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Deferred Rent Explained
ASC 842 changed how many lease accounting items are recorded and tracked. ASC 842 eliminated the concept of deferred rent from ASC 840. To see how lease accounting changed and why deferred rent is no longer relevant, read our ASC 842 Complete Guide.
Some firms are still scrambling to make the transition from ASC 840 to ASC 842, especially on deferred rent.
Recording and tracking it is a complex subject. So let's take a closer look at the procedures involved, how they have changed, and what the ASC 842 changes mean going forward.
What is Deferred Rent?
The first step is to define deferred rent. The definition is simple. In accounting terms, deferred rent is the difference between the actual cash tenants pay landlords and the straight-line rent expense recorded on the lessee’s statement as part of an operating lease.
Straight-line rent spreads lease expenses evenly across each period of the lease term, which simplifies the accounting. Deferred rent arises when the cash a tenant pays in a period differs from that straight-line expense. That happens whenever rent escalates.
Take a three-year lease with rent of $10,000 in year one, $12,000 in year two and $14,000 in year three — $36,000 in total. The straight-line expense is $36,000 ÷ 3 = $12,000 in every year, regardless of what is actually paid. In year one the tenant expenses $12,000 and pays $10,000, so a deferred rent liability of $2,000 builds. In year two expense and cash are both $12,000 and the balance sits still. In year three the tenant expenses $12,000 and pays $14,000, and the $2,000 unwinds to zero.
The straight-line figure never changes. That is the point of straight-lining — deferred rent is the difference it creates against the cash actually paid, not an adjustment to the expense itself.
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ASC 840: Deferred Rent
To understand how recording and tracking deferred rent works, it helps to know what an operating lease is. It also helps to know the role operating leases have traditionally played in ASC accounting standards.
Under ASC 840 a lessee classified a lease as a capital lease if it met any one of four criteria: transfer of ownership, a bargain purchase option, a lease term of 75 percent or more of the asset's estimated economic life, or minimum lease payments with a present value of 90 percent or more of the asset's fair value. A lease that met none of them was an operating lease (Deloitte's Roadmap: Leases, Appendix C). Operating lease payments are recognized as rent expense on the lessee's income statement. The lease itself was not recognized on the balance sheet, but straight-lining an escalating lease does put a balance there: the deferred rent liability this page describes, which ASC 842 later folds into the right-of-use asset at transition (ASC 842-10-65-1(m), ASC 842-20-35-3(b)(1)). Deloitte's Roadmap: Leases, Appendix C, sets out the ASC 840 treatment.
Under that standard, total rent had to be recognized on a straight-line basis over the term of the lease, even if the payments varied during the lease term.
To explain the recording process further: the difference between cash paid and the actual expense was recognized by a debit or credit to deferred rent within the operating lease.
Typically, deferred rent started as a liability. It grew during the first part of the lease term, when payments were low.
Over the lease, those payments gradually increased until the numbers canceled. The account balance was basically zero by the end of the lease.
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ASC 842: Deferred Rent
The good news about deferred rent under ASC 842 is that recording rent expenses on a straight-line basis doesn’t change.
What does change is that lessees must record operating leases on the balance sheet. That wasn’t the case under ASC 840.
As a result, under ASC 842 the lease liabilities and the right-of-use (ROU) assets are both recorded when the lease commences (ASC 842-20-25-1). The lease liability is measured at the present value of the lease payments not yet paid, discounted using the discount rate for the lease at commencement (ASC 842-20-30-1), so most of the changes take place in the recording process.
The right-of-use (ROU) asset represents a lessee's right to use a leased asset for the lease term. It's recognized on the balance sheet under ASC 842. It is measured at the amount of the lease liability, plus any lease payments made at or before commencement and any initial direct costs, less any lease incentives received (ASC 842-20-30-5).
With this new recording structure, the deferred rent account used under 840 is eliminated. That means deferred rent is no longer separately calculated and identified, but it is still recognized in the financial statements.
Under ASC 842, the difference between straight-line rent and cash paid is still recorded on the company’s books. But the net activity in the lease liability and the ROU assets basically becomes deferred rent.
Also, the lease agreement must meet the classification criteria for an operating lease, which is somewhat different under ASC 842. There are also important transition issues in going from ASC 840 to 842. Let’s take a closer look at those as well.
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Deferred Rent During ASC 842 Transition
The new recording procedures under ASC 842 are fairly straightforward. But they do raise a question: what happens to the accumulated balance of deferred rent for an operating lease during the transition from 840 to 842?
At the application date, which for an entity adopting through a cumulative-effect adjustment is the beginning of the reporting period in which it first applies ASC 842 (ASC 842-10-65-1(c)(2)), the right-of-use asset is measured at the lease liability adjusted for the items in ASC 842-20-35-3(b), which include any prepaid or accrued lease payments carried over from ASC 840 (ASC 842-10-65-1(k) and (m)).
That means deferred rent has essentially been renamed during the transition process. Depending on whether it's a cumulative positive or negative amount, it’s now called either accrued rent or prepaid rent.
In most leases deferred rent is a liability, a credit balance, and it reduces the right-of-use asset recognized at transition.
The transition entry has two legs, not two options: the deferred rent balance is derecognized, a debit for the usual escalating lease or a credit where the balance is prepaid, and the offsetting amount adjusts the right-of-use asset established for that same lease (ASC 842-10-65-1(m), ASC 842-20-35-3(b)(1)). The amount is the total deferred rent related to the operating lease.
This journal entry essentially carries over the accumulated deferred rent, so it shifts from a standalone account to part of the new ROU asset.
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Deferred Rent in Journal Entries: Before and After
Using the same lease — three years at $10,000, $12,000 and $14,000, paid at the end of each year, straight-lining to $12,000 a year — here is what changes.
Under ASC 840, the balancing figure went to a deferred rent account. In year one:
Account Debit Credit Rent expense $12,000 Cash $10,000 Deferred rent $2,000
By the end of year three the deferred rent balance is back to zero. The $2,000 excess of cash over expense in the final year draws it down.
Under ASC 842, there is no deferred rent account. The lease is on the balance sheet from day one as a lease liability measured at the present value of the payments not yet paid, and a right-of-use asset measured at that liability plus any payments made at or before commencement and initial direct costs, less incentives received (ASC 842-20-30-1, ASC 842-20-30-5). The straight-line cost is recognized as a single lease expense. The difference that used to sit in deferred rent is now absorbed into the movement of the right-of-use asset and the liability:
Account Debit Credit Lease expense $12,000 Cash $10,000 Lease liability (payment less accretion: $10,000 − accretion) balancing amount Right-of-use asset (single lease cost less accretion: $12,000 − accretion) balancing amount
The two balancing amounts come from the lease's amortization schedule: the liability is reduced by the payment less the period's accretion, and the right-of-use asset is amortized by the single lease cost less that same accretion (ASC 842-20-35-3; single lease cost, ASC 842-20-25-6). KPMG's Handbook: Leases works the same mechanic through an escalating operating lease in Example 6.4.20, and shows it as a journal entry in this exact form in Example 6.6.20. For the pieces of the asset side, see our guide to the ROU asset calculation. What matters is that the $2,000 has not disappeared. It has moved from a standalone liability into the carrying amounts of the asset and liability the lease now puts on the balance sheet.
Note that deferred rent is not prepaid rent. Prepaid rent is cash paid ahead of the period it covers and is an asset. Deferred rent is the accumulated gap between straight-line expense and cash paid. For an escalating lease it is a liability. They are often confused because both arise from timing, and they behave in opposite directions.
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The Bottom Line
The transition from 840 to 842 has one end result. The deferred rent account comes off the balance sheet on the application date, absorbed into the right-of-use asset recognized that day (ASC 842-10-65-1(k) and (m)).
The income statement barely moves. ASC 842 requires a single lease cost allocated over the remaining lease term on a straight-line basis (ASC 842-20-25-6), the same flat $12,000 a year the deferred rent mechanic produced. What changes is the balance sheet: the difference between expense recognized and cash paid is carried in the lease liability and the right-of-use asset instead of a deferred rent account.
It’s important to have up-to-date, powerful lease software that reflects this change accurately. These items need to be tracked in several places during the recording process.
Specifically, all the items that have changed need to be recorded accurately in the line items, the balance sheet, and any later reports your company uses.
How to Make Sure You Understand Deferred Rent in ASC 842
As the sections above show, the recording process for deferred rent under ASC 842 can be somewhat complicated. It's easy to make mistakes, and those mistakes can be costly.
Fortunately, there's a reasonable solution to this problem. At iLeasePro, our leasing experts have worked with both ASC 840 and ASC 842 for years. We understand the changes, the logic behind them, and why they're important.
We can help explain them so you get them right. We can also provide the right software products to help you record and implement the ASC 842 changes correctly.
To do this, call iLeasePro at 888-351-4606, or go to iLeasePro to read about our software products and how they can help you with ASC 842. We'll give you all the information you need to simplify the recording process, and show you how to use it to improve your bottom line.