Deferred rent is the outcome of making a lease payment that is less than its recognized expense on your financial statements. It typically results from free or reduced-rate rent periods, often occurring as lease incentives at the beginning of a new lease.
With the transition from ASC 840 to ASC 842, the deferred-rent classification has become obsolete for accounting. However, it’s still worth understanding how it works, as the difference between your lease liability and what you actually paid will still appear in your expense reports.
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In this article, we’ll use an example to walk through how you would account for deferred rent on your lease, and then we’ll look at how it has changed with the new ASC 842 rules.
For accounting purposes, you calculate your total rent expense on a straight-line basis for the entire lease term, regardless of whether individual payments differ. You then treat any deferred rent as a liability on your balance that offsets your total rent expense.
For example, let’s say you start a new lease with a term of one year and with agreed-upon monthly payments of $10,000. The total expense of that lease would be $120,000. However, if you’re receiving three months of free rent as a lease incentive, then the total expense of your lease would only be $90,000.
To calculate your lease’s recognized monthly expense, you divide the total expense by the rent periods. That’s $90,000 divided by 12 months, which equals a recognized monthly expense of $7,500.
So for your first three rent periods, you have a recognized monthly expense of $7,500, even though you’re paying $0. That difference is the liability that you account for as deferred rent. The balance builds up each month that you have free or reduced-rate rent, and then the balance burns off as you start making monthly payments that are greater than the recognized monthly expense.
This means that after three months, you would have a deferred-rent balance of $22,500. But whenever you make a payment, the balance will decrease by the difference between your payment and the recognized monthly expense. Since your monthly payment is $10,000 and your recognized monthly expense is $7,500, your deferred-rent balance will go down by $2,500 every payment until it reaches $0 at the end of your lease term.
The following chart illustrates:
|Period||Recognized expense||Monthly payment||Deferred rent||Liability balance|
Note that this is a simplified example for the purpose of clarity. Many other factors can impact the calculation of straight-line rent or your actual liability balance.
With the transition to ASC 842, you still need to calculate your total rent expense on a straight-line basis. However, the deferred-rent classification should be replaced with Right of Use Assets (ROU) and lease-liability accounts.
The difference between your lease liability and what you actually paid still shows up on your books, just without the deferred rent label. This can make for some additional complexity in your lease accounting. Be sure to use lease accounting software that includes ROU asset functionality.
Phasing out the deferred-rent classification is just one of the changes brought about by the new ASC 842 rules. And factoring in those new rules is just one of the challenges of modern lease accounting and lease administration.
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