Top 5 ASC 842 Audit Risks and How to Overcome Them

3 min read
April 27, 2022
CoStar Real Estate Manager Blog

Top 5 ASC 842 Audit Risks and How to Overcome Them

For years, corporate accounting teams have been implementing policies and processes for ASC 842 and IFRS 16 lease accounting compliance. And they’re not the only ones. Audit firms also diligently prepared for the changes to audit procedures as a result of the new guidance. 

Here are five major areas that companies must focus on today, because auditors will focus on verifying these things as well.

1. A Complete Collection of Lease Obligations

Firstly, auditors will be looking for a comprehensive collection of lease obligations, which requires companies to mine for lease data throughout the entire organization. This can potentially become a huge issue for companies across all industries. Specifically, collecting equipment (non-real estate) leases can introduce tremendous complexity.  Leases can surprisingly originate from a decentralized, diverse group of departments across the company. Various departments utilize leases with very little impact or involvement from other groups. So, costs are often simply categorized as an expense within the department’s budget. Control of leases may be dispersed throughout the company and visibility is very low as a result.

To ensure thorough collection of lease data, be sure to include a diverse group of stakeholders in meetings and project communications and examine a wide array of data sources to identify leases. Consequently, various departments that have maintained control of their own lease data will need to become involved in centralizing lease data. During this process, it is important to get buy-in from the various groups and emphasize the benefits of the drastic change in lease accounting procedures.  It is important to note the new process is being implemented due to changes in regulations, rather than a new company policy designed to take away control or autonomy. Another useful method for mining lease data includes sending surveys into the field.

2. Unidentified Embedded Leases

A major risk associated with lease accounting compliance is overlooking embedded leases. Project teams need to address this issue head-on.  The type of lease most often overlooked is an embedded lease. Embedded leases are included as part of a larger agreements.  For example, an embedded lease for alarm equipment could be part of a larger agreement with a monitoring service. Or, an embedded lease for servers may be included in a larger IT services contract.  Overlooking embedded leases is a major risk associated with compliance. Project teams need to address the issue head-on and straightaway.

See a comprehensive list of potential sources of embedded leases in this white paper, 12 Step Guide to Lease Accounting Compliance.

3. Proper Separation of Lease and Non-Lease Components

Similarly, extracting the right lease components is another challenge, particularly with gross leases and embedded leases.  To mitigate risk associated with extracting too much (or not enough) data associated with leases, companies should devise policies to help guide data extraction to determine what exactly constitute lease and non-lease components for compliance standards.  Make it a goal to establish policies regarding the practical expedient to combine or separate components early and document them well.  Appropriately abstracting lease and non-lease components into the lease accounting system is critical, and contract language can quickly become complex.  However, technology and accounting partners should be able to offer proper guidance companies on this critical step.

4. Inaccurate Key Assumptions and Variables

In various scenarios, lease accounting teams will make key assumptions upfront. These assumptions generate a substantial difference in the initial right of use asset and lease liability that will be recorded upon adoption.   Examples of these key assumptions include reasonably certain assumptions regarding the exercise of options, establishing an incremental borrowing rate and estimates for CPI or other index related increases.  Companies should undoubtedly expect auditors to ask for documentation of key assumptions, and they will also look for proof regarding the reasonability and consistent application of the assumptions.

5. Software and Key Data Configuration Problems

Recording all leases on the balance sheet is a complex task, and the system used to-date may not have the capabilities to capture the data elements required for compliance.  This is why many companies are choosing to upgrade lease accounting and management software.  Quality lease accounting solutions are always a part of an overall lease management system.  The best software solution providers have decades of experience with equipment and real estate leases and offer multiple modules that reach far beyond lease accounting compliance.  Selecting a proven and well-established lease management system that includes robust lease accounting capabilities is a strategic move many companies are making now.

While it may be tempting to make radical changes during the transition period, it is best to refrain from major process and system changes that do not relate to lease accounting at this point. Instead, consider a phased project approach. The first phase, due by the end of the fiscal year, involves connecting existing lease data to a lease accounting system for essential functionality.  Now is the time to select robust and proven software solutions. Additional phases will roll out at later dates as determined by company strategy.

Early adopters have consistently reported that more time is crucial to reaching compliance. However, by focusing on a phased approach with an eye on these high-risk issues, companies may establish a critical path to success and ultimately make next year’s audit more risk averse.

If you need some back up in the intricate compliance process, look no further than CoStar Real Estate Manager. Schedule a demo today to see how CoStar will get your company over the compliance standard finish line.