How to account for rent free periods

What Is Deferred Rent Concession?

Free rent is a period of time in a lease where the lessee is not required to make rent payments to the lessor. This is also known as a rent holiday. Under generally accepted accounting principles, or GAAP, lessees generally must record rent expense on a straight-line basis over the life of the lease. This means the lessee may record an amount of rent expense during a period in which the lease required no cash payments to the landlord.

Calculate the aggregate lease payments that must be made to the lessor over the entire life of the lease. For example, for a two-year lease that requires payments of $100 a month during year one ($1,200) and $150 a month during year two ($1,800), this amount would total $3,000.

Divide the aggregate lease payments that must be made to the lessor over the entire life of the lease by the number of months covered in the lease. This is the amount of rent expense that must be recorded every month during the life of the lease. In our example of a two-year lease with aggregate lease payments of $3,000, this is $3,000 divided by 24, or $125.

Make a general journal entry in which you debit the rent expense account for the monthly rent payment determined in step 2 and credit deferred rent expense, a liability account, for the same amount.

Repeat step 3 for each month during which you are granted free rent.

At the end of your free rent period, you will typically begin to unwind the deferred rent expense. You still will record the same amount of monthly rent expense, although instead of crediting the deferred rent expense account, you will first credit the entire amount of your cash payment. When the cash payment is in excess of the amount of rent expense, you must debit the excess against the deferred rent account. If the cash payment payment is less than the amount of rent expense, you must credit the difference to the deferred rent account.

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Whether you’re a tenant or landlord who is taking advantage of a rent-free period to secure a new lease on a building or other asset, such as business equipment, you probably have questions on how to account for this rent-free period when it comes time for income reporting to the Canadian Revenue Agency (CRA).

What is a rent-free period?

Landlords of commercial rental space may offer a rent-free period to attract tenants or secure a new lease. This is usually done when there are more available rental units than there are renters in an area or when the landlord or tenant needs time to get the building ready for occupancy. This is also known as a rent holiday.

How is a rent–free period treated for accounting purposes?

Typically, a rent-free period is seen as a deferred liability. This means that the rent-free period still needs to be recorded on both the lessee’s and lessor’s balance sheets. To do this, simply straight-line the rent-free period over the entire length of the lease that is not cancellable.

For example, if Company A is renting office space from Company B with a lease term of one year as follows:

  • 1-3 months: rent-free (3 rent-free months of payments)
  • 4-12 months: $1,250 per month (9 months of payments)

For reporting purposes, the rent will actually be spread evenly across the year of the non-cancelable lease as follows:
$1,250 X 9 = $11,250. For a one-year lease, the lessee is paying a total of $11,250. Therefore, take $11,250 / 12 to get $937.50. This is the actual figure the tenant is paying monthly for the overall 12 months of the lease.

Put simply, the first three months of rent for the tenant is deferred. However, for accounting purposes, the rent amount is spread across the term of the lease in equal parts for both the tenant and the landlord.

Rent-Free Period Accounting

At Hogg, Shain, and Scheck we offer our professional tax accounting services to better help you understand these and other non-traditional business dealings that must be properly reported to the CRA. Contact us today to schedule an appointment and relax, because we can handle it all for you and your business.

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Overview of Prepaid Rent Accounting

Prepaid rent is rent paid prior to the rental period to which it relates, so the tenant should record on its balance sheet the amount of rent paid that has not yet been used.

Rent is commonly paid in advance, being due on the first day of that month covered by the rent payment. The landlord typically sends an invoice several weeks early, so the tenant issues a check payment at the end of the preceding month in order to mail it to the landlord and have it arrive by the due date. This presents a problem for the tenant, since the payment would normally appear in its income statement as rent expense in the period in which the invoice was entered in the accounting software – however, since the payment was recorded and the check was cut in the month before the period to which the payment relates, it is actually prepaid rent.

Example of Prepaid Rent Accounting

The proper way to account for prepaid rent is to record the initial payment in the prepaid assets (or prepaid rent) account, using this entry:

Debit Credit
Prepaid assets $x,xxx
Accounts payable $x,xxx

Then, when the check is cut, the accounting software records this entry:

Debit Credit
Accounts payable $x,xxx
Cash $x,xxx

Finally, the tenant records the following entry sometime during the month to which the rent payment actually applies, which finally charges the payment to expense:

Debit Credit
Rent expense $x,xxx
Prepaid assets $x,xxx

In short, store a prepaid rent payment on the balance sheet as an asset until the month when the company is actually using the facility to which the rent relates, and then charge it to expense.

A concern when recording prepaid rent in this manner is that one might forget to shift the asset into an expense account in the month when rent is consumed. If so, the financial statements under-report the expense and over-report the asset. To avoid this, keep track of the contents of the prepaid assets account, and review the list prior to closing the books at the end of each month.

The accounting treatment is different under the cash basis of accounting, where expenses are only recorded when payment is issued. Thus, a rent payment made under the cash basis would be recorded as an expense in the period in which the expenditure was made, irrespective of the period to which the rent payment relates.

How to account for rent free periods

Straight-line recognition is one of the most commonly used accounting methods whereby the total expense or revenue recorded for a period of time is allocated evenly among all the reporting periods, despite required payments varying over the same term. This method provides a systematic and rational allocation of expense or revenue and is the preferred method of allocation unless a more appropriate method is available. Straight-line recognition is commonly applied to fixed asset depreciation and intangible asset amortization. It is also applied to other types of expenses such as a prepaid insurance agreement and certain revenue streams like subscription agreements. Specifically, under ASC 840 and ASC 842, the straight-line method is used for the recognition of rent expense and rental revenue from operating leases.

Straight-line rent calculations for leases: ASC 842

The new lease accounting standard addresses the recognition of a single lease expense over the term of the lease for operating leases in ASC 842-20-25-6:

“A single lease cost, calculated so that the remaining cost of the lease is allocated over the remaining lease term on a straight-line basis unless another systematic and rational basis is more representative of the pattern in which benefit is expected to be derived from the right to use the underlying asset.”

Under both ASC 840 and ASC 842, the formula to calculate the straight-line expense is as follows: Total net lease payments divided by the total number of periods in the lease.

How to account for rent free periods

For an in-depth discussion of operating lease accounting under ASC 842 and a full example with deferred rent expense and journal entries, read our blog, “Operating Lease Accounting under the New Standard, ASC 842: Full Example and Explanation.”

Additional items within the lease agreement that need to be factored into the straight-line lease expense calculation may include the following:

  • Lease incentives – An incentive is an instance in which the lessor motivates the lessee to sign the lease by offering beneficial terms. A common example of a lease incentive is a tenant improvement allowance. If the lease incentive has not been paid at the lease commencement date, the anticipated cash inflows from the incentive are netted against the cash outflows for the lease payments and factored into the straight-line rent expense calculation. For a more in-depth explanation of lease incentive accounting please refer to this article, Lease Incentive Accounting under ASC 842.
  • Rent abatements or rent-free periods – These are instances where the lessee is not required to pay rent for a set period or recurring periods of the lease, as stated within the lease agreement. These periods of free rent or rent abatement are factored into the total net lease payments, as well as the straight-line rent expense calculation. Check out our article, Rent Abatement and Rent-Free Period Accounting under US GAAP for a more thorough discussion on rent abatements.
  • Rent escalations – Rent escalations are very common in lease agreements. These are instances where the contract stipulates an increase in base rent payments, typically either a percentage or a dollar amount, over the life of the lease. This will impact the calculation of straight line rent expense as these increases will need to be factored into the calculation. The example we walk through below demonstrates how to calculate the straight-line rent expense for a lease agreement with rent escalations.

Straight-line rent expense calculation example

Consider the following scenario:

A retailer enters into a 10-year warehouse lease with initial rent payments of $10,000 a month and a 2% annual rent escalation. The lease commences on January 1, 2022 and ends on December 31, 2031. Let’s assume this is an operating lease, and the retailer transitioned to ASC 842 on January 1, 2022.

How do you calculate the straight-line rent expense for the scenario above? In order to arrive at the correct answer under US GAAP, we need to sum the total net lease payments and then divide those payments by the total number of periods in the lease term.

Step 1: Calculate the total payments

The aggregate payments required under the lease total $1,313,967. See Schedule 1 below:

How to account for rent free periods

Step 2: Calculate the rent expense by dividing the total payments by the lease term

The annual rent expense is $131,397 ($1,313,967 divided by 10 years), and the monthly rent expense is $10,950 ($1,313,967 divided by a lease term of 120 months). See Schedule 2 below:

How to account for rent free periods

In this example, we calculated a straight-line rent expense of $131,397 per year. We can see from Schedule 2, that the annual payments begin at $120,000 and increase each year to reflect the 2% rent escalation but that the expense is consistently recognized on a straight-line basis over the lease term.

Under ASC 840, the difference between the actual cash payment and the expense recognized each period for an operating lease is accounted for in a deferred/prepaid rent account. Under ASC 842, this difference is no longer accounted for in a separate balance sheet account. The new accounting standard captures the difference between the cash payments and the expense recognized for an operating lease as the net change in the lease liability and the right-of-use asset each month.

Summary

Straight-line is an accounting term which refers to the recognition of a constant amount over a specific time period. This article discussed and provided an example of the calculation of straight-line rent expense, but the straight-line method can have many applications. Lease agreements may include rent abatements, allowances, and/or escalations. However, the general theory of calculating the straight-line rent expense for a particular contract will remain constant: sum the total net lease payments and divide by the total number of periods in the lease.

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Lease accounting for escalating rent payments or rent holidays

3. Example of lease accounting for rent holidays

Let us now look at a different example. Company ABC, lessee, entered the following lease agreement:

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:

Monthly
Deferred Rent

Cumulative
Deferred Rent

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 3 rd 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:

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:

Cash (Accounts Payable)

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:

What is Rent Expense?

Rent expense refers to the total cost of using rental property for each reporting period. It is typically among the largest expenses that companies report. Only two expenses are usually larger than rental expense: cost of goods sold (COGS) Cost of Goods Sold (COGS) Cost of Goods Sold (COGS) measures the “direct cost” incurred in the production of any goods or services. It includes material cost, direct and compensation (wages) expense.

How to account for rent free periods

Rent expense is the payment made to a landlord for the rental space that is used by the company. For manufacturing companies the expense is generally divided – on the income statement Income Statement The Income Statement is one of a company’s core financial statements that shows their profit and loss over a period of time. The profit or – between the production and selling & administrative business units. It may sometimes simply be listed in the selling & administrative section of the income statement.

Summary

  • Rent expense is commonly one of the largest expenses a company reports.
  • How a rental space is used affects what account the rent expense is listed under.
  • Deferred rent is when a company is given one or more periods of free rent usually at the beginning of a new lease agreement.

Accrual Basis of Accounting

With the accrual basis of the accounting method, any revenue is listed on the income statement upon earning it, even if the cash hasn’t actually been received yet.

For rental expense under the accrual method, when rent is paid ahead of schedule – which happens rather often – then the rent is recorded in the prepaid expenses account as an asset. Once the business moves into the rental space, or time passes so that the expense becomes current, then the rent expense is then moved to the expense column.

Deferred Rent Asset or Liability

Across the board, companies are supposed to have a consistent rent expense documented every month. This is dictated in the generally accepted accounting principles (GAAP) GAAP GAAP, Generally Accepted Accounting Principles, is a recognized set of rules and procedures that govern corporate accounting and financial . The major problem with this regulation is that monthly rent payments aren’t always consistent. In many cases, because of inflation, for example, monthly rent expense increases over time. On the other hand, the lessor might sometimes give the company a free month or a discount on the rent.

In order to deal with this situation, the balance sheet must include a deferred rent asset or liability account. This account must:

  • Determine the cost of the lease for its entire period, including free months, discounted months, or months that go up because of inflation
  • The amount must then be divided by the total number of months covered under the lease
  • Every month must be listed under the original monthly rental expense, regardless of what was actually paid that month. It is listed in the expense account.
  • Offsetting rent payments – reduction of cost or inflation of cost – is listed in the deferred rent asset or liability account.

How Rental Space Is Used

Rent expense can, in fact, be listed in a number of different places in a company’s financial records. It is often, as mentioned above, listed as a selling or administrative expense. If, for example, the space was used as a place to manufacture goods, the expense would then be listed as part of the cost of goods sold (COGS) for the products produced.

Location, Location, Location

For companies, location is everything, especially for real estate and retail companies. It’s important to be located in a place with a lot of foot traffic and access to the company’s target consumer base. Companies often allocate a large part of their rental expense towards prime locations. For such companies, it’s crucial to weigh the cost of the rent against the benefits and potential boost in revenue that comes from being in a prime location.

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To keep learning and developing your knowledge of financial analysis, we highly recommend the additional CFI resources below:

  • Cost of Goods Manufactured (COGM) Cost of Goods Manufactured (COGM) Cost of Goods Manufactured (COGM) is a term used in managerial accounting that refers to a schedule or statement that shows the total
  • Fixed and Variable Costs Fixed and Variable Costs Cost is something that can be classified in several ways depending on its nature. One of the most popular methods is classification according
  • Inflation Inflation Inflation is an economic concept that refers to increases in the price level of goods over a set period of time. The rise in the price level signifies that the currency in a given economy loses purchasing power (i.e., less can be bought with the same amount of money).
  • Projecting Balance Sheet Line Items Projecting Balance Sheet Line Items Projecting balance sheet line items involves analyzing working capital, PP&E, debt share capital and net income. This guide breaks down how to calculate

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How to account for rent free periods

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How to account for rent free periods

In lease accounting, deferred rent happens when the cash rental payment varies from its expense recognized on the financial statement s and occur s 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 ASC 840 rules.

What Kind of Account is Deferred Rent?

Deferred rent is a balance sheet account traditionally used in legacy accounting standards as defined in ASC 840 . It is the liability coming from the difference between the actual amount paid and the straight-line expense recognized in the financial statements of the lessee.

ASC 840 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.

Where is Deferred Rent on the Balance Sheet?

Deferred rent is a liability on the balance sheet and occurs when rent payments are lower than the straight-line rent expense.

What is the Accounting for Deferred Rent?

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. For example, if the lease term is one year with first-month rental being free and the rental rate for the rest of the months is $1000, then the total rental cost is $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.

What is the Difference Between Prepaid Rent and Deferred Rent?

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.

How ASC 842 Transition Affects Deferred Rent Accounting

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.

At Visual Lease, we make compliance to ASC 842 and other standards a breeze. To learn more about how Visual Lease can help your business contact us now.

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Relevant to ACCA Qualification Paper F7

The accounting topic of leases is a popular Paper F7 exam area that could feature to varying degrees in Questions 2, 3, 4 or 5 of the exam. This topic area is currently covered by IAS 17, Leases. IAS 17, Leases takes the concept of substance over form and applies it to the specific accounting area of leases.

When applying this concept, it is often deemed necessary to account for the substance of a transaction – ie its commercial reality, rather than its strict legal form. In other words, the legal basis of a transaction can be used to hide the true nature of a transaction. It is argued that by applying substance, the financial statements become more reliable and ensure that the lease is faithfully represented.

Why do we need to apply substance to a lease?

A lease agreement is a contract between two parties, the lessor and the lessee. The lessor is the legal owner of the asset, the lessee obtains the right to use the asset in return for rental payments.

Historically, assets that were used but not owned were not shown on the statement of financial position and therefore any associated liability was also left out of the statement – this was known as ‘off balance sheet’ finance and was a way that companies were able to keep their liabilities low, thus distorting gearing and other key financial ratios. This form of accounting did not faithfully represent the transaction. In reality a company often effectively ‘owned’ these assets and ‘owed a liability’.

Under modern day accounting the IASB framework states that an asset is ‘a resource controlled by an entity as a result of past events and from which future economic benefits are expected to flow to the entity’ and a liability is ‘a present obligation of the entity arising from past events, the settlement of which is expected to result in an outflow from the entity of resources embodying economic benefits’. These substance-based definitions form the platform for IAS 17, Leases.

So how does IAS 17 work?

IAS 17 states that there are two types of lease, a finance lease and an operating lease. The definitions of these leases are vital and could be required when preparing an answer in the exam.

Finance lease
A finance lease is a lease that transfers substantially all the risks and rewards incidental to ownership of an asset to the lessee.

Operating lease
An operating lease is defined as being any lease other than a finance lease.

Classification of a lease
In order to gain classification of the type of lease you are dealing with, you must first look at the information provided within the scenario and determine if the risks and rewards associated with owning the asset are with the lessee or the lessor. If the risks and rewards lie with the lessee then it is said to be a finance lease, if the lessee does not take on the risks and rewards, then the lease is said to be an operating lease.

Finance lease indicators
There are many risks and rewards outlined within the standard, but for the purpose of the Paper F7 exam there are several important areas. The main reward is where the lessee has the right to use the asset for most of, or all of, its useful economic life. The primary risks are where the lessee pays to insure, maintain and repair the asset.

When the risks and rewards remain with the lessee, the substance is such that even though the lessee is not the legal owner of the asset, the commercial reality is that they have acquired an asset with finance from the leasing company and, therefore, an asset and liability should be recognised.

Other indicators that a lease is a finance lease include:

  • At the inception of the lease the present value of the minimum lease payments* amounts to substantially all of the fair value of the asset
  • The lease agreement transfers ownership of the asset to the lessee by the end of the lease
  • The leased asset is of a specialised nature
  • The lessee has the option to purchase the asset at a price expected to be substantially lower than the fair value at the date the option becomes exercisable

Finance lease accounting

Initial accounting
The initial accounting is that the lessee should capitalise the finance leased asset and set up a lease liability for the value of the asset recognised. The accounting for this will be:
Dr Non-current assets
Cr Finance lease liability
(This should be done by using the lower of the fair value of the asset or the present value of the minimum lease payments*.)
*Note: The present value of the minimum lease payments is essentially the lease payments over the life of the lease discounted to present value – you will either be given this figure in the Paper F7 exam or, if not, use the fair value of the asset. You will not be expected to calculate the minimum lease payments.

Subsequent accounting

Depreciation
Following the initial capitalisation of the leased asset, depreciation should be charged on the asset over the shorter of the lease term or the useful economic life of the asset. The accounting for this will be:

Dr Depreciation expense
Cr Accumulated depreciation

Lease rental/interest
When you look at a lease agreement it should be relatively easy to see that there is a finance cost tied up within the transaction. For example, a company could buy an asset with a useful economic life of four years for $10,000 or lease it for four years paying a rental of $3,000 per annum.

If the leasing option is chosen, over a four-year period the company will have paid $12,000 in total for use of the asset ($3,000 pa x 4 years) – ie the finance charge in this example totals $2,000 (the difference between the total lease cost ($12,000) and the purchase price of the asset ($10,000)).

When a company pays a rental, in effect it is making a capital repayment (ie against the lease obligation) and an interest payment. The impact of this will need to be shown within the financial statements in the form of a finance cost in the statement of profit or loss and a reduction of the outstanding liability in the statement of financial position. In reality there are several ways that this can be done, but the Paper F7 examiner has stated that he will examine the actuarial method only.

The actuarial method of accounting for a finance lease allocates the interest to the period it actually relates to, ie the finance cost is higher when the capital outstanding is greatest, but as the capital gets repaid, interest payments become lower (similar to a repayment mortgage that you may have on your property). To allocate the interest to a specific period you will require the interest rate implicit within the lease agreement – again this will be provided in the exam and you are not required to calculate it.

One of the easiest ways to apply the actuarial method in the exam is to use a leasing table. Please take note of when the rental payment is actually due, is it in advance (ie rental made at beginning of the lease year) or is it in arrears (ie rental made at the end of the lease year)? This will affect the completion of the lease table as highlighted below: