## 3. Example of lease accounting for rent holidays

Let us now look at a different example. Company ABC, lessee, entered the following lease agreement:

 Leased property Warehouse space Lease term 2 years Lease payments Months 1-3 = \$0/month Months 4-12 = \$4,000/month Months 13-24 = \$5,000/month

As we can see, the landlord provided Company XYZ with three months of free rent. This three-month period is called a rent holiday.

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 = \$96,000* = \$4,000 24 months

(*) Total rent payments = \$0 x 3 + \$4,000 x 9 + \$5,000 x 12 = \$96,000

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 4,000 - 4,000 4,000 1 2 4,000 - 4,000 8,000 1 3 4,000 - 4,000 12,000 1 4 4,000 4,000 - 12,000 1 5 4,000 4,000 - 12,000 1 6 4,000 4,000 - 12,000 1 7 4,000 4,000 - 12,000 1 8 4,000 4,000 - 12,000 1 9 4,000 4,000 - 12,000 1 10 4,000 4,000 - 12,000 1 11 4,000 4,000 - 12,000 1 12 4,000 4,000 - 12,000 2 13 4,000 5,000 (1,000) 11,000 2 14 4,000 5,000 (1,000) 10,000 2 15 4,000 5,000 (1,000) 9,000 2 16 4,000 5,000 (1,000) 8,000 2 17 4,000 5,000 (1,000) 7,000 2 18 4,000 5,000 (1,000) 6,000 2 19 4,000 5,000 (1,000) 5,000 2 20 4,000 5,000 (1,000) 4,000 2 21 4,000 5,000 (1,000) 3,000 2 22 4,000 5,000 (1,000) 2,000 2 23 4,000 5,000 (1,000) 1,000 2 24 4,000 5,000 (1,000) - 96,000 96,000 -

During the first three months, the company does not have to make any rent payments, so the full rent expense is recorded as deferred rents on the balance sheet. At the end of the 3rd month, cumulative deferred rents equal \$12,000 (i.e., \$4,000 x 3 months). During the following nine months, the monthly rent expense equals rent payments, so the company does not need to record any monthly deferred rents. The balance in the cumulative deferred rents account remains \$12,000. During the last 12 months, the company’s rent payments are \$5,000 while rent expense is \$4,000 resulting negative monthly deferred rents of \$1,000. Such negative deferred rents reduce the cumulative deferred rents balance to zero at the end of the lease term.

Company XYZ would make the following monthly journal entry during the first three months of the lease term:

 Account Titles Debit Credit Rent Expense \$4,000 Deferred Rents \$4,000

As you can see, there is no entry to a cash or accounts payable account because during the first three months the company does not have to pay rent (i.e., rent holiday); however, the company still needs to recognize rent expense.

During the next nine months (after monthly rent payments change from \$0 to \$4,000), Company ZYX would make the following monthly journal entry:

 Account Titles Debit Credit Rent Expense \$4,000 Cash (Accounts Payable) \$4,000

During these nine months, the company would not have to record any deferred rent because monthly rent payments equal rent expense. Note, however, that the company already recorded \$12,000 of deferred rent during the first three months of the lease term and these cumulative deferred rents remain unchanged during the nine months.

During the last 12 months (after monthly rent payments change from \$4,000 to \$5,000), Company ZYX would make the following monthly journal entry:

 Account Titles Debit Credit Rent Expense \$4,000 Deferred Rent \$1,000 Cash (Accounts Payable) \$5,000

At the end of the lease term, the company would recognize \$96,000 in rent expense and rent payments and the cumulative deferred rents would equal zero.

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