assessment and periodic testing. For additional guidance, the AICPA Audit Guide suggests specific procedures for testing controls in complex areas like lease accounting.
1. Documentation Review: Start by reviewing all policies, procedures, and training materials related to lease accounting. Ensure they are up-to-date and reflect current processes. Verify that all key decisions, especially around classification and modification accounting, are documented with clear rationales. For comprehensive guidance on required documentation, refer to our article on lease management documentation compliance.
2. Walkthroughs: Conduct walkthroughs of key lease accounting processes from identification to financial reporting. This involves tracing a few transactions through the entire process, interviewing personnel, and observing control activities. For instance, trace a new lease contract from its initial receipt by the procurement team through abstraction, entry into the lease software, and ultimately to the general ledger.
3. Independent Re-performance: For critical controls, such as lease abstraction or classification, consider having an independent member of the accounting team re-perform the control to ensure consistency and accuracy. This lease identification testing can uncover discrepancies that might otherwise be missed.
4. Data Analytics: Utilize data analytics tools to identify anomalies. For example, analyze general ledger accounts for recurring payments that might indicate unrecorded leases. Compare recorded lease terms with payment schedules to detect potential errors.
🚨 Critical: Failure to conduct regular internal validation can result in significant audit findings and require costly re-work during external audits.
Q: How can I prevent control deficiencies in ASC 842? A: Preventing control deficiencies involves a combination of strong policy, trained personnel, appropriate technology, and continuous monitoring. Regularly review your control framework, train staff on ASC 842 intricacies, and leverage lease accounting software to automate calculations and reporting.
Common Mistakes and How to Avoid Them
Even with robust systems, certain pitfalls frequently lead to control deficiencies in lease accounting: common findings controls. Understanding these can help organizations proactively strengthen their internal environment. What documentation is required for control deficiencies in lease accounting: common findings? Comprehensive documentation of all controls, testing procedures, identified deficiencies, and remediation plans is crucial.
Pitfalls and Best Practices in Lease Accounting Controls
| Common Mistake | Explanation | Best Practice for Avoidance |
|---|---|---|
| 1. Manual Lease Management | Relying on spreadsheets for lease data, increasing risk of errors and omissions. | Implement a dedicated lease accounting software or system to centralize and automate. |
| 2. Isolated Lease Ownership | Lease identification and accounting handled in silos, without cross-functional coordination. | Establish a cross-functional lease committee (Procurement, Legal, Accounting, Treasury). |
| 3. Inconsistent Discount Rate Application | Using different discount rates for similar leases or failing to recalculate rates for modifications. | Define clear policies for discount rate determination and application, including reassessments. |
| 4. Lack of Training | Staff unfamiliar with ASC 842 complexities and control procedures. | Provide regular, comprehensive training to all relevant personnel (e.g., new lease accounting standard implementation challenges). |
| 5. Ignoring Operating Expense Accounts | Not reviewing general ledger accounts for recurring payments suggesting an unrecorded lease. | Perform periodic searches of expense accounts (e.g., rent, equipment rental) for potential leases. |
| 6. Neglecting Lease Modifications | Failing to recognize lease modifications (e.g., extensions, terminations) in a timely manner. | Establish a formal procedure for capturing and processing all lease changes. |
💡 Tip: A study by Deloitte indicated that nearly 40% of companies reported significant challenges with data abstraction and ongoing remeasurements for leases, directly pointing to control weaknesses in these areas3.
Calculation Example: Impact of an Unrecorded Lease
Scenario: A company fails to record a 5-year operating lease with annual payments of $20,000, and an incremental borrowing rate of 5%.
| Component | Value | Calculation |
|---|---|---|
| Annual Payment | $20,000 | Stated in lease agreement |
| Lease Term | 5 years | Stated in lease agreement |
| Discount Rate | 5.00% | Company's incremental borrowing rate |
| Lease Liability | $86,590 | PV of $20,000 annuity for 5 years at 5% (PVAF = 4.32948) = $20,000 * 4.32948 |
| ROU Asset | $86,590 | Initial measurement equals lease liability (no initial direct costs/incentives) |
| Impact on Balance Sheet | Understated by $86,590 | Both Lease Liability and ROU Asset are understated. |
Key Takeaway: An unrecorded lease materially impacts the balance sheet by understating assets and liabilities, leading to non-compliance with ASC 842. This is a common and impactful control deficiency.
What Strong Execution Looks Like in Practice
Organizations with effective controls in lease accounting demonstrate several common characteristics that lead to cleaner audits and more reliable financial reporting. This includes a clear understanding of ASC 842 disclosure requirements.
✅ Best Practice: Companies achieving strong lease accounting compliance often leverage technology, maintain a culture of meticulous documentation, and foster interdepartmental collaboration.
A well-executed lease accounting process is characterized by:
- Centralized, Automated System: All lease agreements are managed within a dedicated lease accounting software, ensuring a single source of truth and automated calculations. This often leads to smoother SOC 1 lease accounting software audits.
- Cross-Functional Team: A team comprising representatives from finance, legal, procurement, and operations meets regularly to identify new leases, review contracts, and discuss modifications.
- Proactive Identification: A process where new contracts are flagged for lease assessment before execution, minimizing the risk of unrecorded leases.
- Robust Documentation: Every decision, assumption, and calculation is clearly documented and readily available for review.
- Regular Reconciliation: Lease sub-ledgers are reconciled to the general ledger monthly, with variances promptly investigated and resolved. This process helps address "what are typical audit findings related to lease accounting controls?"
For example, a multinational corporation with strong execution might utilize a global lease management system that automatically identifies changes in lease terms from contract amendments, feeds them into the accounting engine, and generates the necessary journal entries and disclosures. Their audit trails are comprehensive, showing who abstracted each lease, who reviewed it, and when entries were posted. This proactive and systematic approach minimizes control deficiencies in lease accounting: common findings.
Next Steps
Addressing control deficiencies in lease accounting: common findings requires continuous effort and commitment. Organizations should regularly reassess their internal controls, especially as their lease portfolio evolves or accounting standards are updated. Proactive internal reviews and leveraging technology are key to maintaining compliance and streamlining the audit process.
Related Articles
- Implementing Top 10 Lease Accounting Internal Controls
- Auditing ASC 842 Lease Accounting: An Auditor's Guide
- Top 10 Year-End Lease Accounting Challenges
- How to Achieve Lease Accounting Compliance
