In lease accounting, deferred rent happens when the cash rental payment varies from its expense recognized on the financial statements and occurs when the tenant is provided free rent in one or more periods, or if there are escalating rent payments. Here is everything you need to know about deferred rent under ASC 840 and ASC 842 rules.
Deferred rent is a balance sheet account traditionally used in legacy accounting standards as defined in ASC 840. Deferred rent arises when the amount expensed exceeds the amount paid. A balance will build up and then burn off when the cash paid exceeds the amount expensed.
ASC 842 requires the total rent expense to be recognized on a straight-line basis during the lease period even if rent payments differ. The debiting or crediting of the deferred rent account monthly allows the lessee to record the rent expense using the straight-line basis and catch whatever difference is between the amount paid and the expense recognized in this account. The cumulative balance of the deferred rent when the lease is terminated has to be equal to zero.
Accounting for the free rent period and subsequent periods are as follows:
Add the total cost of the rent payments for the entire lease period. Then divide this total amount of payments by the total number of periods in the lease, including any early access period. So although the first month was technically “free,” we still have a payment that appears on our balance sheets.
If the lease term is one year with the first-month rental being free and the rental rate for the coming months being $1,000, then the total rental cost will be $11,000 .
Divide the total rental cost by the total number of periods in the lease contract including the free rental month. In our example, we will divide $11,000 by 12 months and get $917.
Each month of the lease, the average monthly rate should be charged as an expense, regardless of whether there was an actual payment made. In our example, the expense for the first month is $917 even if there is no actual payment since the tenant did not pay for the first month. This means that the $917 debited to expenses is offset by a credit to the deferred rent account.
For the remaining months of the lease, the same average amount should be charged as an expense. This is $917 in our example. Should there be an offsetting of the rental payment and if the payment and expense don’t match, then the difference should be applied to the deferred rent account.
In our example, the monthly payment for the remaining period after the free month has lapsed is still $1,000, an amount that’s higher by $83 than the amount charged as rent expense, which is $917. This difference should be used to reduce the amount of the deferred rent liability during the remaining months of the rental period until it becomes zero.
The same accounting approach should be used even if the rental amount changes throughout the lease period. For example, if the lease rate increases in the succeeding months, then the average rent expense should be charged in all months with a portion of it forming part of the deferred rent liability.
There’s a difference between deferred rent vs. prepaid rent. The former is a liability and occurs when the lessor provides free rent, usually at the start of the lease term, or there are escalating rent payments. Prepaid rent is rent paid up front that is to be expensed in a future period.
The concept of straight-line rent expense on operating leases was retained despite the transition to the ASC 842. But under the new mechanics, the deferred rent should be replaced by the Right of Use (ROU) asset and lease liability accounts. The ASC 842 guidelines are much more complicated than its predecessor, ASC 840. Thus, any lease accounting software must have ROU Asset functionality in place. It is best to go for trusted accounting software such as ours.
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Where is Deferred Rent on the Balance Sheet?
Deferred rent journal entries are liabilities on the balance sheet and occur when rent payments are lower than the straight-line rent expense.