ASC 842 and Notes Payable
Hi everyone,
I have two scenarios to discuss regarding a client’s financial reporting.
First, the client signed a lease in January 2023 for a building that is currently under construction. Once they take possession, they will receive 10 months of free rent. While the lease agreement generates a rent obligation for expense reporting, the client wants to categorize it as a non-operating expense since they haven’t made any actual rent payments. I’m not in agreement with this approach.
Secondly, the client has taken out a short-term loan, which they are required to repay within 10 months. I’m planning to disclose this in the financial notes, but the client insists it doesn’t need to be disclosed due to its immateriality (the loan is $400,000, while their total assets amount to $10 million). Additionally, they’re reporting a solid profit of $600,000, so there are no concerns about their viability.
I’d appreciate any insights or advice from my Audit colleagues on these matters. Thank you!
One response
It sounds like you’re navigating a couple of nuanced issues with your client. Let’s break them down one at a time.
1. Lease Accounting under ASC 842
Regarding the lease for the building under ASC 842, your inclination to disagree with the client’s treatment of the rent expense makes sense. Under ASC 842, leases are viewed differently than prior standards, and the fact that the client signed the lease implies a contractual obligation, regardless of the free rent period. Even though they aren’t making cash payments during the first 10 months, the lease obligation must still be recognized on the balance sheet as a right-of-use asset and a corresponding lease liability.
The rent expense should be recognized on a straight-line basis over the lease term, which includes the free months. This means that the client would still need to recognize the total rent expense over the lease term, and the fact that they haven’t paid anything yet doesn’t negate the lease commitment. This treatment aligns with the principle that lease expenses reflect the right to use the property over the lease term.
2. Disclosure of Short-term Loans
For the short-term loan of $400k, while it may seem immaterial in relation to total assets of $10 million, you should consider both quantitative and qualitative factors when determining whether or not to disclose it.
Quantitative: Materiality often relies on a percentage of total assets, total revenue, or net income. The $400k loan represents 4% of total assets, which can be argued as material depending on company policies and practices.
Qualitative: The nature of the loan and its potential impact on financial position and operations may also warrant disclosure. Even if the loan doesn’t materially affect the financial statements, if it is a new borrowing or has specific terms that could impact liquidity, disclosing it for transparency might be prudent.
Ultimately, GAAP disclosure requirements underline the importance of providing a complete picture to users of the financial statements, so if there’s any doubt, it may be beneficial to include the note for clarity.
In summary, for both scenarios, it’s essential to adhere to ASC 842 guidelines and materiality principles in your financial reporting. Open communication with the client about the rationale behind these standards might help them see the importance of proper Accounting treatment and disclosure.