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Straight-line Expense Recognition of Leases

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

*We do not give free tax advice to non-clients by email, blog comment response or phone. If you would like to set up an appointment to meet with one of the Henry+Horne tax advisors to discuss the specifics of your lease-related questions/situation, please visit our contact page.

Comments

  1. Kibong says:

    Hi
    Classification between Short term and long term of deferred rent is a requirement per GAAP? If it is, where do I have to find the FASB NO. or ASC No.? Thank you.

    • hhadmin says:

      Kibong –

      Thank you for your question and interest in our blog. FASB ASC 840-10-50-2 requires that disclosure be made to include a general description of the entity’s leasing arrangements. It does not specifically indicate a requirement to classify or disclose short-term or long-term deferred rent.

      Jeffery W. Patterson, CPA, MBA

  2. Frieda says:

    Hi Jeffrey – I so enjoyed reading your blog, thank you.
    A 126 month lease, first 6 months free rent with an early termination after month 42. To make things simple the free rent = $50,000, to calculate the fee due at month 42 do I use 126 month or my boss thinks 120? $50,000/126*(126-42)=33,333
    thank you for your help!

    • hhadmin says:

      Frieda –

      Thank you for your question. The free rent would be deferred equally over the life of the total lease.

      Jeffery W. Patterson, CPA, MBA

  3. sahin says:

    my monthly deferred rent je is not tie out to the zero at the end of the leases period? what should I do with the balance ?

    also if my lease is renew with the new rent what what would I do with the deferred rent balance that I have left with the old lease?

    • hhadmin says:

      Sahin –

      Thank you for your interest in our blog. At the end of the originally leased term, the deferred rent should equal zero if it was properly amortized over the life of the lease. At the beginning of the new lease you would again amortize any deferred rent over the total life of the new lease.

      Jeffery W. Patterson, CPA, MBA

  4. AJ says:

    Hi Jeffrey,
    I just need some clarification on this one:

    A Building lease agreement as follows:
    Term – 37 months – 05/01/15 to 05/31/18
    Monthly rent – 20K, 5% increase annually
    1 month Abatement – 05/01/15-05/31/15

    1) Are we using 37 or 36 months in Rent Schedule and Deferred Revenue Schedule? Considering 1 month is Abatement and 36 is the actual payment month.

    2) Are we recognizing 2 month of rent (May and June)for Fiscal year 06/30/15? with One month equivalent to be set as deferred rent?

    Thank you!

    • hhadmin says:

      AJ –

      The deferred calculation should be based on the lease term. Therefore, if the lease is a 37 month lease it should be calculated on 37 months beginning in May.

      Jeffery W. Patterson, CPA, MBA

  5. AJ says:

    Hi Jeffrey,
    With regards to deferred rent calculation:
    Term – 61 months with 1 month abatement.
    Should we calculate deferred rent with 61 months or 60 months (actual payment)?

    • hhadmin says:

      Hi AJ –

      Thanks for the question. The deferred calculation should be based on the lease term. Therefore, if the lease is a 61 month lease, it should be calculated on 61 months.

      Jeffery Patterson, CPA, MBA

  6. Mira says:

    Hi Jeffery,
    Thank you for your response.
    May I confirm if Sales Tax should be a part of SL calculation or we have to expense it?
    Thank you in advance for your time and help.

  7. Hayde says:

    Hi Jeffrey,

    Thank you very much for responding to my question.

    I have a follow up question as the surrender of the 40K sq ft will not terminate the whole lease. It is still effective until year 2027 and will pay rent for the remaining floors.

    So my next question is…Can I reverse only the portion of the Deferred Rent for the surrendered space 40K sq ft using pro rated? Or, let the total 825K Deferred Rent continue to build and draw down later until the end of the lease term?

    Thanks again,

    Hayde

  8. Hayde says:

    Hi Jeffrey,

    Thank you very much for this blog! Helps a lot in understanding the accounting side of leases.

    I have a question on how the termination fee is handled and the effect on the deferred rent. The lease term is 25 years, 4 floors with a total of 120,000 sq ft. at 198K per month rent currently for the next 5 years. On March 31, 2017, the 2nd floor with 40,000 sq ft will be surrendered and we’ll pay 1.5M as termination fee. At the time of surrender the Deferred Rent will be 825K. How will I book the termination fee? Do I have to reverse corresponding the deferred rent?

    Hope you could help me.

    Thanks,
    Hayde

    • hhadmin says:

      Hayde –

      Thank you for your question. Typically, if your lease is terminated as opposed to being amended to include the new landlord, then you would need to remove the deferred rent account from the balance sheet. In order to do so, you would need to debit the deferred rent account to eliminate the entire amount. The offsetting credit could be either to reduce the rent expense account or to an “other income” account. In either case, it would be useful to disclose the transaction in the notes of the financial statement in order assist the user of the statements in understanding the effects of the transaction. You can refer to FASB ASC 840-20-55 for more information on how to book the termination penalty.

      Jeffery W. Patterson, CPA, MBA

  9. Alison says:

    Is there a difference in “free” rent vs “abated” rent? Can they be used interchangably? Are they treated the same from an accounting standpoint?

    • hhadmin says:

      Alison,

      There is no difference between free and abated rent, the terms are used interchangeably and are treated the same.

      Thanks for reading the blog,

      Jeffery W. Patterson, CPA

    • Carol says:

      What happens when your landlord sells the building to a new landlord and terminates the current lease. There is currently $200K in the deferred rent account. Please provide entry.

    • hhadmin says:

      Carol –

      Thank you for your question. Typically if your lease is terminated as opposed to being amended to include the new landlord, then you would need to remove the deferred rent account from the balance sheet. In order to do so you would need to debit the deferred rent account (in your case for $200,000) to eliminate the entire amount. The offsetting credit could be either to reduce the rent expense account or to an “other income” account. In either case, it would be useful to disclose the transaction in the notes of the financial statement in order assist the user of the statements in understanding the effects of the transaction.

      Jeffery W. Patterson, CPA

    • Mira says:

      Hello,
      Thank you for this blog, it’s really helpful.
      May back to question about renewals.
      If lease agreement renew every three year should we calculate SL expense separately for each three year or we have to recalculate it based on full term (as 3+3+3)?
      Thank you

    • hhadmin says:

      Hi Mira –

      Thank you for your question and interest in our blog. Renewals and extensions of operating leases are treated as new agreements.

      Jeffery W. Patterson, CPA

  10. Sharon says:

    Hi Jeffery,

    Suppose: Company enters into a 180 month lease with 18 calendar month rent abated. The Leasehold improvement were substantial completed April 15 and the company moved in on May 15th. The landlord prorated, charged and abated the rent for the month of April.
    1. Do I straight line the rent expense over 180.5 months and expense .5 months in April.
    2. Since I only got credit for 1/2 months rent in April should I expect to get 1/2 month credit in the 19th month

    Thanks

    • hhadmin says:

      Sharon –

      When did the 180 month lease term actually commence? That should be the point as to when the expense would need to start being recognized. Rent would be recognized over the duration of the lease period from the commencement date. For instance, if May is the first month, and starts the first period for rent abatement for the 18 months, you would begin amortizing rent effective May 1st. If the 180 month period began April 15 the recognition of rent expense should start in April with ½ month of calculated straight line rent. If only ½ month of credit was given for April and the company is entitled to full 18 months of rent abatement, then you would expect that ½ month would be credited during that 19th calendar month, with ½ month credit and ½ month payment responsibility of the company. If the leasehold improvements were completed in April and the company could have moved in during April but didn’t, and the landlord provided an additional ½ month of rent abatement (last half of April) on top of the 18 months per the lease agreement, you could argue that the additional ½ month of rent abatement provided is immaterial to the overall 180 month lease and not do anything for the month of April.

      Thanks for reading the blog,

      Jonathan Poppel, CPA

    • Carol says:

      If operating expenses are charged separately from rent and there is a rent ‘holiday’ and the abatement period includes both the rent and the operating expenses, do I need to straight-line the operating expenses in addition to the base rent?

    • hhadmin says:

      Hi Carol,

      Operating expenses should be recorded as incurred and only the lease payments should be expensed on a straight-line basis. Thanks for reading the blog.

      Jeffery W. Patterson, CPA

    • Tonya says:

      How would I account for a lease billing in one fiscal year but is actually for lease in the current fiscal year and paid in the current year.

      Example:
      Fiscal year ends 08/31
      Bill received for monthly lease rental and other operating expenses.

      No accrual was done as of yet.

      Bill paid in September (the following fiscal year)
      with appropriate expense accounts noted.

      Please advise.

      Thanks

    • hhadmin says:

      Hi Tonya,

      Lease expenses should be recorded as expenses in the period in which they occur. If the fiscal year ends on August 31, and the bill for the August lease payment is not received and paid until September, the lease expense should be recorded for August and an amount should be recorded in accounts payable.

      Thanks for reading,
      Jeffery W. Patterson, CPA

    • Nola says:

      I came across this discussion and finds it very helpful. I do have some questions as I am working on similar leases with yearly rent increases and lease incentives.

      The situation is: The 1st six months are free, the 7th to 12th month, there is a partial rent abatement of approx. $3,500. We also receive moving and tenant improvement allowances.

      Lease is for 7 years and I straight lined lease expense over the life of the lease. Monthly lease expense excluding amortized lease incentive is approx. $35,640.

      Minimum lease payment in year 1 is $38,800. Total lease incentive approx. $271,000 (incl TI and moving allowances) which is amortized over the life of the lease and equals to approx. $2,988 per month.

      Since my 1st 6 months are free, what would be my entry in the first 6 months? Also, would my recurring entry be:

      Dr. Rent expense $35,640
      Dr. Deferred asset/lease Incentive $2,988
      Dr. Deferred asset. $672 ( excess payment over expense)
      Cr cash. $38,800

      To record the incentive:
      Dr. Other receivable. $271k
      Cr. ST/ LT deferred liability $271k

      I need your help to get some perspective on these entries.

      Tnx

    • hhadmin says:

      Nola

      To determine your lease expense you would need to take the minimum payments over the life of your lease, in your case for 7 years. Beginning in the first month, you would record the excess over the expense as deferred rent payments. Your debit would be to rent expense and your credit would be to your accrued liability in the first six months. Subsequent to that you would debit your expense, credit cash and the difference would be your deferred rent.

      Thanks for reading the blog!

      Jeffery W. Patterson, CPA

    • Natalie says:

      Hi,

      How would you account a lease where the tenant would pay percentage rent in the first three years of the lease and will pay base rent starting in year four? Would you straight line rent starting in year four or does it revert back to when the lease term began? Also do you know of what guidance would support this situation. Thanks!

    • hhadmin says:

      Natalie,

      Your situation is a unique situation that I am not aware is specifically covered by any guidance. The guidance that is out there is for your traditional lease arrangements that have escalating lease payments. This was put into place so that companies didn’t enter into lease arrangements with payments that were significantly inflated on the back end or had upfront rent holidays and be allowed to recognize reduced expenses in the beginning years of the lease. In your situation, since you have percentage rent that is applicable in the first three years, it would make sense to recognize the actual rent incurred for that year since it is variable to your percentage rent base. Usually, I see percentage rate based off of net sales/revenues, however your base may be different. Accordingly, this rent expense will vary in direct relation to the base that is being used to calculate the base rent. Starting in year four, when base rent commences, you would want to calculate the straight -line lease expense over the remainder of the period. Any further percentage rent above and beyond the base rent starting in year four, would be recognized in the year it occurs. Since it is difficult to determine what the percentage rent is going to be since the base that will be used is undeterminable up front, I believe there is good support to approach it this way. Of course, if your percentage rent is not paid monthly, you will still want to make sure to recognize a portion of your rent expense each month through the first three years based upon the estimate percentage rent incurred for that month. Then in year four, you can start recognizing the expense monthly on the straight-line basis.

      Thanks for reading the blog.

      Jonathan Poppel, CPA

  11. ile says:

    What happens if in addition to regular rent payments (e.g. $17K/month expensed on SL basis, but pay $1900 every month currently), you are invoiced with additional operating expenses that vary month to month (e.g. $1K in a particular month)? Would the additional operating expense ($1K in this example) simply be an additional expense/payable entry not included in our straight-line deferred rent and expense entries? Or is it included?

    • hhadmin says:

      Hi Ile –

      An entity is required to disclose the minimum future lease payments and to record those on a straight-line basis. An additional operating expenses would be an additional expense.

      Jeffery W. Patterson, CPA

  12. Marlon Alvarado says:

    Hello,

    I have a question. If the lease has been extended during the term of the lease and base rent amount has changed in the current term, how am I supposed to adjust the Straight Line Rent Schedules.

    • hhadmin says:

      Marlon:
      If there is a modification of future lease payments, that modification should be accounted for by the lessee prospectively over the term of the modified lease.

      Jeffery W. Patterson, CPA

  13. Debbie says:

    Hi Jeffrey,

    Have you seen a software or can excel do it for tracking “many” of these types of leases? Excel spreadsheet is getting big so hoping for an easier way to track plus updating changes is time consuming.

    Thanks

    • hhadmin says:

      Hi Debbie –

      There may be software that can track your leases for you, however typically is it done through Excel. There may be a template available to help you consolidate and track your many leases.

      Jeffery W. Patterson, CPA

    • Kim says:

      Did you ever find a template to track your leases?

  14. KEBL says:

    Can you clarify, and provide the applicable IRS reference, why I would be required to pay taxes on the portion of my father’s pension that he specifically deferred taking while he was alive [so he only took a partial pension] so he could leave it to me in order to take care of my mother? Why isn’t this considered an inheritance and non-taxable?

    • hhadmin says:

      You may want to check out IRS Publication 559. Assets that you inherit are not taxable to you, but any income earned on these assets is taxable to the beneficiary. In other words, if you father were still alive, he would have paid tax on the pension, so the beneficiaries must then pay tax on the income.

      Donna H. Laubscher, CPA

  15. Dave B says:

    Question: Suppose during the term of the lease, a portion of the space is relinquished (lets say 1/3) and the rent is proportionately reduced. What happens to the existing deferred rent on the books? Change in Estimate? PPA? Will the gain / loss flow through income or equity? Thanks!

    • hhadmin says:

      Hi Dave –

      Sorry it took so long for a response. I needed to consult others and get some information to answer it properly. FASB ASC 840-20-55-4-to 6 may provide some insight into this situation although it discusses an increase in rent over a shortened lease period. The same principle applies in that if there is a modification of future lease payment, that modification should be accounted for by the lessee prospectively over the term of the modified lease. Therefore it would not be a change in estimate nor would it require a prior period adjustment. You would then be required to recalculate what the deferred rent would be as of the relinquishment date, considering the revised lease rates going forward and compare that to the deferred lease liability on the books at that date. The difference would then need to be amortized over the remainder of the lease and the change recorded in the deferred lease liability going forward.

      Jeffery W. Patterson, CPA

  16. Khouly says:

    Thanks Jeffery for the example. So easy and clear.

    I appreciate if you can extend the example to include the treatment in year 2 and also the required disclosure in year 1 & 2. Let me figure this out and please correct me if I am wrong:

    Year 1
    DR Rent expense 6,720
    CR Bank/Cash 6,000
    CR Deferred rent payable 720

    Disclosure in year 1 – minimum lease payments is 33,600 – 6000 = 27,600

    Year 2 deferred rent payable is calculated as follows:
    Accumulated payments = 6,000 X 2 = 12,000
    Accumulated rent expense = 6,200 X 2 = 6720 X 2 = 13,440
    Deferred rent – year 2 = 13,440 – 12,000 = 1,440 –> BS

    • hhadmin says:

      Your year 1 debits, credits and disclosure are correct. In year two, your debits and credits would be the same as year one, your total deferred rent would be $1,440, and your disclosure would again be reduced by $6,000. Year 3 however you would debit rent expense $6,720, credit cash $7,200 and debit your deferred rent payable $480. Your disclosure would then be reduced by $7,200 for each remaining year.

      Jeffery W. Patterson, CPA

  17. Gavin Turner says:

    I understand now

    my debit is my straight line expense
    my credit is cash
    my other credit is the difference between Staright line expense and cashout

    Thanks alot.

  18. Gavin Turner says:

    I am curious. I am a staff auditor 1st year and I and in this situation right now with a client. Thank you for explaining this although I am getting a little confused.

    I understand I would credit the excess amount to a deferred rent, but what would be my debit?

  19. Pricilla says:

    Is there a need to apply staightline basis for real estate properties operating leases too.

    • hhadmin says:

      Hi Pricilla,

      Yes, this does apply to an operating lease involving real estate. Thanks for your question and for reading the blog!

      Jeffery W. Patterson, CPA

  20. Sumit Tony says:

    Thanks for the clarification. What will happen in case the lease agreement give right to lesse to renew the lease period with an esclation after its original expiry?

    • hhadmin says:

      An organization is required to disclose a schedule by years of minimum future rentals on noncancelable leases as well as a general description of the leasing arrangement including the existence and terms of renewal or purchase options and escalation clauses.

      Jeffery W. Patterson, CPA

  21. steven says:

    very good explanation. how would you show the minimum required rental payments under the lease for year 2,3,4,5? Would you show $560 x 12 for each year in the notes in the financials or would you show the escalating amounts for each year that they would actually pay?

    • hhadmin says:

      Steven,

      Disclosure would include the future minimum lease payments under the lease (in essence, the cash payments). This discloses the minimum lease commitments that the entity is contractually obligated to. Furthermore, the entity would need to disclose its accounting policy for calculation of rent expense on the straight line basis and the differences between the recognition under the SL basis and actual cash payments is reflected as a deferred rent liability. For government entities the accounting for escalating leases are handled differently per GASBS 13.

      Jeffery W. Patterson, CPA

    • JASON says:

      We have a 36 month lease, escalating every year with a twist. We have full access to the property for only 30 months (2 months during the summers the property rented can be used by the landlord as needed) 2 Questions:
      1. Do we even use a deferred rent approach since the use is not guaranteed?
      2. If we do use the deferred rent approach is the amount SL over 30 months, skipping the 2 months each year or over 36 months?
      I have searched high and low and cannot find anything resembling this besides a rent holiday, but that assumes the renter has access to the rented space. Any help would be greatly appreciated.

    • hhadmin says:

      FASB indicates that the lease obligation is the amount equal to the minimum lease payments at the beginning of the lease. It also indicates that the minimum lease payments should be recorded on a straight-line basis over the total length of the lease. So in your case, if the length of your lease is 36 months, you would straight-line your total payments over that period, even if you may not have access to the property during a portion of that lease.

      Thanks for reading the blog,

      Jeffery W. Patterson, CPA

    • David says:

      Hello,

      What about a situation where the lease terms are amended? For example, the original lease term was for 5 years starting at $1,000/month for the first year and increasing by $50 dollars every year so the deferred rent liability would be:

      End of Year 1= $1,200
      End of Year 2= $1,800
      End of Year 3= $1,800
      End of Year 4= $1,200
      End of Year 5= $0

      After Year 3, the client signs a replacement lease agreement on the same property with different terms. What would happen to the $1,800 deferred rent liability that is sitting on the books? Thanks

    • hhadmin says:

      David –

      FASB ASC 840-20-55-4 to 6 may provide some insight into this situation. The modification should be accounted for by the lessee prospectively over the term of the modified lease. Therefore, it would not be a change in estimate nor would it require a prior period adjustment. You would then be required to recalculate what the deferred rent would be as of the replacement date, considering the revised lease rates going forward and compare that to the deferred lease liability on the books at that date. The difference would then need to be amortized over the remainder of the lease and the change recorded in the deferred lease liability going forward.

      Jeffery W. Patterson, CPA, MBA