Accounting 101 - Deferred Rent 78

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Accounting for Deferred Rent

Note:  The following is from a series of accounting reference articles found on Big4Guru.com.
Deferred Rent
What is it?
The simplest way to understand deferred rent is to think of an example.  Let’s say you started a business and the first thing you did was sign a five-year lease for office space.  In an effort to sign you as a tenant, the landlord (aka “lessor”) offers you lower rent payments in the first year that “escalate” (i.e. go up) as the years progress.  To keep it simple, let’s say the rent schedule is this:
Year 1:   $1,000 / month = $12,000 / year
Year 2:   $1,250 / month = $15,000 / year
Year 3:   $1,500 / month = $18,000 / year
Year 4:   $1,750 / month = $21,000 / year
Year 5:   $2,000 / month = $24,000 / year
These amounts represent the actual cash that you will be paying each month.  When booking the journal entries for this, this will be the credit (either to cash or a payable).  The question is what is the debit?
ASC section 840-20-25-1 states the following:
Rent shall be charged to expense by lessees (reported as income by lessors) over the lease term as it becomes payable (receivable). If rental payments are not made on a straight-line basis, rental expense nevertheless shall be recognized on a straight-line basis unless another systematic and rational basis is more representative of the time pattern in which use benefit is derived from the leased property, in which case that basis shall be used.
You see, the FASB requires that rental expense be “recognized on a straight-line basis.”  This means that the same amount of expense must be recognized each month, regardless of the actual rent payment during the month.  Let’s calculate our monthly rent expense.
From the table above, we can easily compute that the total rent paid over the course of the lease is $90,000.  ($12k +$15k + $18k + $21k + $24k).  This figure, divided by the total months in the lease (60), gives us out straight-line rent expense:
Total Rent / Total Periods = Straight-Line Rent Expense per period
$90,000 / 60 months = $1,500 / month = $18,000 per year. 
We now have the debit in our journal entry.
With a debit to expense for one amount and a credit to cash for another amount, the plug goes to deferred rent.  Depending on the payment schedule, deferred rent can either be an asset or a liability.
In the case of a lease with increasing payments each year, as in our example, deferred rent is a liability.  The liability balance builds through the first two years when the expense exceeds the cash payments, levels off during year 3 when these amounts are equal, and then drops down to zero over the course of the final two years when rent expense is less than the rent payments.  The journal entries for each year are as follows:
Journal Entries – Year 1
Dr. Rent expense        1,500
       Cr. Deferred rent                         500
       Cr. Cash                                       1,000
Journal Entries – Year 2
Dr. Rent expense        1,500
       Cr. Deferred rent                         250
       Cr. Cash                                       1,250
Journal Entries – Year 3
Dr. Rent expense        1,500
       Cr. Cash                                       1,500
Journal Entries – Year 4
Dr. Rent expense        1,500
Dr. Deferred rent            250
       Cr. Cash                                       1,750
Journal Entries – Year 5
Dr. Rent expense        1,500
Dr. Deferred rent            500
       Cr. Cash                                       1,750