Sometimes operating leases aren’t as straightforward as they seem to be and there are a couple of situations that create a deferred rent amount that is often overlooked by accountants. Generally Accepted Accounting Principles require that operating leases expenses 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. However, often minimum lease payments may not be level over the entire lease term.
One common example is escalating lease payments where the amounts charged over the life of the lease increases, usually on an annual basis. Or similarly, as an incentive a lessor could provide a rent “holiday” in which the first month or more is waived. Both of these cases create a deferred rent amount that should be recognized. On a straight-line basis, the total minimum payments under the lease would be calculated and then divided equally over the life of the lease. The difference between this amount and the amount actually paid would create deferred rent in the early term of the lease as the monthly payments are less than the monthly straight-line expense. The deferred rent would be reduced in the later term of the lease as the higher lease payments exceed the monthly straight-line expense.
Likewise, if a lessee is provided with up-front cash payments from the lessor to sign the lease or if payments are given to reimburse the lessee for specific costs such as moving costs, the lessee should recognize incentive payments as a reduction of rental expense over the term of the lease.
As an example of recognizing rent expense on a straight-line basis when lease payments vary, assume that a lessee is required to make payments of $500 during the first two years of a five-year lease, and must make monthly payments of $600 thereafter during the lease term. Total rent expense (payments) under the lease would be $33,600 and the amount charged to expense each month during the lease term would be $560 (33,600 ÷ 60 months). The excess of expense over payments ($560 -$500) during the first two years would be credited to an accrued liability account (deferred rent) each month. In subsequent months, the accrued liability would be reduced by the excess of the monthly payments over the monthly expense ($600 − $560).
Jeff Patterson, CPA