When renting commercial properties, landlords often offer discounts at the beginning of the lease. This results in a graduated lease schedule requiring increasing lease payments over the term of the lease. Generally accepted accounting principles, however, require businesses to record lease payments using a straight line accounting method that averages the lease payments over the lease. This situation will result in a deferred rent expense for the business leasing the property.
What is Deferred Rent?
Rent expenses are generally shown on a company's financial statements as a consistent amount from month to month. This is known as the straight line method of accounting. This if fine where the lease rent is consistent over time. However, many leases contain rent review provisions where the rent increases in line with inflation. Others offer a rent free period at the beginning of the lease as an incentive for the tenant to sigh up. To dealing with these variable rent payments, accountants use an account called deferred rent expense.
How to Calculate Deferred Rent
Determine the monthly lease payment per year of the lease. For example, assume a four-year lease requires you to pay $1,000 per month in year one, $1,500 in year two, $2,000 in year three, and $2,500 in year four.
Now, determine the straight line rent expense for the lease. The straight line rent expense is the total amount of rent you will pay over the lease divided by the term of the lease in months. Continuing with the example from the previous step, ($1,000 x 12) + ($1,500 x 12) + ($2,000 x 12) + ($2,500 x 12) = $12,000 + $18,000 + $24,000 + $30,000 = $84,000 / 48 = $1,750. This figure represents your monthly lease obligation using the straight line accounting method.
Finally, subtract the actual monthly lease payment from the straight line lease payment figure. Continuing the same example, in year one, $1,750 - $1,000 = $750. In year two, $1,750 - $1,500 = $250. In year three, $1,750 - 2,000 = -$250. In year four, $1,750 - $2,500 = -$750. These figures represent your deferred rent expenses per month in years one through four. In this example, since the actual rent payment is greater than the straight line rent payment, you would not record a deferred rent expense in years three or four of this lease.