ASC 842 and Notes Payable: Two Scenarios for Consideration
Hello everyone,
I’m facing two different situations with a client that I’d like to get your thoughts on.
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The client signed a lease in January 2023 for a building that is currently under construction. Once they take possession, they’ll receive 10 months of free rent. Despite the lease obligation indicating a rent expense, the client prefers to classify this as a non-operating expense since they haven’t actually paid any rent yet. I’m inclined to disagree with this assessment.
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The client has also secured a short-term loan, which they need to repay within 10 months. I plan to disclose this in a note, but the client insists it isn’t material enough to warrant disclosure, given that the loan is $400k against total assets of $10 million. They are also reporting a healthy profit of $600k, so there’s no concern about going bankrupt.
I would appreciate any insights from my Audit colleagues on these matters. Thank you!
One response
Your scenario presents a couple of interesting challenges regarding ASC 842 and disclosures. Here are some thoughts on each situation:
1. Lease Accounting Under ASC 842:
Regarding the lease signed in January 2023, it’s important to remember that ASC 842 requires organizations to recognize lease liabilities and right-of-use (ROU) assets for all leases, regardless of payment terms (e.g., rent holidays). Even if the client is not paying rent during the construction period and has 10 months of free rent, they still need to recognize the lease obligation and the associated ROU asset at the present value of the future lease payments when the client takes possession.
The free months of rent should be factored into the lease liability calculation but won’t negate the need to recognize the lease under ASC 842. The total rent expense should be recorded on a straight-line basis over the lease term, regardless of actual cash payments. Therefore, I would stand by your inclination to disagree on this point. The lease qualifies as an operating obligation that needs to be accounted for properly, and it shouldn’t be categorized as a non-operating expense based merely on the timing of cash flows.
2. Disclosure of Notes Payable:
For the short-term loan, while the client argues that the $400k loan is immaterial relative to their total assets ($10 million) and overall profit ($600k), ASC 205-10-50-3 states that entities should disclose information about material liabilities in the notes to the financial statements. The determination of materiality can be subjective; however, a loan of $400k, constituting 4% of total assets, could be considered material from a quantitative perspective.
Additionally, since it’s a short-term obligation and may impact liquidity assessments, disclosing it even if the company is in a strong financial position is prudent. Transparency is essential, and stakeholders should have access to all liabilities, material or otherwise. You might want to help your client understand the importance of full disclosure for the sake of clarity and to prevent any potential misunderstandings with external stakeholders.
In summary, I would recommend adhering to ASC 842 principles regarding lease Accounting and advocating for the disclosure of the short-term loan for the sake of transparency and complete financial reporting. Engaging the client in a discussion around best practices in financial reporting and the rationale behind adherence to these Accounting standards could be beneficial.