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 | |
|---|---|---|---|---|
| January | $1,000 | $1,250 | $250 | $250 |
| February | $1,000 | $1,250 | $250 | $500 |
| March | $1,000 | $1,250 | $250 | $750 |
| April | $1,000 | $1,250 | $250 | $1,000 |
| May | $1,000 | $1,250 | $250 | $1,250 |
| June | $1,000 | $1,250 | $250 | $1,500 |
| July | $1,500 | $1,250 | ($250) | $1,250 |
| August | $1,500 | $1,250 | ($250) | $1,000 |
| September | $1,500 | $1,250 | ($250) | $750 |
| October | $1,500 | $1,250 | ($250) | $500 |
| November | $1,500 | $1,250 | ($250) | $250 |
| December | $1,500 | $1,250 | ($250) | $0 |
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.
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