Last Updated on January 8, 2023 by Morgan Beard
You put in the hard work to transition to ASC 842, the new lease accounting standard. You’ve got your amortization schedules and your journal entries sorted out. Everything seems to be going well, but there is only one surefire way to know: your first audit under ASC 842.
It’s understandable if you are anxious about being audited under a new standard. There’s no need to worry, however. In this article, you’ll learn everything you need to know to be fully prepared for the likely procedures of an ASC 842 lease accounting audit.
The Challenges of a Lease Audit Under ASC 842
The change from ASC 840 to ASC 842 meant a lot of changes for lease accountants, and it’s no different for auditors. Shortly after adopting ASC 842, industry watchers were already pointing out that the lease section of audits would be considerably different than before. Understanding what auditors see as challenges in an ASC 842 audit can give clues about what to expect with your required accounting entries.
Those challenges include lease identification and how lease modifications are dealt with.
Auditors will be looking to see that all leases are identified under the ASC 842 definition of what constitutes a lease. While this may seem straightforward, some contracts may contain language indicating an implicit lease agreement without ever mentioning the word “lease.” This is known as an embedded lease, and they’re more common than you might think.
How to Reduce Lease Identification Risk
You can do some things to reduce the risk around the identification of leases. This includes:
- Have all contracts on hand for auditors to review. Identify all departments and personnel who can enter into lease-style contracts.
- Pay special attention to departments with high-dollar items like production equipment, vehicles, and IT infrastructure.
- Review and identify general ledger accounts for regular, standard payments.
- Decide the lease and non-lease components and whether to separate the components within the contract terms and conditions. And/or to apply lessee practical expedients.
Lease Modification Issues
In some cases, under ASC 842, a lease modification can result in a new lease.This raises issues regarding the identification and completeness of leases. To correctly identify when a modification should result in a new lease, remember the following two conditions:
- The modification has granted an additional right of use asset to the lessee that was not included in the original lease
- Lease payments have increased, in line with the value of a standalone asset of this type.
If both of those conditions are met, you now have two leases.
To illustrate a real-world scenario where this could happen, imagine your IT department has leased five servers for a new e-commerce project. The new site is successful, bringing the need to lease an additional five servers to help handle the workload, with a corresponding increase in lease payments.
Under ASC 840, this could have been one amended lease. But as the additional five servers meet the two conditions outlined above, these are two separate leases under ASC 842. Remember these rules, as proper identification of modified leases, will help ensure a smooth audit, under the new accounting principles
Policies and Internal Controls
Auditors understand that ASC 842 represents a shift in long-held lease accounting practices. They will want to gauge how you have implemented the changes and how you are maintaining them in the future. This is where your policies and internal controls will be examined.
As with any significant change to operational procedure, ASC 842 requires new and updated policies. If your new policies are already in place, be sure to have them ready for auditors to review. If not, this is a good opportunity to have the auditors help shape your policy changes.
As with any audit, be prepared to be asked questions about your policies. Assume that auditors will want clarity on the finer points of your ASC 842 policies and be ready to give thorough answers to their questions.
You can also be sure that auditors will want to see documentation of your internal controls. Identifying lease accounting personnel will likely be on the agenda, as will a breakdown of how duties are segregated. Policy and procedure manuals will be reviewed, so have them on hand and be prepared to grant access to the auditors.
Policies and Controls Checklist
Here’s a list of things you can do ahead of time to ease the audit of your policies and internal controls:
- Review internal controls to ensure they reflect the changes in ASC 842. Collect all policies, procedures, and documentation of internal controls so that they will be easily accessible to auditors.
- Ensure that your discount rate calculations are documented and consistent with the ASC 842 accounting policy election. As this figure is critical to other lease accounting calculations, you can expect auditors will be reviewing your process.
- New disclosure requirements are outlined under ASC 842 as a means to provide auditors with more transparency into your financial reports.
- Have documentation of any ASC 842 training or certification on hand. Being able to show auditors that your team has a strong understanding of the new requirements will go a long way toward a favorable audit.
Communication is Key
Keeping an open line of communication with your auditors is a solid practice year-round. Especially in times when changes have been made to standard accounting practices, reaching out to auditors throughout the year can help you know what to expect. Stakeholder feedback both internally and externally will aid in your initial implementation as well as ongoing auditing procedures.
Once the audit is underway, respond to their emails and other requests promptly. Ignoring issues in an audit will not make them go away; it will only delay the completion of the audit. Outside service providers can help aid transition reliefs and review the potential impact on your financial statements.
Assess and Prep Your Systems
There’s no doubt that ASC 842 adds complexity to lease accounting processes. The requirement that both operating leases and finance leases (formerly known as capital leases) are recognized on the balance sheet means that changes need to be made to your accounting systems.
To help prepare your systems for review, do your own internal audit ahead of time. Assess whether your GL needs new accounts and is otherwise correctly accounting according to updated standards. Doing a test run of your reports and month-end close processes can reveal any gaps or mistakes in your processes.
You will also want to arrange for auditors to have access to your lease accounting software. Many private and public companies have turned to specialized cloud-based solutions to help transition to ASC 842 and ensure compliance afterward. Auditors will likely want to ensure that these systems are properly configured and performing accounting functions in compliance with new Accounting Standards Codification.
Allowing auditors to see for themselves within your software systems can go a long way toward earning favorable audit results. Work with your IT group and any functional users ahead of time so that appropriate levels of access can be granted ahead of time.
Occupier Gives You Peace of Mind
With a full-featured lease accounting system in place, you will feel confident going into any audit. Today’s best lease accounting software solution ensures data quality, and compliance with the entire ASC 842 standard, giving you peace of mind. Occupier has the products and services you need to manage the entire lease accounting life cycle. With our systems in place, finance leases, operating leases, and lease modifications are all calculated in compliance with ASC 842, helping you stay prepared for audits year-round. And, collaborate with your real estate team on lease data cleanliness, rent expenses, tracking of lease commencement dates as well as mitigate audit risk.Feel free to check out our present value calculator, lease classification test, and our lease accounting compliance hub. When you’re ready to see how a complete suite of tools built on a modern and innovative tech stack transforms your lease accounting, reach out to us and schedule a demo. You’ll never sweat an audit again.