Subject: ASC 842 and Notes Payable Considerations
Hi everyone,
I’m facing two situations here that I would appreciate your insights on.
First, we have a client who signed a lease in January 2023 for a building that is currently under construction. They will receive 10 months of free rent once they take possession. The lease requires them to recognize rent expense, but the client wants to categorize it as a non-operating expense since they haven’t actually paid any rent yet. I’m not convinced this is the right approach.
In a separate scenario, the client also secured a short-term loan with a repayment term of 10 months. I plan to disclose this loan in the notes, but the client insists it’s immaterial (the loan amount is $400k, while their total assets are $10 million). They’re turning a healthy profit of $600k as well, so there are no going concern issues to address.
What are your thoughts on these matters? I would greatly appreciate feedback from my Audit colleagues.
Best,
[Your Name]
One response
Your post raises some important points regarding the application of ASC 842 and the treatment of the loan in your client’s financial statements. Here are my thoughts on each scenario:
Lease Accounting under ASC 842:
Under ASC 842, leases must be recognized on the balance sheet, irrespective of whether the lease payments are made or not. The client receiving 10 months of free rent doesn’t negate the fact that they have a lease obligation. The correct Accounting treatment would involve recognizing a right-of-use asset and a corresponding lease liability at the present value of the lease payments over the term of the lease, including the free rent period. Since the rent expense is deferred, it should still be recognized in the income statement according to the straight-line method, which means they should allocate the total rent expense over the lease term, including the free rent periods. Therefore, I agree with you that it is a mistake to classify this as a non-operating expense because the lease obligation is a contractual commitment that needs to be reflected in the financials.
Disclosure of Short-Term Loan:
Regarding the short-term loan of $400k, while the client argues that it’s immaterial given their total assets of $10 million and annual profits of $600k, it’s important to consider the qualitative aspects of materiality as well. Even though it may not impact the financial statements significantly in terms of dollar amounts, disclosure of obligations that may affect operational liquidity or that may be important to stakeholders (e.g., lenders, investors) is critical. The loan could have implications for cash flow, future financing activities, or operational flexibility, making it a relevant item for disclosure. Therefore, it would be prudent to include this loan in the notes to the financial statements, as transparency is key in maintaining trust with stakeholders.
In conclusion, I echo your stance that both scenarios need to be handled with careful consideration of ASC 842 and GAAP principles related to materiality. It’s always best to err on the side of transparency and proper Accounting treatment to reflect the economic reality of the transactions.