ASC 842 Transition Guide for Auditors

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Chapter 1

How ASC 842 affects auditors

Say “so long” to SALY

Sadly, SALY is suspended this year. ASC 842 is in effect, and auditing leases will never be the same. That is, until all clients adopt new accounting policies for all their leases. Who knows how long that will take?

Don’t panic

This guide explains the details of lease accounting as it applies to auditors.

The unfortunate truth is that many audit clients will need a lot of help becoming audit-ready. This presents you, the auditor, with an opportunity. Encouraging the decisions in this guide at adoption will help you:

Perform a rigorous audit with high customer satisfaction
Simplify audit procedures and manage audit scope
Increase audit efficiency and scalability
Simplify future audits
Build a more valuable auditor-client relationship
Ensure effective, ongoing accounting policies

About us: Netgain has already helped hundreds of companies transition with our flagship product, NetLease. Now, we’ve brought together our CPAs and former auditors to produce this guide. We offer a cloud-based solution built for auditors that simplifies the transition for clients and creates a consistent audit workflow: NetLease for Auditors.

Chapter 2

Transition guidance: Audit procedures

The transition (Day One) accounting is crucial to the audit because the decisions made here will affect leases for their duration. Your clients will need to navigate a matrix of decisions to determine how to perform the initial accounting under the new standard.

Risk point: Transition decisions and their proper application are a high-risk area of the audit.

In the following sections, we’ll explain the options clients have and how they will affect your audit.

Perspective: Auditors will inevitably need to help clients transition to 842. Use this opportunity to simplify the audit and build a lasting relationship with your client.

Practical expedients

Entity policies elected

Transition reliefs elected

Transition method elected

Transition areas

New GL accounts

Transition journal entries

Disclosure reporting

Chapter 3

Practical expedients

Entity policy elections

Guide audit clients through the practical expedients available. These policy decisions will greatly influence the level of effort required to comply with the new standard:

Recommendation:

Inclusion/exclusion of short-term or low–value leases

Clients should elect to exclude these leases from their 842 portfolios. This will reduce balance-sheet impact and ongoing lease maintenance.

Lease with terms originally longer than 12 months do not fall under this category even if the remaining lease term at transition is less than 12 months.

Separating lease from non-lease components

Clients should elect to separate these, when possible, to avoid unnecessary balance-sheet impact

Discount rate used

Most clients will not have the data or sophistication to properly calculate a rate other than the risk-free rate available to private clients only.

Portfolio approach

Allows clients to simplify their ongoing accounting but will still require a discerning eye from the auditors. Clients rarely have a lease population that is homogenous enough to analyze as a portfolio.

Perspective: When possible, direct clients to take the path of least resistance based on their accounting expertise, data quality and resource availability.

ENTITY ELECTIONS	SUMMARY	APPLICATION	GUIDANCE	WHAT WE'VE SEEN
Short-term or low-value leases	As an accounting policy, a lessee may elect not to apply the recognition requirements to short-term leases. Instead, a lessee may recognize the lease payment in profit or loss on a straight-line basis over the lease term and variable lease payments in the period in which the obligation for those payments is incurred.	Elected by class of underlying asset	ASC 842- 20-25-2	Typically elected: Reduces the level of effort of implementation and ongoing accounting. Low-value threshold: No prescribed threshold from FASB (IFRS threshold $5,000). Many companies use their fixed-asset capitalization limit for leases as well.
Not separating lease from non–lease components	A lessee may choose not to separate non–lease components from lease components and, instead, to account for each separate lease component and the non–lease components associated with that lease component as a single lease component.	Elected by class of underlying asset	ASC 842 -10-15-37	Typically elected: Particularly if non-lease components are predictable; high level of effort required during the analysis including determining the stand-alone selling prices of the non-lease components.
Discount rate	A lessee that is not a public business entity is permitted to use a risk-free discount rate for the lease instead of its incremental borrowing rate, determined using a period comparable with that of the lease term, as an accounting policy election made by class of underlying asset.	Elected by class of underlying asset	ASC 842 -20-30-3	The vast majority of privately held companies are electing to use the risk-free rate despite the balance-sheet gross-up effects.
Portfolio approach	A lessee may account for its leases at a portfolio level provided that the application of the leases model to the portfolio would not differ materially from the application of the leases model to the individual leases in that portfolio.	Elected at portfolio level	ASU 2016 -02 BC120	Not typically elected: In theory, this approach is possible, but clients rarely have a portfolio of leases with characteristics similar enough to be accounted for at a portfolio level.

Chapter 4

Transition reliefs

Perspective: The transition reliefs a client uses also change the scope of the audit and subsequent audit procedures.

Use of hindsight: If a client elects to use hindsight when determining lease classifications, they will be allowed to analyze the actual outcomes of lease terms and provisions and adjust comparative periods accordingly.

This policy must be elected for all leases active during the respective period.

Not commonly used.

Risk point: If hindsight is elected, the audit team will need to test the lease–portfolio activity to verify lease renewals, terminations, asset impairments, etc.

Package of practical expedients: A client electing this package of expedients will greatly reduce the level of audit procedures required around the implementation. Essentially, this package eliminates the need for clients to reassess any previously made accounting decisions around portions of their lease–accounting portfolio.

Whether a contract is or contains a lease: Clients do not need to reevaluate their lease portfolio at transition. Contracts that have been deemed leases will continue to be recorded as leases, and contracts that were not deemed to contain a lease do not need to be reassessed

Lease classification: Clients do not need to reperform any classification tests for their lease portfolio at transition. Any leases commencing after the transition date will need to be properly compared to the guidance-classification criteria

Initial direct costs: Clients do not need to reassess costs of a lease that were included as initial direct costs for leases at transition. Under ASC 840, direct costs can include internal costs and external costs such as legal fees. Under ASC 842, initial direct costs are defined as incremental costs of a lease that were incurred solely because of the lease agreement. Therefore, certain incremental costs previously capitalized under ASC 840 will be expensed under ASC 842.

Perspective: Only under unique circumstances would a client benefit from not electing the package of practical expedients.

TRANSITION RELIEFS	SUMMARY	APPLICATION	GUIDANCE	WHAT WE'VE SEEN
Use of hindsight	An entity may also elect a practical expedient, which must be applied consistently by an entity to all of its leases (including those for which the entity is a lessee or a lessor) to use hindsight in determining the lease term (that is, when considering lessee options to extend or terminate the lease and to purchase the underlying asset) and in assessing impairment of the entity’s right-of-use assets.	May be elected separately or in conjunction with the practical expedient package.	ASC 842 -10-65-1	Typically not elected. High effort and cost for little benefit.
Package of practical expedients: Whether a contract is or contains a lease  Lease classification  Initial direct costs	An entity may elect the following practical expedients, which must be elected as a package and applied consistently by an entity to all of its leases (including those for which the entity is a lessee or a lessor), when applying the pending content that links to this paragraph to leases that commenced before the effective date: An entity need not reassess whether any expired or existing contracts are or contain leases. An entity need not reassess the lease classification for any expired or existing leases (that is, all existing leases that were classified as operating leases in accordance with Topic 840 will be classified as operating leases, and all existing leases that were classified as capital leases in accordance with Topic 840 will be classified as finance leases). An entity need not reassess initial direct costs for any existing leases.	Must be elected as a package.	ASC 842 -10-65	Typically elected. Greatly improves implementation efficiency and costs.

TRANSITION RELIEFS

SUMMARY

APPLICATION

GUIDANCE

WHAT WE'VE SEEN

Use of hindsight

An entity may also elect a practical expedient, which must be applied consistently by an entity to all of its leases (including those for which the entity is a lessee or a lessor) to use hindsight in determining the lease term (that is, when considering lessee options to extend or terminate the lease and to purchase the underlying asset) and in assessing impairment of the entity’s right-of-use assets.

May be elected separately

or in conjunction with the

practical expedient package.

ASC 842

-10-65-1

Typically not elected.

High effort and cost for little benefit.

Package of practical expedients:

Whether a contract is or contains a lease 
Lease classification 
Initial direct costs

An entity may elect the following practical expedients, which must be elected as a package and applied consistently by an entity to all of its leases (including those for which the entity is a lessee or a lessor), when applying the pending content that links to this paragraph to leases that commenced before the effective date:

An entity need not reassess whether any expired or existing contracts are or contain leases.

An entity need not reassess the lease classification for any expired or existing leases (that is, all existing leases that were classified as operating leases in accordance with Topic 840 will be classified as operating leases, and all existing leases that were classified as capital leases in accordance with Topic 840 will be classified as finance leases).

An entity need not reassess initial direct costs for any existing leases.

Must be elected as a package.

ASC 842

-10-65

Typically elected. Greatly improves implementation efficiency and costs.

Chapter 5

Transition methods

Effective method

Apply the new standard from the transition date forward. Comparative periods in the financial statements are still presented under ASC 840.
Common: This method is used by the majority of companies.

Comparative method

Apply the new standard for all comparative periods presented in the financial statements. This means that clients will have to retroactively account under ASC 842 rules, with the option to obtain some relief using hindsight.
Uncommon: Not recommended.

Chapter 6

Ongoing guidance: Audit procedures

With ASC 842, the ongoing (Day Two) accounting has great significance to the auditor. It has become a material portion of the audit.

How a client performs lease accounting going forward impacts this audit and all audits for the rest of the leases’ duration. Clients will need help choosing Day Two methods.

Perspective: Don’t waste time trying to understand and test client spreadsheets. Use NetLease for Auditors.

The table below describes common areas of audit risk and how to address them with substantive procedures.

Risk Point: Excel sheets lend themselves to formulaic errors as well as misapplication of guidance. Learn more here: Can I Adopt ASC 842 with Spreadsheets?

AUDIT AREA	AUDIT RISK	AUDIT ASSERTION	EXAMPLE PROCEDURES	NETLEASE REPORT
Lease Calculations	Initial balances (ROU Asset and Lease Liability) are not properly calculated and recorded.	Accuracy Completeness Existence	Compare asset and liability balances calculated by NetLease to balances booked by client.	Journal-Entry Report: Lease Activity Lease-Balance Roll-Forward Report
Lease Calculations	Lease expense is not properly recorded.	Accuracy Completeness	Compare lease-expense journal entries generated by NetLease to client provided lease expense journal entries.	Journal Entry Report: Lease Activity
Lease Calculations	ROU asset amortization is not properly recorded.	Accuracy Completeness	Compare ROU amortization journal entries generated by NetLease to client provided ROU amortization journal entries.	Journal Entry Report: Lease Activity
Quantitative Footnote Disclosures	Lease assets/ liabilities presented by client are not accurate and complete.	Accuracy Completeness	Compare NetLease–generated disclosure reporting package to client-provided footnote disclosures.	Supplemental Balance-Sheet Information
Quantitative Footnote Disclosures	Lease expense presented by client is not accurate and complete.	Accuracy Completeness	Compare NetLease–generated disclosure reporting package to client-provided footnote disclosures.	Components of Lease Costs and Impairments
Quantitative Footnote Disclosures	The cash-flow information presented by the client is not accurate and complete.	Accuracy Completeness	Compare NetLease–generated disclosure reporting package to client-provided footnote disclosures.	Supplemental Cash-Flow Information
Quantitative Footnote Disclosures	Future lease liabilities presented by the client are not accurate and complete.	Accuracy Completeness	Compare NetLease–generated disclosure reporting package to client-provided footnote disclosures.	Undiscounted Lease Maturity Waterfall
Quantitative Footnote Disclosures	Weighted average remaining lease term and borrowing rate are not properly recorded by client.	Accuracy Completeness	Compare NetLease–generated disclosure reporting package to client-provided footnote disclosures.	Weighted Average Term Weighted Average Rate
Embedded Leases	Embedded leases are not identified and recorded by the client.	Completeness	N/A	N/A
Lease Classification	Leases are not properly classified as operating or financing.	Accuracy	Enter applicable lease information into the Classification tab in NetLease to obtain a system-generated lease classification to compare to client-provided classification.	N/A
Lease Calculations	All transactions have been recorded in the proper period	Completeness Cutoff	Obtain physical evidence of period end transactions to ensure lease transactions have been recorded in the proper period.	N/A
Impairment	ROU assets may be unrecoverable and subject to impairment	Existence Accuracy	Evaluate assets for potential impairment indicators including: significant changes to the FMV, operating cash flows of the asset, or other general impacts such as legal proceedings or adverse economic changes	N/A

AUDIT AREA

AUDIT RISK

AUDIT ASSERTION

EXAMPLE PROCEDURES

NETLEASE REPORT

Lease

Calculations

Initial balances (ROU

Asset and Lease Liability)

are not properly calculated

and recorded.

Accuracy
Completeness
Existence

Compare asset and liability

balances calculated by NetLease

to balances booked by client.

Journal-Entry Report: Lease Activity
Lease-Balance Roll-Forward Report

Lease

Calculations

Lease expense is not

properly recorded.

Accuracy
Completeness

Compare lease-expense journal

entries generated by NetLease to

client provided lease expense

journal entries.

Journal Entry Report: Lease Activity

Lease

Calculations

ROU asset amortization is

not properly recorded.

Accuracy
Completeness

Compare ROU amortization

journal entries generated by

NetLease to client provided

ROU amortization journal entries.

Journal Entry Report: Lease Activity

Quantitative

Footnote

Disclosures

Lease assets/ liabilities

presented by client are not

accurate and complete.

Accuracy
Completeness

Compare NetLease–generated

disclosure reporting package to

client-provided footnote disclosures.

Supplemental Balance-Sheet Information

Quantitative

Footnote

Disclosures

Lease expense presented

by client is not accurate

and complete.

Accuracy
Completeness

Compare NetLease–generated

disclosure reporting package to

client-provided footnote disclosures.

Components of Lease Costs and Impairments

Quantitative

Footnote

Disclosures

The cash-flow information

presented by the client is

not accurate and complete.

Accuracy
Completeness

Compare NetLease–generated

disclosure reporting package to

client-provided footnote disclosures.

Supplemental Cash-Flow Information

Quantitative

Footnote

Disclosures

Future lease liabilities presented

by the client are not accurate and

complete.

Accuracy
Completeness

Compare NetLease–generated

disclosure reporting package to

client-provided footnote disclosures.

Undiscounted Lease Maturity Waterfall

Quantitative

Footnote

Disclosures

Weighted average remaining

lease term and borrowing rate

are not properly recorded by client.

Accuracy
Completeness

Compare NetLease–generated

disclosure reporting package to

client-provided footnote disclosures.

Weighted Average Term
Weighted Average Rate

Embedded

Leases

Embedded leases are not identified

and recorded by the client.

Completeness

N/A

Lease

Classification

Leases are not properly

classified as operating or

financing.

Accuracy

Enter applicable lease information

into the Classification tab in NetLease

to obtain a system-generated lease

classification to compare to

client-provided classification.

N/A

Lease

Calculations

All transactions have been

recorded in the proper period

Completeness
Cutoff

Obtain physical evidence

of period end transactions

to ensure lease transactions

have been recorded in the

proper period.

N/A

Impairment

ROU assets may be

unrecoverable and subject

to impairment

Existence
Accuracy

Evaluate assets for potential

impairment indicators including:

significant changes to the FMV,

operating cash flows of the asset,

or other general impacts such as

legal proceedings or adverse

economic changes

N/A

Chapter 7

Embedded leases

What is an embedded lease?

Not all contracts that meet the accounting definition of a lease are obvious. Sometimes, a contract may need to be recorded as a lease even if it is not labeled “lease.” A contract meets the definition of a lease if it “conveys the right to control the use of a specified asset.”

For example

Acme Co. may have entered a contract with Standard Co. to host its data on a dedicated server. If embedded within the agreement is the right for Acme Co. to direct the use of that specific server, the agreement could meet the definition of a lease and need to be recorded as a lease.

Companies looking to be compliant with ASC 842 must review contracts and investigate whether those contracts contain embedded leases. These can be difficult to identify, so many companies have elected to engage consulting firms to assist in this process. For more information, read Don’t Be Surprised by Embedded Leases under ASC 842

Identifying your client’s embedded leases

Embedded leases can be tough to find. They can be a real lease in a stack of contracts, to coin a phrase. These are the best practices for finding them:

Meet with the operational teams across the organization. Interview them to determine if their contract structures could potentially contain embedded leases.

Obtain and analyze a full listing of expense-account activity during a specified time period. Search for consistent outgoing transactions to a single vendor and analyze the nature of the expense.

Ask legal to help. The legal department can help in reviewing contracts and identifying potential embedded leases.

Embedded lease examples

Here are some real-world examples of leases that fit the definition: conveys the right to control the use of a specified asset.

A company requires one truck dedicated to making deliveries only for that company.

A customer requires a dedicated production line from a manufacturer to produce a run of products.

Is Software as a Service (SaaS) considered an embedded lease?

Thankfully, no. The right to use intangible assets is outside of the scope of ASC 842. For intangible assets, look to the ASC 350 for proper accounting standards.

Chapter 8

Additional guidance: Auditing in Excel vs. NetLease for Auditors

We do not recommend auditing in Excel because of the extra risk it invites.

Cons:

Not scalable

Need to create a custom lease schedule for any special conditions of the lease

No audit trail or visibility into activity and changes

Excel version control does not provide full details

Difficulty organizing all documents required

No central document repository

Difficulty auditing individual journal entries

No control or automation around journal entries

Difficulty reporting

No automation for reporting

Complexity of auditing lease modifications

No automation around modifications or early terminations

High risk of errors and miscalculations

Lack of automation invites human error

Benefits of NetLease for Auditors

NetLease for Auditors creates a stable workflow for any number of leases at a fixed cost. Simply enter the lease–contract details and get complete amortization schedules and journal entries based on ASC 842, IFRS 16 and GASB 87 guidelines.

Pros:

Predictable pricing

standardizes audit cost by allowing unlimited users, clients and leases

Saves time

by standardizing audit procedures with complete amortization schedules

Simplifies disclosure audit

by creating out-of-the-box reports for disclosures

Makes classification and modifications easy

Produces sensitivity analysis

for identifying client errors

Perspective: Audit firms of all sizes benefit from NetLease for Auditors. Virtually all leases, even complex leases with early terminations or modifications, can be tested for accuracy.

Chapter 9

Day two in Excel vs. NetLease

It is worth your time to warn audit clients that the traditional Excel approach won’t work with the complex requirements of ASC 842. Any cost savings they achieve will be outweighed by the drawbacks. Convincing your clients to implement a software solution has downstream benefits for both your client and your audit staff.

For auditors:

Risks of clients using Excel

Cons.

Ongoing lease accounting in Excel is difficult to audit

Need to reverse-engineer client spreadsheets and calculations

Modifications, terminations and other lease activities are prone to error

No journal-entry automation

No reporting available

Benefits of NetLease

Pros.

Saves time by standardizing procedures around lease accounting

Provides system-generated amortization schedules that require the client to think through the complete list of inputs required for accurate accounting

Provides system-generated journal entries, including modifications and terminations

Provides complete disclosure reporting

Creates a central repository for lease documents

Incentivizes loyalty by simplifying audit procedures

For audit clients:

Risks of using Excel

Cons.

Complexity grows out of control if leases have any special conditions

Difficult to perform at scale because each lease needs its own accounting

Prone to inaccuracy, which produces audit risk and ongoing accounting confusion

Difficulty performing the three types of modifications and ROU impairments

Time consuming

Benefits of NetLease

Pros.

Improved accuracy and efficiency of lease accounting operations such as modifications, terminations, journal entries, disclosure reports

Saves time and resources with automation

Simple reporting for better decision-making throughout the lease lifecycle

Once they have been audited in NetLease for Auditors, leases do not need to be re-entered

Perspective: Both NetLease products are implemented and supported by CPAs and former auditors. Netgain brings four years of experience with software lease accounting. We show you how the calculations work so you can trust the system to eliminate accuracy risk.

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