Last Updated on February 28, 2023 by Morgan Beard
As companies transition to the new lease accounting standard, ASC 842, they face many new challenges. One of the more difficult hurdles in the final stages of the transition process is figuring out what to do with deferred rent liabilities that were required under ASC 840.
Under ASC 840, operating leases with escalating rent payments were accounted for in a straightforward fashion. Rent expense was recognized on a straight-line basis, with the deferred rent liability account handling the imbalance between the straight-line expense and the actual cash payments made.
ASC 842 does away with the deferred rent account. All accounting for operating leases under the new standard is contained within a right-of-use asset and lease liabilities, reported on the Balance Sheet Account. This leaves many lease accountants wondering if they’re handling the transition appropriately and accurately capturing deferred rent going forward.
Deferred rent can be complicated under the new standard. Here’s what you need to look out for when it comes to deferred rent for ASC 842.
What is Deferred Rent?
In accounting terms, deferred rent is a liability that historically was created through leasing activities. For operating leases, it’s the result of a difference between the actual cash paid and the straight-line expense recorded on a lessee’s financial statements. If a tenant is provided free rent in one or more periods an entire lease term, or if there are escalating lease payments, the actual cash payment will not match the recognized straight-line expense. This creates a situation where deferred rent is created on the books.
In most cases, deferred rent is a liability that increases over the initial part of a lease term as payments start low and gradually increase. By the end of the term, deferred rent gradually decreases to zero.
The Difference Between Prepaid Rent and Deferred Rent
While it may seem as if prepaid rent might follow the same accounting procedures as deferred rent, this is not the case.
Remember the deferred payments are a liability. It occurs when a lessor provides a period or periods of free months rent to the lessee, often at the start of a lease. Deferrals in rent also occurs when the straight line rent does not match the cash paid. A key example of this would be rent escalations. Whereas prepaid rent is simply rent paid upfront, and an expense that will be expensed in a future period.
Transitioning Deferred Rent From ASC 840 to ASC 842
ASC 842 brings many changes. Companies transitioning from ASC 840 to ASC 842 face many challenges and have many questions. One of the most common is, “How do I handle my deferred rent accounts?” It’s a pertinent question because it’s not immediately clear how the accounts should transfer, and on what date, under the new guidance.
The proper time to make the transition is the company’s date of ASC 842 adoption. On that date, a lessee measures a ROU asset equal to the lease liability, adjusted for the following amounts: prepaid or accrued rent; the remaining balance of any lease incentives given to the lessee by the lessor; any unamortized initial direct costs, and any impairments of the ROU asset.
The starting point for the measurement of the ROU asset is the lease liability. The accounting treatment is calculated as the present value of lease payments, which includes any fixed payments less any lease incentives paid or payable to the lessee.
After the lease liability is determined, you begin the ROU measurement by determining the lease liability value and then adjusting for prepaid rent, accrued rent, initial direct costs, lease incentives, and any impairments. Because of the adjustments, it’s common for the lease liability to not match the ROU asset at the adoption date.
Deferred Rent Example: Transitioning to ASC 842
Here is a basic example with the journal entries necessary to account for an existing deferred rent liability transitioning from ASC 840 to ASC 842.
In this scenario, the lessee has a real estate lease contract for a storefront building with an annual rent increase of 2%. Under ASC 840, the lessee has accounted for the lease rent expense on a straight-line basis and properly recognized a lease liability throughout the term.
On the date of transition to ASC 842, the deferred rent liability balance is $100,000. There are no lease incentives or initial direct costs. Lease liability calculations have been done and equal $1,500,000. Here are the journal entries:
|Deferred rent liability||$100,000|
If the lessee had not properly recognized the deferred rent liability under ASC 840, the journal entries would look like this:
In this set of journal entries, the debit to the retained earnings account is an adjustment for an expense that should have been recognized in prior periods. These sorts of adjustments have been common during the transition to ASC 842.
Why You Need a Plan for Deferred Rent
An operating lease without free rent periods or rent escalation will not typically have deferred rent. In those cases, the straight-line rent expense and actual cash payments are the same in every period. Therefore, actual cash flows don’t change.
But under ASC 842, there are a few items that can change an average rent payment or a straight-line rent expense. This includes any initial direct costs and lease incentives. In these cases, there will be a discrepancy between the straight-line expense and actual cash payments.
So, even if you’re looking at an operating lease without any rent-free periods, you still need a plan for deferred rent. Learning how to properly credit and debit the ROU asset and lease liability accounts, and properly account for deferred rent, is an essential skill for a successful ASC 842 transition.
Since it’s far more common to have a cumulative deferred rent balance at the time of transition, you’ll need to know how to properly adjust the ROU asset. And you’ll also need to consider the other items that make up an ROU asset adjustment, like initial direct costs and impairments.
It’s all these intricacies that have made deferred rent one of the trickier parts of an ASC 842 transition. Help from finance experts is always recommended when undergoing such sweeping changes. It’s also a terrific opportunity to have lease accounting software that can help you manage the ROU asset and lease liabilities and ensure compliance with the new standard.
Occupier Keeps You Compliant With ASC 842
Properly handling deferred rent liabilities is just one of the hurdles in an ASC 842 transition. When you add in the unique circumstances of your business and your lease contracts, lease accounting can start to consume time and resources that you’d rather dedicate to more important tasks like financial analysis and strategic planning.
You need a comprehensive software package that you can trust to free up your staff and streamline your lease accounting.
Occupier’s lease management software lets you manage the lease accounting life cycle with ease. Recognizing every lease, generating journal entries, and closing the books and reviewing the income statement has never been easier. Occupier allows you to seamlessly calculate the ROU asset and lease liabilities, all automated with ease in an incredibly user-friendly interface. You and your team can also be confident that your company is maintaining compliance with ASC 842 or IFRS 16 without having to be an expert in lease accounting standards.
With Occupier’s intuitive and innovative tech stack, you remove the silos between departments and empower all your teams to collaborate and strategize. To find the solutions that fit your unique business, schedule an Occupier demo today.
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