Material Weakness vs. Significant Deficiency in Lease Accounting

Understand Lease Accounting Material Weakness vs. Deficiency

ASC 842 lease accounting is hard work, even for a careful team. One question comes up often in a financial statement audit: is a control gap a material weakness or a significant deficiency? Controllers, accounting managers and auditors all need to know the difference. It bears on how accurate the financial reports are and on how much investors trust them.

The Public Company Accounting Oversight Board (PCAOB) defines both grades in Auditing Standard (AS) 2201, Appendix A. A material weakness is "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" (paragraph .A7).

A significant deficiency is "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" (paragraph .A11). Good ASC 842 controls are what keep the risk of either one low.

AS 2201 applies to audits of public companies (issuers). A private company's audit is performed under the auditing standards of the American Institute of Certified Public Accountants (AICPA) instead. Those standards address how these deficiencies are communicated in AU-C section 265, Communicating Internal Control Related Matters Identified in an Audit.

For a complete breakdown, see our lease accounting guide.

Audit teams look hard at an organization's lease accounting as a matter of routine. They want to see sound processes and records that support lease accounting compliance. When a company does not keep up adequate internal controls for lease accounting, a control deficiency can move up a grade fast.

This article draws the lines between the grades. It shows how auditors find these issues and lists steps a team can take to prevent them, so the company is ready for its next audit. Getting the lease population complete under ASC 842 is a core step in preventing such deficiencies.

How Auditors Grade a Lease Control Failure

Auditors come at lease accounting through a few key assertions in the financial statements. They aim to verify that the company has identified every lease contract, measured it accurately, and presented and disclosed it properly. A main focus is completeness: have all leases, embedded ones too, been captured?

They also assess the design and operating effectiveness of an entity's lease controls procedures. That means a look at how the team finds new leases, modifications, terminations and short-term lease elections.

✅ Best Practice: A sound lease accounting process includes a centralized lease population, accounting policies applied consistently, and strong reconciliations to keep the data sound.

For ASC 842, auditors will review the company's policies and procedures. They look closely at the internal controls over how the team calculates right-of-use (ROU) assets and lease liabilities. They also check the controls around the inputs to the lease liability, such as the discount rate (ASC 842-20-30-2 through 30-4), the lease term (ASC 842-10-30-1) and the lease payments (ASC 842-10-30-5).

Identifying every lease is only half the job. A company also needs a sound process for the accounting and disclosure that come after. Controls that fall short in these areas can lead to a material weakness designation.

Auditor Focus Areas for ASC 842

Auditors often perform lease identification testing. They read contracts that sit outside the identified lease population to look for potential embedded leases. They also reconcile lease schedules to general ledger accounts and to the support behind them.

For example, one common step is to pick a sample of expense accounts and look for payments that might relate to unrecorded leases. To do this work well, a team has to know the risks of an incomplete lease population.

Where Lease Deficiencies Escalate to Material Weakness

A few common traps can lead to control deficiencies in lease accounting. They often come from unclear processes, too little training, or too little technical accounting skill. One major risk is that business units or jurisdictions apply ASC 842 principles in different ways.

• Incomplete Lease Identification: The team fails to search for and find every contract that contains a lease, above all those not labeled as one. An embedded lease is a lease component that sits inside a larger contract and may not be explicitly identified as a lease. A missed embedded lease leaves the lease population incomplete.
• Inaccurate Data Input: The team makes errors in key lease inputs such as the lease term, discount rate or variable lease payments. These errors directly affect the measurement of the ROU (right-of-use) asset and the lease liability.
• Subsequent Event Processing Failure: Controls over lease modifications, reassessments or terminations are too weak. The result is wrong adjustments to ROU assets and lease liabilities. For instance, an audit finding might be that the team did not properly re-measure a lease after a significant change in scope or consideration.
• Lack of Expertise: The in-house team lacks the technical accounting skill that the harder parts of ASC 842 call for. Examples are how to determine lease vs. non-lease components and how to account for sale-leaseback transactions. The Financial Accounting Standards Board (FASB) Codification covers both: ASC 842-10-15-28 through 15-31 on separating lease from nonlease components, and Subtopic 842-40 on sale and leaseback transactions ¹.
• Segregation of Duties: The lease accounting process lacks enough segregation of duties, so errors or fraud could go unnoticed. For example, the same person who enters lease data should not approve the related general ledger entries.

Calculation Example: Impact of Incorrect Discount Rate

Scenario: A company signs a new 10-year finance lease with payments of $100,000 a year. Payments are in arrears, so the first one falls a year after commencement. There are no prepayments, initial direct costs or incentives.

ASC 842-20-30-3 sets the order for the discount rate: the rate implicit in the lease when it is readily determinable, otherwise the incremental borrowing rate (IBR). A lessee that is not a public business entity may instead elect a risk-free rate for a period comparable with the lease term. That is an accounting policy election made by class of underlying asset. This company has made no such election, and the implicit rate is not readily determinable.

The IBR is "the rate of interest that a lessee would have to pay to borrow on a collateralized basis over a similar term an amount equal to the lease payments in a similar economic environment" (ASC 842 Master Glossary). It is an estimate specific to the company, not a rate observed in a market.

Deloitte's Roadmap: Leases, section 7.2, describes two routes to it. One is discussions with bankers or other lenders. The other is reference to obligations of a similar term issued by others with a similar credit rating.

A sound estimate here would have been 6%. Instead, the company carries forward a 4% rate from a capital lease under the superseded ASC 840.

The lease liability is the present value of the lease payments not yet paid, discounted at the discount rate for the lease at commencement (ASC 842-20-30-1). With nothing paid up front and no initial direct costs or incentives, the ROU asset starts at the same amount (ASC 842-20-30-5). Each liability below is $100,000 times the annuity factor for 10 payments in arrears, (1 − (1 + r)⁻¹⁰) ÷ r.

Using too low a rate overstates both the lease liability and the ROU asset, here by $75,081. Because this is a finance lease, the error also reaches the income statement, where ASC 842-20-25-5 requires interest on the lease liability and amortization of the ROU asset. The overstated ROU asset carries into that amortization, which the table does not show.

First-year interest is the rate times the opening liability, because the first payment falls at year-end (ASC 842-20-35-1(a)). That is $736,009 × 6% = $44,161, against $811,090 × 4% = $32,444. Interest expense is understated by $11,717.

An operating lease would differ. Its single lease cost under ASC 842-20-25-6(a) would be $100,000 a year at either rate, so only the balance sheet would be wrong.

Key Takeaway: An error in a critical input like the discount rate can lead to a material misstatement. In a finance lease it can hit both the balance sheet (ROU asset and lease liability) and the income statement (interest expense) over the life of the lease. This is why strong ROU asset controls matter.

⚠️ Risk Alert: A common audit finding is that a company missed service contracts with embedded leases. The balance sheet then understates ROU assets and lease liabilities. This can be a direct path to a material weakness.

Organizations must set up thorough processes for embedded lease discovery and accounting. For why guidance on putting controls in place matters, see our article on implementing top 10 lease accounting internal controls to ensure success.

Practical Checklist for Lease Accounting Controls

A structured approach is critical to keeping ASC 842 controls effective. This checklist gives a frame for the steps a team needs to take to identify, account for and disclose leases accurately.

Checklist: Ensuring Lease Completeness and Accuracy

Q: How to identify embedded leases in contracts? A: To find embedded leases, read closely the 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 takes a systematic contract review protocol that draws on teams across the company, including procurement, legal and operations.

💡 Key Takeaway: A full lease inventory, kept up to date, is the base of effective lease accounting controls. It directly lowers the risk of an incomplete lease population. Organizations should use technology to help with the new lease accounting standards and technology requirements.

How to Assess and Document Severity

To validate lease accounting controls, a team has to do more than put processes in place. It has to keep watching and testing them to make sure they work. Accounting teams should set up 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 for leases in particular, teams should:

1. Perform Independent Contract Review: From time to time, pull a sample of vendor contracts from procurement systems or expense accounts. Pick ones that are not now identified as leases (e.g., service agreements, IT contracts, manufacturing agreements). Review these contracts for signs that they contain an embedded lease.
2. 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. Look into any significant variances. Our article on lease management documentation compliance has more on this process.
3. Test Key Inputs: Pick a sample of leases. Independently verify the inputs used in the lease accounting calculations, such as the lease term, discount rate and payments. Check them against the original contracts and supporting documents.
4. Conduct "Walkthroughs": Document and perform walkthroughs of the end-to-end lease accounting process, from contract inception to financial statement disclosure. This helps the team spot control gaps and see how transactions flow.
5. Review System-Generated Reports: Make sure that system-generated lease schedules and journal entries follow accounting policies and reconcile to source data. Controls over system access and changes are key here.

A right-of-use (ROU) asset is "an asset that represents a lessee's right to use an underlying asset for the lease term" (ASC 842 Master Glossary). Validation should check in particular that ROU assets are measured accurately and that the later accounting for them is right.

Common Misjudgements of Severity and How to Avoid Them

Even with the best intent, companies often stumble in their lease accounting compliance work, and critical audit findings follow. These errors can range from misreading the technical rules to operations that do not run well.

Material Weakness vs. Significant Deficiency: Common Mistakes

Q: What documentation is required for material weakness vs. significant deficiency in lease accounting? A: Any control deficiency needs full documentation. Describe the deficiency in detail and name the financial reporting areas it affects (e.g., ROU assets, lease liabilities). Add the root cause and management's plan for remediation.

If it escalates to a material weakness, the documentation should also assess the quantitative and qualitative impact on previously issued financial statements. Or, for a restatement, it should cover the nature of the misstatement.

🚨 Critical: Failure to identify and properly account for embedded leases can lead to restatements and significant audit findings in ASC 842 compliance. It can also raise a control deficiency to a material weakness.

Example Scenario: Undiscovered Embedded Leases

A manufacturing company enters into a long-term service agreement for a specialized machine. The agreement explicitly identifies the machine. It gives the company the right to direct the use of the machine, and the machine cannot be used for other customers during the contract term. The accounting team looks only for explicit leases, so it does not identify this as an embedded lease.

An auditor performs lease identification testing. The auditor reviews the service contract within a sample of large operating expenses and finds the embedded lease. The miss leads to a material understatement of ROU assets and lease liabilities. The auditor then classifies the control deficiency as a material weakness in internal controls over financial reporting relating to completeness of lease obligations.

What a Well-Handled Deficiency Looks Like

Organizations that execute ASC 842 compliance well manage their lease portfolios ahead of time and with strong internal controls. The payoff is smoother audits, fewer auditor questions and more trust in financial reporting. Strong execution means the accounting team runs lease identification testing as a routine and keeps a full, current lease inventory.

For instance, a company can link its lease accounting software directly to its procure-to-pay system. The link can then automatically flag potential leases before they are fully executed, so the team finds them early. This practice keeps the risk of undiscovered embedded leases to a minimum.

Such companies have clear policies for setting key lease inputs. Qualified staff review those inputs and document the review, and the inputs are independently verified. These entities know that lease accounting compliance is an ongoing process, not a one-time project. Their internal audits test on a regular basis how well ASC 842 procedures work, which gives assurance to management and the audit committee.

The completeness assertion gets routine attention. Each quarter the team reviews expense accounts and contracts to look for unrecorded leases. Acting early this way greatly lowers the chance that the annual audit turns up a material weakness. In the end, strong execution keeps the financial statements accurate and spares the company the significant time, cost and harm to its name that come with control deficiencies.

Where to Go From Here on Control Deficiencies

To learn more and make your lease accounting processes stronger, look at the resources below. Managing your lease portfolio ahead of time is key to avoiding audit findings and keeping internal controls strong.

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: How do I avoid material weaknesses in my company's lease accounting?

A: It takes work on several fronts to avoid material weaknesses in lease accounting. Set up strong internal controls, use a systematic process to identify all leases (including embedded ones), and make sure the ROU asset and lease liability calculations are accurate. Keep full documentation, and run regular internal reviews or self-assessments of your ASC 842 compliance. Specialized lease accounting software can also reduce risks significantly.