On January 1, 2022 ASC 842 lease standards went into effect for organizations. But is your not-for-profit prepared for a potential audit?
The ASC 842 leasing standard is effective for not-for-profit organizations and private companies with annual reporting periods beginning after December 15, 2021. External auditors will test compliance with the new lease accounting requirements during the annual audit of the reporting period that commences after that date. As a baseline, auditors will review the controls in their client’s leasing system and perform a risk assessment. The risk assessment consists of six main assertions:
Following risk assessment, auditors will design procedures at the assertion level to ensure that the financial statements are presented in accordance with generally accepted accounting principles. To prepare for your annual audit, it is imperative to understand what questions an auditor will be considering when performing their initial risk assessment.
Did your organization include the full population of leases when implementing ASC 842?
Completeness will be a major audit area when external auditors test for compliance with ASC 842. Auditors will test the assertion that all leases are properly capitalized on the balance sheet. One of the most significant changes between ASC 842 and ASC 840 is that under the new regulation, lessees should recognize a lease liability and right-of-use assets for both operating and finance leases. Accordingly, the balance sheet will reflect an asset and an offsetting liability for finance and operating leases. Evidence of completeness that management could provide to an external auditor include, but are not limited to, a reconciliation of the rent expense as of the most recent accounting period to the underlying lease agreements and documentation of the procedures performed to ensure that the full list of leases has been evaluated. In the absence of such evidence, auditors will likely spend extra time performing additional procedures such as interviewing personnel and performing a physical examination of assets.
Did your organization accurately value the leases that are presented on the statement of financial position?
To test the Valuation/Allocation assertion, auditors will test to ensure that the present value calculations of leases held by the organization are accurate. The main components of these calculations are discount rates and lease terms. Therefore, auditors will test that the amounts used by management in their calculation of the present value is aligned with the amounts in the contract or that management has alternative evidence to support the amounts used in the present value determination.
Are the leases held by the organization recorded in the proper period?
Cut-off is the third main assertion that auditors will often design procedures to test. Auditors are looking to verify that all leases have been recorded in the correct period. For lessees, any lease that is entered into after the transition date (the date your organization implements the new standard) should be recognized at the commencement date. Auditors will likely select leases entered into near the transition date (before and after) to ensure proper cut-off is achieved. For organizations that elect to take the package of practical expedients, the procedures will be focused on leases entered into after the transition date, since the determination of the lease term and classification would not change in the transition. For organizations that elect to take the hindsight practical expedient, auditors will likely perform cut-off procedures before and after the transition date.
Did the organization properly classify all leases as an operating lease or a finance lease?
Classification/Presentation & Disclosures is the assertion that transactions are appropriately classified. As a reminder, leases are classified as operating leases or finance leases. Simply put, operating leases are agreements to use and operate assets without a transfer of ownership. Common examples for not-for-profit organizations include office space and equipment. Finance leases are those that meet the five criteria outlined in 842-10-25-2. A common example is an open-ended vehicle lease with an obligation to purchase the vehicle once the lease ends. The risk is that operating leases are improperly classified as finance leases or short-term leases. If an operating lease is misclassified as a finance lease, the organization may improperly record interest expense vs lease expenses. If an operating lease is misclassified as a short-term lease, the lease liability and right-of-use asset will not be reflected on the statement of financial position. In designing procedures to test this assertion, an auditor may select a number of leases and reperform the ASC 842 classification test.
The remaining two assertions are Existence/Occurrence and Rights/Obligations. With respect to leases, these assertions are typically determined not to be high risk areas. However, based on how management evaluates an organization’s financial performance, there could be an incentive to understate liabilities. In such cases, auditors may design procedures to test on these assertions as well.
Another aspect of implementation that will affect an organization’s compliance with ASC 842 is how well internal controls are documented. Ideally, an organization will have a contracting process that is able to identify whether any new agreements entered into contain assets (and lease agreements). When it comes to lease accounting, there are two types of recommended controls: detective and preventative. Detective controls are performed periodically and can be as simple as reviewing a listing of all contracts executed and the related lease accounting conclusions. Preventative controls are designed to prevent errors on the front end of the process. An example of a basic preventative control is inserting the question “does this agreement contain equipment or property?” into the process.
Overall, the implementation of ASC 842 can add a layer of complexity to the lease accounting process. In order to be prepared for the annual audit, it’s key to understand all the new requirements surrounding the new lease standard and how and where they impact your organization, have adequate documentation of all evaluations done and controls put in place and, as always, keep an open line of communication with the external auditors year-round.
Please reach out to your Baker Tilly advisor if you have questions regarding ASC 842 leasing standards. We continue to monitor legislative developments and will issue additional alerts as warranted.
The information provided here is of a general nature and is not intended to address the specific circumstances of any individual or entity. In specific circumstances, the services of a professional should be sought. Tax information, if any, contained in this communication was not intended or written to be used by any person for the purpose of avoiding penalties, nor should such information be construed as an opinion upon which any person may rely. The intended recipients of this communication and any attachments are not subject to any limitation on the disclosure of the tax treatment or tax structure of any transaction or matter that is the subject of this communication and any attachments.