Generally accepted accounting principles dictate that rent expense should be shown on the financial statements of a business as a consistent amount from month to month. In accounting parlance, that's called a "straight line" method.
That's all well and good when the lease is actually that consistent over time, but many times a lease may require for the monthly payment to increase with inflation over time. Other times, a lessor may offer a rent holiday – a "first month free" type of incentive. For accountants, dealing with these odd payment structures requires the use of an account called "deferred rent expense."
How to calculate deferred rent expense
To demonstrate how the deferred rent expense account works in practice, let's work through a simple, illustrative example. Let's assume that a business has a 12 month lease with a rental payment of $1,000 per month for the first six months and $1,500 for the second six months.
The first step to accounting for this lease structure is to determine the average monthly rent payment for the entire lease. In this case, that is six payments of $1,000 and six payments of $1,500, or $15,000 total. That total payment, divided by the 12 month lease term, means the average payment is $1,250.
According to GAAP, that $1,250 average payment is the amount that should be used each month to create the financial statements. Of course, the business is $250 less than that in the first six months of the lease, and then $250 more than that in the second six months. On a month to month basis, that just doesn't balance.
To account for those differences, the accountant should use a deferred rent expense account. In this example, each month for the first six months of the lease, the deferred rent account will rise by $250 per month. Then, in month seven when the rent increases to $1,500, deferred rent will decrease by $250 a month.
|Rent Paid||Rent Expense||Deferred Rent||Cumulative Deferred Rent|
Over the entire term of the lease, the monthly rent expense does not change. Accounting rules say that it must remain constant, or straight line, at $1,250 each month. The rise and the fall of the deferred rent account ensures that the company is capturing the actual cash being paid on the financial statements, while staying in line with this accounting rule.
How one Seattle couple secured a $60K Social Security bonus -- and you can too
A Seattle couple recently discovered some little-known Social Security secrets that can boost many retirees' income by as much as $60,000. They were shocked by how easy it was to actually take advantage of these loopholes. And although it may seem too good to be true, it's 100% real. In fact, one MarketWatch reporter argues that if more Americans used them, the government would have to shell out an extra $10 billion... every year! So once you learn how to take advantage of these loopholes, you could retire confidently with the peace of mind we're all after, even if you're woefully unprepared. Simply click here to receive your free copy of our new report that details how you can take advantage of these strategies.
This article is part of The Motley Fool's Knowledge Center, which was created based on the collected wisdom of a fantastic community of investors based in the Foolsaurus. Pop on over there to learn more about our Wiki and how you can be involved in helping the world invest, better! If you see any issues with this page, please email us at email@example.com. Thanks -- and Fool on!
Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.