ASC 842 and Notes Payable
Hey everyone, I’ve got a couple of scenarios I’d like your input on.
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Lease Scenario: My 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. While the lease obligation mandates a rent expense, the client wants to classify it as a non-operating expense since they haven’t actually paid any rent yet. I’m not entirely convinced by this approach.
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Short-Term Loan: The client also secured a short-term loan that they’ll repay in 10 months. Although I plan to disclose this in a note, the client insists it’s immaterial and doesn’t warrant inclusion because the loan amount is $400,000, while their total assets are $10 million. Plus, they’re turning a solid profit of $600,000, so there are no concerns about going concern.
I’d appreciate any insights from my Audit peers!
One response
It’s great that you’re engaging with your Audit counterparts on these scenarios; both involve important considerations under ASC 842 and general financial reporting practices.
Scenario 1: Lease with Rent Abatement
In regards to the lease agreement where the client has 10 months of free rent, it’s important to adhere to the principles of ASC 842, which requires lessees to recognize lease liabilities and right-of-use assets based on the total lease payments over the lease term, including any rent concessions. Even though the client is not paying rent for the first 10 months, the lease obligation should still reflect the full term of the lease.
It might be helpful to explain to your client that rent abatement does not eliminate the lease obligations or the expense recognition under the effective interest method mandated by ASC 842. Ideally, they should recognize the total lease liability and right-of-use asset, incorporating the present value of future cash flows. The rent expense would be recognized on a straight-line basis over the lease term, making sure to include those initial free months in the calculation.
Scenario 2: Short-term Loan Disclosure
For the short-term loan of $400k, consider the requirement under ASC 275, which discusses the importance of disclosing significant risks and uncertainties. While the loan may appear immaterial when viewed in relation to total assets & earnings, sometimes the qualitative aspects may warrant disclosure.
You may want to assess the materiality of the loan in the context of the company’s financial condition and results of operations. Even if the loan seems minor relative to total assets, it may have implications for liquidity or operational flexibility. Given the client’s insistence on immateriality, reiterating the concept of qualitative materiality might be necessary here. It’s always prudent to err on the side of transparency when dealing with liabilities that affect the financial position.
In both cases, maintaining a clear line of communication with the client will be critical, as well as providing them with rationale that aligns with compliance and best practices in Accounting standards. Would it be useful to consult with your firm’s policy on disclosures to provide further backing to your arguments?