Understand Lease Accounting Material Weakness vs. Deficiency
Navigating the complexities of ASC 842 lease accounting presents significant challenges for even the most meticulous accounting teams. A critical distinction that often arises during financial statement audits is the difference between a material weakness vs. significant deficiency in lease accounting. Understanding this difference is paramount for controllers, accounting managers, and auditors, as it directly impacts financial reporting accuracy and investor confidence. Material weakness is defined as a deficiency, or a combination of deficiencies, in internal control over financial reporting, such that there is a reasonable possibility that a material misstatement of the company's annual or interim financial statements will not be prevented or detected on a timely basis. Conversely, a significant deficiency refers to a deficiency, or a combination of deficiencies, in internal control over financial reporting that is less severe than a material weakness, yet important enough to merit attention by those responsible for oversight of the company's financial reporting. Effective ASC 842 controls are essential to minimize the risk of either.
Audit teams routinely scrutinize an organization's lease accounting practices. Auditors are looking for robust processes and documentation to ensure lease accounting compliance. Failure to maintain adequate internal controls for lease accounting can quickly elevate control deficiencies. This article will clarify the distinctions, explore how auditors identify these issues, and provide actionable steps to prevent them, ensuring companies are well-prepared for their next audit. Ensuring how to ensure lease completeness for ASC 842 compliance is a foundational step in preventing such deficiencies.
What Auditors Are Actually Looking For
Auditors approach lease accounting with a focus on several key assertions within the financial statements. They aim to verify that all lease contracts are identified, accurately measured, and properly presented and disclosed. A primary focus is on completeness, ensuring that all leases, including embedded ones, are captured. They assess the design and operating effectiveness of an entity's lease controls procedures. This includes examining the processes for identifying new leases, modifications, terminations, and short-term lease elections.
✅ Best Practice: KPMG emphasizes that a robust lease accounting process includes a centralized lease population, consistent application of accounting policies, and strong reconciliation procedures to ensure data integrity. 1
Auditors will review the company's policies and procedures related to ASC 842, scrutinizing the internal controls over the calculations of right-of-use (ROU) assets and lease liabilities. They examine the controls around data inputs, such as discount rates, lease terms, and payments. A Big Four firm perspective, such as that from Deloitte, highlights the importance of not just identifying leases, but also having a sound process for subsequent accounting and disclosure 2. Insufficient controls around these areas can lead to a material weakness vs. significant deficiency in lease accounting designation.
Auditor Focus Areas for ASC 842
| Audit Assertion | Key Focus | Potential Deficiency Source |
|---|---|---|
| Completeness | All leases are identified and recorded. | Undetected embedded leases, incomplete lease inventory |
| Accuracy/Valuation | ROU assets & lease liabilities are correctly calculated. | Incorrect discount rates, unrecognized lease incentives |
| Rights/Obligations | Entity controls the lease assets and is obligated for payments. | Misclassified arrangements, improper legal review |
| Presentation/Disclosure | Lease accounting is properly presented in financial statements and footnotes. | Incomplete footnote disclosures, improper classification |
Auditors often perform lease identification testing by reviewing contracts outside of the identified lease population to find potential embedded leases. They also reconcile lease schedules to general ledger accounts and supporting documentation. For example, a common procedure involves selecting a sample of expense accounts to identify payments that might relate to unrecorded leases. Understanding what are the risks of incomplete lease population is crucial for this process.
Key Risks and Failure Points
Several common pitfalls can lead to control deficiencies in lease accounting. These often stem from a lack of clear processes, inadequate training, or insufficient technical accounting expertise. One major risk involves the inconsistent application of ASC 842 principles across different business units or jurisdictions.
- Incomplete Lease Identification: Failure to search for and identify all contracts containing a lease, especially those not explicitly labeled as such. An embedded lease refers to a lease component contained within a larger contract that may not be explicitly identified as a lease. This is a perpetual challenge, as highlighted by various industry studies, and often leads to an incomplete lease population.
- Inaccurate Data Input: Errors in determining key lease inputs such as the lease term, discount rate, or variable lease payments. These inaccuracies directly impact the measurement of ROU (Right-of-Use) asset controls and lease liabilities.
- Subsequent Event Processing Failure: Inadequate controls over lease modifications, reassessments, or terminations leading to incorrect adjustments to ROU assets and lease liabilities. For instance, an audit finding might concern a failure to properly re-measure a lease following a significant change in scope or consideration.
- Lack of Expertise: Insufficient internal technical accounting expertise regarding ASC 842 complexities, such as determining lease vs. non-lease components, or accounting for sale-leaseback transactions. The Financial Accounting Standards Board (FASB) provides extensive guidance on these nuances 3.
- Segregation of Duties: Insufficient segregation of duties within the lease accounting process, potentially allowing for errors or fraud to go undetected. For example, the same individual who enters lease data should not approve the associated general ledger entries.
Calculation Example: Impact of Incorrect Discount Rate
Scenario: A company fails to properly calculate the incremental borrowing rate (IBR) for a new lease. Instead of using a market-observable rate of 6%, they use a pre-ASC 842 capital lease rate of 4%.
| Component | Correct Value (6% IBR) | Incorrect Value (4% IBR) | Difference |
|---|---|---|---|
| Initial Lease Liability (PV) | $912,852 | $991,894 | $79,042 |
| Initial ROU Asset | $912,852 | $991,894 | $79,042 |
| First Year Interest Exp. | $54,771 | $39,676 | $(15,095) |
| Assumes 10-year lease, $100,000 annual payments, no initial direct costs or incentives. |
Key Takeaway: An error in a critical input like the discount rate can lead to a material misstatement in both the balance sheet (ROU asset and lease liability) and income statement (interest expense) over the life of the lease. This highlights the importance of robust ROU asset controls.
⚠️ Risk Alert: A common audit finding relates to companies overlooking service contracts with embedded leases, resulting in an understatement of ROU assets and lease liabilities on the balance sheet. This can be a direct path to a material weakness.
<br>
Organizations must establish comprehensive processes for embedded lease discovery and accounting. You can review the importance of control implementation guidance, at our article on implementing top 10 lease accounting internal controls to ensure success.
Practical Checklist for Lease Accounting Controls
Implementing a structured approach is critical to maintaining effective ASC 842 controls. This checklist provides a framework for ensuring that the necessary steps are taken to identify, account for, and disclose leases accurately.
Checklist: Ensuring Lease Completeness and Accuracy
| Step # | Control Activity | Frequency | Responsible Party | Documentation Required |
|---|---|---|---|---|
| 1. | Centralized Lease Repository: Maintain a complete inventory of all contracts. | Ongoing | Lease Administrator | Contract summaries, lease schedules |
| 2. | Contract Review Protocol: Systematically review all new contracts for embedded leases. | Monthly | Accounting Manager | Review log, embedded lease memoranda |
| 3. | Discount Rate Validation: Obtain and validate appropriate incremental borrowing rates (IBRs). | Quarterly | Treasury/Controller | IBR documentation, market rate analysis |
| 4. | Lease Term Determination: Document the non-cancellable period and options. | Per Lease | Legal/Ops Supervisor | Lease agreements, option review memos |
| 5. | Modification Procedure: Process lease modifications in accordance with ASC 842. | As Occurs | Accounting Staff | Modified lease schedules, journal entries |
| 6. | Reconciliation Process: Reconcile lease schedules to the general ledger. | Monthly | Senior Accountant | Reconciliation reports, variance analysis |
| 7. | Disclosure Preparation: Prepare and review lease footnote disclosures. | Annually | Controller | Disclosure checklist, reviewed footnotes |
| 8. | Software Controls: Utilize lease accounting software with proper user access controls. | Ongoing | IT/Accounting | Access logs, system configuration reports |
Q: How to identify embedded leases in contracts? A: Identifying embedded leases involves scrutinizing contracts that are not explicitly identified as leases, such as service agreements, purchase orders, or supply agreements. Look for clauses that convey the right to control the use of an identified asset for a period of time. This requires a systematic contract review protocol involving cross-functional teams, including procurement, legal, and operations.
💡 Key Takeaway: A comprehensive, regularly updated lease inventory is the cornerstone of effective lease accounting controls and directly mitigates the risk of an incomplete lease population. Organizations should leverage technology to assist with the new lease accounting standards and technology requirements.
How Accounting Teams Should Validate Their Approach
Validation of lease accounting controls involves more than just implementing processes; it requires ongoing monitoring and testing to ensure their effectiveness. Accounting teams should establish a program of self-assessment or internal audit to review their ASC 842 compliance.
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. To validate completeness specifically for leases, teams should:
- Perform Independent Contract Review: Periodically select a sample of vendor contracts (e.g., service agreements, IT contracts, manufacturing agreements) from procurement systems or expense accounts that are not currently identified as leases. Review these contracts for characteristics of an embedded lease discovery.
- Reconcile to Source Systems: Reconcile the lease population in the lease accounting software or system to general ledger lease-related accounts or expense line items. Investigate any significant variances. Our article on lease management documentation compliance offers more insight into this process.
- Test Key Inputs: Select a sample of leases and independently verify the inputs used in the lease accounting calculations, such as the lease term, discount rate, and payments, against original contracts and supporting documentation.
- Conduct "Walkthroughs": Document and perform walkthroughs of the end-to-end lease accounting process, from contract inception to financial statement disclosure. This helps identify control gaps and understand how transactions flow. The AICPA provides guidance on walkthroughs as a vital internal control evaluation tool 4.
- Review System-Generated Reports: Ensure that system-generated lease schedules and journal entries align with accounting policies and reconcile to source data. Controls over system access and changes are crucial here.
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. Validation should specifically review the accurate measurement and subsequent accounting for ROU assets.
Common Mistakes and How to Avoid Them
Even with the best intentions, companies often stumble in their lease accounting compliance efforts, leading to critical audit findings. These errors can range from technical misinterpretations to operational inefficiencies.
Material Weakness vs. Significant Deficiency: Common Mistakes
| Common Mistake | Audit Impact | Best Practice/Remediation |
|---|---|---|
| 1. Incomplete Lease Population: Failing to capture all leases. | Understatement of ROU assets and lease liabilities. Leads to material weakness vs. significant deficiency in lease accounting controls. | Implement a robust contract review process; utilize lease accounting software. |
| 2. Incorrect Discount Rates: Applying inappropriate incremental borrowing rates. | Material misstatement of lease liabilities and ROU assets. | Establish a formal policy for IBR determination; engage treasury or external experts. |
| 3. Inadequate Journal Entry Controls: Lack of review or approval for lease-related journal entries. | Errors in financial statements; potential for fraud. | Implement clear segregation of duties; require manager approval for all entries. |
| 4. Late or Incomplete Disclosures: Missing required footnote detail. | Non-compliance with FASB disclosure requirements. | Use a disclosure checklist; involve auditors in early review of disclosures. |
| 5. Ignoring Lease Modifications: Not properly accounting for changes to existing leases. | ROU assets and lease liabilities are misstated. | Establish a formal process for identifying and accounting for all lease modifications. |
Q: What documentation is required for material weakness vs. significant deficiency in lease accounting? A: For any control deficiency, comprehensive documentation is required. This includes a detailed description of the deficiency, the financial reporting areas it impacts (e.g., ROU assets, lease liabilities), the root cause, and management's plan for remediation. If it escalates to a material weakness, documentation should also include an assessment of the quantitative and qualitative impact on previously issued financial statements or, for a restatement, the nature of the misstatement.
🚨 Critical: Failure to identify and properly account for embedded lease discovery continues to be a leading cause for restatements and significant audit findings in ASC 842 compliance. This can elevate a control deficiency to a material weakness vs. significant deficiency in lease accounting controls.
Example Scenario: Undiscovered Embedded Leases
A manufacturing company enters into a long-term service agreement for a specialized machine. The agreement specifies that the company has the right to direct the use of the machine, which is explicitly identified, and it cannot be used for other customers during the contract term. The accounting team, focused on explicit leases, does not identify this as an embedded lease. An auditor performing lease identification testing reviews the service contract within a sample of large operating expenses and discovers the embedded lease. This oversight leads to a material understatement of ROU assets and lease liabilities, prompting the auditor to classify the control deficiency as a material weakness in internal controls over financial reporting relating to completeness of lease obligations.
What Strong Execution Looks Like in Practice
Organizations with strong execution in ASC 842 compliance manage their lease portfolios proactively and with robust internal controls. This translates into smoother audits, fewer auditor inquiries, and greater confidence in financial reporting. Strong execution means the accounting team routinely performs lease identification testing and maintains a comprehensive, updated lease inventory.
For instance, a company that integrates its lease accounting software directly with its procure-to-pay system can automatically flag potential leases before they are fully executed, allowing for early identification. This practice minimizes the risk of undiscovered embedded leases. They have clear policies for determining key lease inputs, with documented reviews by qualified personnel and independent verification. These entities understand that lease accounting compliance is an ongoing process, not a one-time project. Their internal audits regularly test the effectiveness of ASC 842 procedures, providing assurance to management and the audit committee.
The completeness assertion is routinely addressed through quarterly reviews of expense accounts and contracts, specifically looking for unrecorded leases. This proactive approach significantly reduces the likelihood of a material weakness vs. significant deficiency in lease accounting being identified during the annual audit. Ultimately, strong execution ensures accurate financial statements and avoids the significant time, cost, and reputational damage associated with control deficiencies.
Next Steps
To further enhance your understanding and strengthen your lease accounting processes, consider reviewing additional resources. Proactive management of your lease portfolio is key to avoiding audit findings and maintaining robust internal controls.
Related Articles
- Auditing ASC 842 Lease Accounting: An Auditor's Guide
- Top 10 Year-End Lease Accounting Challenges
- New Lease Accounting Standard Implementation Challenges
- Implementing the New Lease Accounting Standard
Q: Siri, how do I avoid material weaknesses in my company's lease accounting?
A: Avoiding material weaknesses in lease accounting requires a multi-faceted approach. This includes establishing strong internal controls, implementing a systematic process for identifying all leases (including embedded ones), ensuring accurate calculations for ROU assets and lease liabilities, maintaining comprehensive documentation, and performing regular internal reviews or self-assessments of your ASC 842 compliance. Leveraging specialized lease accounting software can also significantly reduce risks.
