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Top 5 Audit Risks For Lease Accounting Compliance

Top 5 Audit Risks for Lease Accounting Compliance

Avoid these top 5 audits risks for lease accounting compliance.

As corporate accounting teams rush to implement policies and processes for ASC 842 and IFRS 16 lease accounting compliance, audit firms are also diligently preparing 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 beginning in 2019.

1. A Complete Collection of Lease Obligations

Leases can originate from a decentralized, diverse group of departments across the company. Various departments utilize leases with very little impact or involvement from other groups, and costs are often simply categorized as an expense within the department’s budget. As a result, control of leases may be dispersed throughout the company and visibility is very low. Specifically, collecting equipment (non-real estate) leases can introduce tremendous complexity.  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.

2. Unidentified Embedded Leases

Embedded leases are included as part of a larger agreements, and is the type of lease most often overlooked.  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, and project teams need to address the issue head-on.

3. Proper Separation of Lease and Non-Lease Components

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.  Policies regarding the practical expedient to combine or separate components should be established early and documented 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

There are various scenarios where key assumptions are required upfront, and these assumptions can 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 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.  As long as a robust and proven software solution is selected now, additional phases can be rolled out strategically at a later date.

Early adopters to the new ASC 842 and IFRS 16 standards consistently report that more time is needed for lease accounting compliance than originally anticipated.  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.

Matt Waters, CPA

Lease Accounting Subject Matter Expert with over 15 years of Management Experience in Accounting and Finance