How to Assess Materiality and Recognition Thresholds
Last Updated on August 30, 2022 by Neil Patel Accel
Implementing the new standard is complex and takes time. Under ASC 842, operating leases are now on the balance sheet, creating questions amongst finance teams as to how materiality applies to those lease contracts. In essence, materiality concerns the significance of an item to users of a registrant’s financial statements. An entity is not required to apply U.S. GAAP to immaterial items; therefore, materiality is always a consideration in the preparation of financial statements. Depending on your lease, defining materiality levels and recognition thresholds may prove tedious.
FASB outlines the concept of materiality as follows:
“The omission or misstatement of an item in a financial report is material if, in the light of surrounding circumstances, the magnitude of the item is such that it is probable that the judgment of a reasonable person relying upon the report would have been changed or influenced by the inclusion or correction of the item.”
This formulation in the accounting literature is in substance identical to the formulation used by the courts in interpreting the federal securities laws. The Supreme Court has held that a fact is material if there is – a substantial likelihood that the . . . fact would have been viewed by the reasonable investor as having significantly altered the “total mix” of information made available.
Finance teams know that assessing materiality is an important task that you need to complete before year-end. This task entails assessing your lease portfolio for materiality and recognition thresholds. Why? Well, if the outcome of this assessment determines that the leases are immaterial or meet the criteria for early amortization.
How to Assess Materiality:
Financial statements are the foundation of every company and should always be based on truth. However, there’s one thing that can make them less reliable: materiality. Materiality refers to the impact of an omission or misstatement in a company’s financial statements on users. In other words, it’s all about the transparency of lease information, and exclusion of contracts can have significant consequences on an organization’s balance statements!
Assess the lease portfolio
The threshold for materiality will help management identify which leases are essential and need to be reviewed while eliminating immaterial contracts from further review. For example, material leases, like office space, retail space, airplanes etc., are more easily identifiable and your team most likely has data abstracted from these lease types. Inmaterial leases like copiers, vehicles, laptops and espresso machines were historically off the balance sheet thus lacking associated lease accounting processes. Under IFRS 16, ISAB explicitly states that the materiality threshold is $5,000, so anything less than that does not need to be on the books. Although FASB, under ASC 842 has not explicitly outlined the materiality threshold so lessees must use judgement to assess materiality.
The lack of a specific statement about materiality makes it difficult for companies to know if they need certain disclosures. It does not indicate some circumstances under which an entity could omit these items from their financial statements, so this leaves room for lessees to assume what information should be provided to stand up as viable entities within today’s market environment. It is implicit in the overall disclosure objective to have an appropriate level of detail for significant leasing activities. Companies need to consider a number of factors before deciding whether or not they should establish a lease recognition threshold and, if so, at what amount.
Define the Portfolio
A lessee can choose to apply the guidance in ASC 842 on a portfolio basis, which means they would not need to look at each lease individually. They can do this if they think it won’t make a big difference than if they applied it on a lease-by-lease basis. Grouping leases with similar assets at a portfolio level makes assessing materiality slightly simpler. Here are a few examples of application of the portfolio approach:
- By Lease Term – Grouping lease contracts by comparable lease terms is allowable given that the variety of leasing options and clauses aligns within the lease economics.
- By Discount Rate – Application of a single discount rate across all leases within a portfolio is allowable given that the materiality at the portfolio level does not differ from a lease-level application.
- With Fixed Asset Schedules – Since the ROU Asset is recorded on the balance sheet, lessees can decide to align their materiality threshold with their fixed asset materiality policy.
Since materiality is different for each lessee, there are no rules that all reporting entities can use to group leases into portfolios. If a reasonable portfolio cannot be determined, then you should not use a portfolio approach. A “reasonable portfolio” consists of leases that have the same lease terms and underlying assets. The efficiency of the portfolio approach aids businesses with a larger portfolio of leases.
Capitalization Threshold for Leases:
The capitalization threshold is the dollar amount that determines the proper financial reporting of the asset. An entity should not simply default to its existing capitalization threshold for its property, plant and equipment (PP&E). Since the existing capitalization threshold for PP&E does not take into account the liability side of the balance sheet and it most likely does not include the effect of the additional asset base introduced by ASC 842 then it should not be used.
Instead, one reasonable approach to developing a capitalization threshold for leases under ASC 842 is to use the lesser of the following:
- A capitalization threshold for PP&E, including ROU assets
- A recognition threshold for liabilities that considers the effect of lease liabilities
When evaluating and applying a capitalization threshold for leases, entities should consider the following:
- The gross balance of each side of the lease entry — It would be inappropriate for an entity to consider only the net balance sheet effect of the lease entry (which is often zero) when assessing materiality.
- Disclosure requirements — Entities will often want to omit disclosures about leases that they have determined, on the basis of their use of capitalization thresholds (as discussed above), do not need to be recognized on the balance sheet. While it may be appropriate to omit such disclosures, an entity will need to consider the impact of the omitted disclosures when performing a materiality assessment to establish the thresholds.
- Implications related to internal control over financial reporting (ICFR) — As entities revisit and change (or create new) capitalization thresholds for financial reporting purposes, they should be cognizant of the related ICFR implications. In addition, entities should consider the Form 10-K and Form 10-Q disclosure requirements under SEC Regulation S-K, Item 308(c), with respect to material changes in ICFR.
- SAB Topic 1.M (SAB 99) — Entities may find the guidance on materiality in SAB Topic 1.M helpful when identifying an appropriate capitalization threshold for leases.
Lease Recognition Threshold:
The lease recognition threshold is an important aspect to consider when determining your lease’s length. This threshold lets you know how much rent has been paid in relation to what properties are being recognized as occupied by their respective lessee(s) before it becomes active again after its initial period expires or if there are any other type restrictions on renewal notices like renewals require notice periods within certain boundaries.
Applying a recognition threshold will be difficult. Setting it at an appropriate level may require significant judgment, and this is never easy to do well. Setting your threshold at an appropriate level may require sound assumptions. Generally, it would not be appropriate to do the following: start with the company’s PP&E capitalization threshold, see how it affects your net assets (ROU assets less lease liabilities), or ignore the effect of the threshold on financial statements.
It may be helpful for many companies to think about the lease liability first when establishing the recognition threshold. This is because we would expect it to be relatively rare for a company to conclude that its capitalization threshold for ROU assets would be less than its recognition threshold for lease liabilities.
For those tasked with implementing a new standard ASC 842, assessing materiality and recognition threshold can be difficult. To learn more about getting started with lease accounting under ASC 842, read our blog, The Ultimate Guide to Navigating the Lease Accounting Lifecycle Under ASC 842 Compliance.
Check out our Lease Accounting Compliance Hub for all things ASC 842.