What is Deferred Rent: Definition, Example, and Implications

By: ROS Team

Have you ever signed a lease agreement with a period of free rent upfront? Or perhaps negotiated a deal with gradually increasing rent payments? If so, you’ve likely encountered the concept of deferred rent.

But what exactly is deferred rent, and how does it work? This article aims to unpack this financial term, explaining its meaning, how it arises, and how it affects different parties involved.

What Is Deferred Rent?

In simple terms, deferred rent refers to a situation where the average rent expense recorded on your financial statements exceeds the actual rent payments you make during a particular period. This discrepancy often arises due to various lease concessions, such as:

Free Rent Periods: Landlords may offer tenants several months of free rent to incentivize signing a lease. This creates deferred rent, as no immediate payment is made while the rent expense accrues throughout the lease term.
Rent Holidays: Similar to free rent, but for specific periods within the lease, like renovations or slow seasons.
Gradually Increasing Rent: Leases with escalating rent payments create deferred rent initially, as early payments are lower than the average rent expense spread across the entire lease term.

In essence, with deferred rent, you are shifting rent payments from the beginning to the later part of the lease. This impacts how both tenants and landlords manage their finances.

What is Deferred Rent — Photo Credit: Canva

Implications of Deferred Rent

Financial Reporting

Deferred rent impacts the lessee’s financial statements by affecting the recognition of rent expenses and lease liabilities. It can distort the depiction of the entity’s financial performance and financial position if not appropriately accounted for.

Cash Flow Management

Lessees may experience fluctuations in cash flows due to deferred rent arrangements. While they may not incur immediate cash outflows for rent payments, they are still liable for these obligations in the future, which could affect budgeting and liquidity management.

Lease Analysis

Deferred rent requires careful consideration during lease analysis and negotiations. Lessees need to assess the overall financial implications of deferred rent incentives provided by lessors and understand their long-term commitments under the lease agreements.

Difference Between Prepaid Rent and Deferred Rent

While both involve paying rent in advance, prepaid and deferred rent differ in accounting treatment and nature:

Prepaid Rent: You simply pay ahead for future rent periods, treated as an asset until used, and then expensed as you benefit from the rental space. Think of it as paying for future months of an apartment upfront.

Deferred Rent: You receive concessions like free rent or escalating payments, creating a liability as you owe the full rent but haven’t paid it yet. Imagine getting free months initially, then having higher payments later to compensate.

Deferred Rent Under ASC 842

Under the older accounting standard ASC 840, deferred rent was recognized as a separate liability on the tenant’s balance sheet. Under ASC 842, deferred rent is no longer a separate line item on the balance sheet.

However, the concept still exists and is reflected in the relationship between two key accounts:

Right-of-Use (ROU) Asset: This represents the tenant’s right to use the leased asset over the lease term.

Lease Liability: This represents the present value of the total rent obligation under the lease.

The difference between the periodic decrease in the ROU asset and the periodic increase in the lease liability reflects the undiscounted deferred rent. In simpler terms, it shows how much of the rent obligation hasn’t been recognized as an expense yet.

How It Works:

Initially: ROU asset > Lease liability due to lower initial payments (e.g., free rent). This difference represents deferred rent.

Over Time: As rent expense is recognized, the ROU asset decreases, and the lease liability increases. The difference gradually shrinks.

By the End of the Lease: Both accounts reach zero, reflecting the complete recognition of the rent obligation.

Deferred Rent Example

Let’s imagine a company signs a 5-year lease for office space with the following terms:

Total Rent Over 5 Years: $60,000
Annual Rent: $12,000
Free Rent for the First Year

Under ASC 842, we wouldn’t see a separate “deferred rent” line item. However, the difference between the ROU asset and the lease liability will reflect the deferred rent initially.

Year 1:

Rent Paid: $0 (due to free rent)
Annual Straight-Line Rent Expense: $12,000
ROU Asset Decreases By: $12,000
Lease Liability Increases By: $12,000
Difference (Undiscounted Deferred Rent): $12,000 (ROU decrease = $12,000 – Lease liability increase = $12,000)

Year 2:

Rent Paid: $12,000
Annual Straight-Line Rent Expense: $12,000
ROU Asset Decreases By: $12,000
Lease Liability Increases By: $12,000
Difference (Undiscounted Deferred Rent): $0 (both accounts decrease/increase by the same amount)

Year 3-5:

Same Process as Year 2
Undiscounted deferred rent remains $0 as rent paid and recognized expense match

This example demonstrates how deferred rent under ASC 842 isn’t a separate line item but rather embedded in the dynamic between the ROU asset and lease liability, reflecting the portion of rent obligation not yet recognized as an expense.

Impact of Deferred Rent: Tenants vs. Landlords

Tenants:

Financial Flexibility: Deferred rent can offer short-term cash flow relief, especially for businesses establishing themselves or undergoing significant upfront investments.
Matching Principle: By spreading rent expense over the entire lease term, aligns with the principle of matching costs to the benefits received throughout the asset’s useful life.
Transparency: Although not explicitly shown under ASC 842, understanding deferred rent helps accurately assess future rent obligations and financial health.

Landlords:

Incentivizing Leases: Offering deferred rent options can attract tenants and secure agreements, especially in competitive markets.
Predictable Cash Flow: While initial payments might be lower, the total rent received remains the same, ensuring consistent income over the lease term.
Tax Implications: Depending on the jurisdiction, tax treatments for deferred rent may differ from regular rent payments, requiring careful consideration.

Rent Deferred: Final Thoughts

Deferred rent is a critical aspect of lease accounting that necessitates careful consideration and accurate financial reporting. Lessees and lessors must understand its implications and adhere to the appropriate accounting standards to ensure transparent and reliable financial statements.