Accounting guidance on escalating rent payments or rent holidays
Accounting standards (US GAAP) indicate that rent should be
recognized as expense over the lease term as it becomes payable. However, if
rent payments are not made on a straight-line basis, rent expense still needs
to be recognized on a straight-line basis. There is an exception to this rule:
if another systematic and rational basis is more representative of the time
pattern in which use benefit is derived from the leased property, that basis
shall be used.
This “straight-lining” provision may be applicable to
agreements where there are escalating rent payments or rent holidays.
Monthly Rent Expense =
|
Total Rent
Payments Over Lease Term
|
Number of Month
|
Differences between monthly rent expenses and rent payments
are known as deferred rents. Deferred rents are recorded in either an
asset account (e.g., other current or non current assets) when the cumulative
difference between rent expenses and rent payments as of a balance sheet date
is negative or a liability account (e.g., other current or non current
liabilities) when the cumulative difference is positive. The balance in a
deferred rent account normally increases, reaches its highest point and then
gradually decreases as the lease term approaches its end.
Example of lease accounting for escalating rent payments
Let’s look at an example of recording lease expenses when
there are escalating rent payments. Company ABC, lessee, entered the following
lease agreement:
| Leased property | Office space |
| Lease term | 2 years |
| Lease payments | Year 1 = $10,000/month Year 2 = $11,000/month |
We will also assume there are no other unusual terms in the
agreement (e.g., purchase option) and the lease is classified as an operating
lease.
The monthly rent expense can be calculation as follows:
Monthly Rent
Expense =
|
$252,000*
|
= $10,500 |
24 months
|
(*) Total rent payments = $10,000 x 12 + $11,000 x 12 = $252,000
Relationships between rent expenses, rent payments and
deferred rents are presented in the table below:
Year
|
Month
|
Rent
Expense |
Rent
Payment |
Monthly
Deferred Rent |
Cumulative
Deferred Rent |
1
|
1
|
10,500
|
10,000
|
500
|
500
|
1
|
2
|
10,500
|
10,000
|
500
|
1,000
|
1
|
3
|
10,500
|
10,000
|
500
|
1,500
|
1
|
4
|
10,500
|
10,000
|
500
|
2,000
|
1
|
5
|
10,500
|
10,000
|
500
|
2,500
|
1
|
6
|
10,500
|
10,000
|
500
|
3,000
|
1
|
7
|
10,500
|
10,000
|
500
|
3,500
|
1
|
8
|
10,500
|
10,000
|
500
|
4,000
|
1
|
9
|
10,500
|
10,000
|
500
|
4,500
|
1
|
10
|
10,500
|
10,000
|
500
|
5,000
|
1
|
11
|
10,500
|
10,000
|
500
|
5,500
|
1
|
12
|
10,500
|
10,000
|
500
|
6,000
|
2
|
13
|
10,500
|
11,000
|
(500)
|
5,500
|
2
|
14
|
10,500
|
11,000
|
(500)
|
5,000
|
2
|
15
|
10,500
|
11,000
|
(500)
|
4,500
|
2
|
16
|
10,500
|
11,000
|
(500)
|
4,000
|
2
|
17
|
10,500
|
11,000
|
(500)
|
3,500
|
2
|
18
|
10,500
|
11,000
|
(500)
|
3,000
|
2
|
19
|
10,500
|
11,000
|
(500)
|
2,500
|
2
|
20
|
10,500
|
11,000
|
(500)
|
2,000
|
2
|
21
|
10,500
|
11,000
|
(500)
|
1,500
|
2
|
22
|
10,500
|
11,000
|
(500)
|
1,000
|
2
|
23
|
10,500
|
11,000
|
(500)
|
500
|
2
|
24
|
10,500
|
11,000
|
(500)
|
-
|
252,000
|
252,000
|
-
|
During the first month, rent expense equals $10,500 (by the
way, monthly rent expense does not change) and the rent payment is $10,000. The
difference of $500 (positive amount) represents deferred rent. Because this is
the first month, the cumulative deferred rent is also equal to $500. During the
second month, rent expense is $10,500 and the rent payment is $10,000 again
resulting in a monthly deferred rent of $500. Cumulative deferred rent during
the second month is $1,000 (i.e., $500 from the first month plus $500 from the
second month).
At the end of the 12th month the cumulative
deferred rent reaches its highest amount (i.e., $6,000). Starting with the 13th month, the monthly rent payment increases to $11,000 while rent expense remains
$10,500. This results in a negative monthly deferred rent of $500 which will
continue to be negative until the end of the lease term. Negative monthly
deferred rents gradually decrease cumulative deferred rents to zero.
Cumulative deferred rent is what will be recorded in a
deferred rent liability account. Note that the entire amount of cumulative
deferred rent is shown as a current liability at the end of the first year (i.e.,
12th month) because the cumulative deferred rent balance will be
liquidated within the next 12 months.
Company ABC would make the following monthly journal entry
during the first 12 months of the lease term:
| Account Titles |
Debit
|
Credit
|
| Rent Expense |
$10,500
|
|
| Cash (Accounts Payable) |
$10,000
|
|
| Deferred Rents |
$500
|
During the next 12 months (after monthly rent payments
change from $10,000 to $11,000), Company ABC would make the following monthly
journal entry:
| Account Titles |
Debit
|
Credit
|
| Rent Expense |
$10,500
|
|
| Deferred Rents |
$500
|
|
| Cash (Accounts Payable) |
$11,000
|
At the end of the lease term, the company would recognize
$252,000 in rent expense and rent payments and the cumulative deferred rents
would equal zero.
Example of lease accounting for rent holidays
Let us now look at a different example. Company ABC, lessee,
entered the following lease agreement:
| Leased property | Warehouse space |
| Lease term | 2 years |
| Lease payments | Months 1-3 = $0/month Months 4-12 = $4,000/month Months 13-24 = $5,000/month |
As we can see, the landlord provided Company XYZ with three
months of free rent. This three-month period is called a rent holiday.
We will also assume there are no other unusual terms in the
agreement (e.g., purchase option) and the lease is classified as an operating
lease.
The monthly rent expense can be calculation as follows:
Monthly Rent
Expense =
|
$96,000*
|
= $4,000 |
24 months
|
(*) Total rent payments = $0 x 3 + $4,000 x 9 + $5,000 x 12
= $96,000
Relationships between rent expenses, rent payments and
deferred rents are presented in the table below:
Year
|
Month
|
Rent
Expense |
Rent
Payment |
Monthly
Deferred Rent |
Cumulative
Deferred Rent |
1
|
1
|
4,000
|
-
|
4,000
|
4,000
|
1
|
2
|
4,000
|
-
|
4,000
|
8,000
|
1
|
3
|
4,000
|
-
|
4,000
|
12,000
|
1
|
4
|
4,000
|
4,000
|
-
|
12,000
|
1
|
5
|
4,000
|
4,000
|
-
|
12,000
|
1
|
6
|
4,000
|
4,000
|
-
|
12,000
|
1
|
7
|
4,000
|
4,000
|
-
|
12,000
|
1
|
8
|
4,000
|
4,000
|
-
|
12,000
|
1
|
9
|
4,000
|
4,000
|
-
|
12,000
|
1
|
10
|
4,000
|
4,000
|
-
|
12,000
|
1
|
11
|
4,000
|
4,000
|
-
|
12,000
|
1
|
12
|
4,000
|
4,000
|
-
|
12,000
|
2
|
13
|
4,000
|
5,000
|
(1,000)
|
11,000
|
2
|
14
|
4,000
|
5,000
|
(1,000)
|
10,000
|
2
|
15
|
4,000
|
5,000
|
(1,000)
|
9,000
|
2
|
16
|
4,000
|
5,000
|
(1,000)
|
8,000
|
2
|
17
|
4,000
|
5,000
|
(1,000)
|
7,000
|
2
|
18
|
4,000
|
5,000
|
(1,000)
|
6,000
|
2
|
19
|
4,000
|
5,000
|
(1,000)
|
5,000
|
2
|
20
|
4,000
|
5,000
|
(1,000)
|
4,000
|
2
|
21
|
4,000
|
5,000
|
(1,000)
|
3,000
|
2
|
22
|
4,000
|
5,000
|
(1,000)
|
2,000
|
2
|
23
|
4,000
|
5,000
|
(1,000)
|
1,000
|
2
|
24
|
4,000
|
5,000
|
(1,000)
|
-
|
96,000
|
96,000
|
-
|
During the first three months, the company does not have to
make any rent payments, so the full rent expense is recorded as deferred rents
on the balance sheet. At the end of the 3rd month, cumulative
deferred rents equal $12,000 (i.e., $4,000 x 3 months). During the following
nine months, the monthly rent expense equals rent payments, so the company does
not need to record any monthly deferred rents.
The balance in the cumulative
deferred rents account remains $12,000. During the last 12 months, the
company’s rent payments are $5,000 while rent expense is $4,000 resulting
negative monthly deferred rents of $1,000. Such negative deferred rents reduce
the cumulative deferred rents balance to zero at the end of the lease term.
Company XYZ would make the following monthly journal entry
during the first three months of the lease term:
| Account Titles |
Debit
|
Credit
|
| Rent Expense |
$4,000
|
|
| Deferred Rents |
$4,000
|
As you can see, there is no entry to a cash or accounts
payable account because during the first three months the company does not have
to pay rent (i.e., rent holiday); however, the company still needs to recognize
rent expense.
During the next nine months (after monthly rent payments
change from $0 to $4,000), Company ZYX would make the following monthly journal
entry:
| Account Titles |
Debit
|
Credit
|
| Rent Expense |
$4,000
|
|
| Cash (Accounts Payable) |
$4,000
|
During these nine months, the company would not have to
record any deferred rent because monthly rent payments equal rent expense. Note,
however, that the company already recorded $12,000 of deferred rent during the
first three months of the lease term and these cumulative deferred rents remain
unchanged during the nine months.
During the last 12 months (after monthly rent payments
change from $4,000 to $5,000), Company ZYX would make the following monthly
journal entry:
| Account Titles |
Debit
|
Credit
|
| Rent Expense |
$4,000
|
|
| Deferred Rent |
$1,000
|
|
| Cash (Accounts Payable) |
$5,000
|
At the end of the lease term, the company would recognize
$96,000 in rent expense and rent payments and the cumulative deferred rents
would equal zero.
No comments:
Post a Comment