ASC 842 and Notes Payable
Hello! I have two scenarios I’d like to discuss.
In the first case, a client signed a lease in January 2023 for a building currently under construction. Once they take possession, they will receive 10 months of free rent. While the lease obligation calls for rent expense, the client prefers to classify it as a non-operating expense since they haven’t actually paid any rent yet. I’m leaning toward disagreeing with this classification.
In the second scenario, the client secured a short-term loan due to be repaid within 10 months. I plan to disclose this in the notes, but the client argues that it should not be disclosed because it’s immaterial (the loan is $400k against total assets of $10 million). Additionally, they are reporting a decent profit of $600k, indicating no going concern issues.
I would appreciate the thoughts of my Audit colleagues on these matters!
One response
It sounds like you’re navigating some nuanced issues related to ASC 842 and the treatment of the lease and loan. Here are some considerations for each scenario:
Lease Situation
Recognition of Lease Liability and ROU Asset: Under ASC 842, the lease should be recognized regardless of the payment structure. The lessee is required to record both a right-of-use (ROU) asset and a lease liability at the present value of the lease payments, even if there are periods of rent-free occupancy. The free rent periods do not eliminate the obligation; instead, they affect the amortization of the lease expense over the term of the lease.
Lease Expense Classification: The argument to classify lease payments as a non-operating expense could be challenged. Lease payments are typically considered operating expenses unless the lease relates to a financing transaction or the entity is in the business of leasing. The provision for 10 months of free rent does not negate the need to recognize lease expense in the income statement and amortize that effectively over the lease term.
Note Payable Situation
Materiality Considerations: While the loan might seem immaterial in relation to total assets, transparency in financial reporting is crucial. Many auditors would typically advise disclosing significant short-term borrowings, even if they are below a usual threshold of materiality.
Going Concern Considerations: Although a going concern is not an issue, as the client is profitable, the short-term loan’s structure can still impact liquidity and cash flow reporting. Disclosing the loan aligns with providing a full picture of the financial position, which is essential for stakeholder decisions.
Regulatory and Stakeholder Expectations: Depending on the client’s industry and stakeholder requirements (e.g., lenders, investors), there might be a stronger rationale for disclosure beyond mere materiality thresholds. Consider encouraging the client to err on the side of transparency.
Recommendations
Lease: Advise the client to follow ASC 842’s requirement to recognize the ROU asset and lease liability, and explain how the rent-free period impacts the expense recognition over the lease term.
Loan: Recommend including the note payable in disclosures to ensure compliance with best practices in financial reporting, covering liquidity and financial risk considerations.
Collaboration with your Audit counterparts to present a unified stance could strengthen the case for compliance and uphold the integrity of financial reporting.