Prepaid rent is something that most tenants will need to deal with at some point. For some, this is an ongoing bookkeeping concern that impacts balance sheets month after month. As the name suggests, prepaid rent is rent paid prior to the rental period it's related to in a tenant-landlord contract. On the landlord's end, prepaid rent is actually referred to as unearned rent. A landlord will keep the rental amount on a balance sheet instead of placing it on an income statement until the rent is "earned" in the following month.
Why Is Prepaid Rent Common?
Tenants commonly pay rent in advance simply because they want to avoid late rental payments. Some landlords actually require prepaid rent for high-value, specialized properties. While many tenants pay 12 months in advance, any rental payment that arrives prior to the official payment due date is technically considered prepaid rent.
While common, prepaid rent can still create some bookkeeping confusion for tenants. Take a look at the basics of how to account for a rent expense that is paid in advance.
How to Handle Prepaid Rent
First, it's helpful to know that the IRS defines "a rent expense" as the amount paid for the use of any property not owned by the entity using the property. Prepaid rent expenses are calculated based on the specific monthly rent included in a rental agreement. In a case where a tenant prepays $10,000 for a one-year lease, the landlord will need to "credit" cash for $10,000 while they also "debit" rent for the same amount. Ultimately, the landlord is keeping the prepaid rent as an asset until the month when the charge is applied to actual rent costs; at this point, it is then charged as an expense.
In a situation where a tenant pays the $10,000 to cover the entire year in advance, it's necessary to adjust the books monthly to account for the shifting value of the asset. The tenant will have used up one month of the lease agreement by the end of the first month. This means that the books must be adjusted to reflect the value of $10,000 x 1/12. The tenant will repeat this every month until the prepaid balance no longer has value as an asset because it's down to $0.
The first entry for prepaid rent doesn't technically impact a tenant's financial statements because the credit and debit are effectively canceled out. However, the subsequent adjustments will impact financial statements because they all represent further decreases in assets with increases in expenses.
What Is Prepaid Rent Classified as in Accounting?
Prepaid rent is initially classified as an asset. That's because it offers a future economic benefit to the tenant. Prepaid rent is considered an expenditure that has not yet been recorded as an expense even though it is something that the tenant has paid for in advance. As a result, prepaid rent is paid during one period even though it isn't recognized until a subsequent period.
What Happens If a Prepaid Rent Expense Isn't Shifted From an Asset to an Expense?
If a landlord forgets to shift prepaid rent from an asset to an expense in the month that the rent is "consumed" by the tenant, this can create a problem where you're underreporting the expense while reporting too much for the asset. For companies that deal with prepaid rent, failing to make the shift can lead to false income and balance sheet statements. The shifting of prepaid rent for each month that a lease agreement is in place is something that should be checked each month before the books are closed.
Adam Luehrs is a writer during the day and a voracious reader at night. He focuses mostly on finance writing and has a passion for real estate, credit card deals, and investing.