## 2. Example of lease accounting for escalating rent payments

Let’s look at an example of recording lease expenses when there are escalating rent payments. Company ABC, lessee, entered the following lease agreement:

 Leased property Office space Lease term 2 years Lease payments Year 1 = \$10,000/month Year 2 = \$11,000/month

We will also assume there are no other unusual terms in the agreement (e.g., purchase option) and the lease is classified as an operating lease.

The monthly rent expense can be calculation as follows:

 Monthly Rent Expense = \$252,000* = \$10,500 24 months

(*) Total rent payments = \$10,000 x 12 + \$11,000 x 12 = \$252,000

Relationships between rent expenses, rent payments and deferred rents are presented in the table below:

 Year Month Rent Expense Rent Payment Monthly Deferred Rent Cumulative Deferred Rent 1 1 10,500 10,000 500 500 1 2 10,500 10,000 500 1,000 1 3 10,500 10,000 500 1,500 1 4 10,500 10,000 500 2,000 1 5 10,500 10,000 500 2,500 1 6 10,500 10,000 500 3,000 1 7 10,500 10,000 500 3,500 1 8 10,500 10,000 500 4,000 1 9 10,500 10,000 500 4,500 1 10 10,500 10,000 500 5,000 1 11 10,500 10,000 500 5,500 1 12 10,500 10,000 500 6,000 2 13 10,500 11,000 (500) 5,500 2 14 10,500 11,000 (500) 5,000 2 15 10,500 11,000 (500) 4,500 2 16 10,500 11,000 (500) 4,000 2 17 10,500 11,000 (500) 3,500 2 18 10,500 11,000 (500) 3,000 2 19 10,500 11,000 (500) 2,500 2 20 10,500 11,000 (500) 2,000 2 21 10,500 11,000 (500) 1,500 2 22 10,500 11,000 (500) 1,000 2 23 10,500 11,000 (500) 500 2 24 10,500 11,000 (500) - 252,000 252,000 -

During the first month, rent expense equals \$10,500 (by the way, monthly rent expense does not change) and the rent payment is \$10,000. The difference of \$500 (positive amount) represents deferred rent. Because this is the first month, the cumulative deferred rent is also equal to \$500. During the second month, rent expense is \$10,500 and the rent payment is \$10,000 again resulting in a monthly deferred rent of \$500. Cumulative deferred rent during the second month is \$1,000 (i.e., \$500 from the first month plus \$500 from the second month).

At the end of the 12th month the cumulative deferred rent reaches its highest amount (i.e., \$6,000). Starting with the 13th month, the monthly rent payment increases to \$11,000 while rent expense remains \$10,500. This results in a negative monthly deferred rent of \$500 which will continue to be negative until the end of the lease term. Negative monthly deferred rents gradually decrease cumulative deferred rents to zero.

Cumulative deferred rent is what will be recorded in a deferred rent liability account. Note that the entire amount of cumulative deferred rent is shown as a current liability at the end of the first year (i.e., 12th month) because the cumulative deferred rent balance will be liquidated within the next 12 months.

Company ABC would make the following monthly journal entry during the first 12 months of the lease term:

 Account Titles Debit Credit Rent Expense \$10,500 Cash (Accounts Payable) \$10,000 Deferred Rents \$500

During the next 12 months (after monthly rent payments change from \$10,000 to \$11,000), Company ABC would make the following monthly journal entry:

 Account Titles Debit Credit Rent Expense \$10,500 Deferred Rents \$500 Cash (Accounts Payable) \$11,000

At the end of the lease term, the company would recognize \$252,000 in rent expense and rent payments and the cumulative deferred rents would equal zero.

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