ASC 842 and Notes Payable: Seeking Insight
Hello everyone. I have two scenarios I’d love to discuss.
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A client signed a lease in January 2023 for a building under construction. Once they take possession, they will benefit from 10 months of free rent. Although the lease obligation incurs a rent expense, the client wants to classify it as a non-operating expense since they haven’t actually paid rent yet. I’m not sure I agree with this classification.
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The same client obtained a short-term loan with a repayment period of 10 months. While I plan to disclose this in a note, the client insists it shouldn’t be disclosed due to its immateriality (the loan amount is $400k against total assets of $10 million). They are also generating a profit of $600k, so there are no concerns regarding going concern.
I’d appreciate any thoughts or feedback from my Audit colleagues.
One response
In the scenario you’ve outlined, both lease Accounting under ASC 842 and the treatment of a short-term loan raise some important considerations.
1. Lease Accounting (ASC 842):
Under ASC 842, leases are generally classified as either operating or finance leases. Regardless of the fact that the client is receiving 10 months of free rent, the lease obligation is recognized on the balance sheet at the present value of the future lease payments. The free rent period also affects the expense recognition under ASC 842. The client will still incur a rent expense over the lease term that reflects the total lease payments, including those free months, which must be averaged over the lease term. Considering it a non-operating expense doesn’t align with ASC 842’s principles, as the rent is indeed part of their operating activities.
Thus, it’s reasonable to disagree with the client’s position. They should recognize the lease liability and the right-of-use asset in compliance with ASC 842.
2. Short-Term Loan Disclosure:
Regarding the short-term loan of $400k, while it may seem immaterial compared to total assets of $10 million, it’s essential to consider the context and the significance of that information for users of the financial statements. The 5% ratio of the loan to total assets could be considered material in some contexts, particularly in relation to liquidity and financing activities. The client’s profitability of $600k doesn’t negate the potential impact of the loan on their financial position.
Most Accounting frameworks emphasize transparency, and disclosing the loan can provide relevant context for stakeholders assessing the financial statements. I would recommend disclosing the loan in a note to ensure the financial statements present a complete picture of the company’s financial obligations and commitments.
Ultimately, while there may be differing views on materiality, aligning with generally accepted accounting principles and putting forth full disclosure when possible aligns with best practices in financial reporting.