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Calculating straight-line rent for an operating lease that includes a rent-free period is a common scenario. However, many businesses are incorrectly accounting for this type of lease. In this article, we’ll demonstrate the correct method of performing this calculation under ASC 840.

Note: In another article, we provide a full example of accounting for an operating lease under ASC 842 that includes a rent-free period.

## What is rent abatement?

In a commercial lease agreement, rent abatement is an instance in which the tenant, or lessee, is not required to make payments for a specified period of time. This time period may be during initial tenant improvements, during landlord improvements, or it may be specified as a rental concession granted by the landlord. The specified period of time for the rent abatement is referred to as the rent-free period.

## Rent-free period accounting and calculating straight-line rent

One of our users asked the following question on calculating straight-line rent for a lease that includes a rent-free period:

We have a lease with a landlord. While construction is taking place, the landlord lets us use a smaller space during the construction period, and only charges us for partial rent during that period. My question is whether or not we should include the early occupancy period / construction period in order to calculate straight-line rent. In other words, should the full lease term include the early occupancy period / construction period?

This is a very complicated issue, but we can help simplify it. The complexity here is not just when you start straight-lining the lease, but what amounts you straight-line and when.

The simple answer to the question is yes, the lease term should include the early occupancy period where the tenant is granted access to the smaller space. To learn more about when to begin straight-lining a lease, read our blog, Lease Commencement Date: How to Know when a Lease Starts.

Another one of our readers, a Director of Finance and Accounting, asked us the following question and for clarification about partial square footage:

In your example about early access, the tenant was using partial square footage during construction. What if we aren’t occupying any part of the building during the construction period but the lease is signed?

For accounting purposes, the lease does not start until you have possession of the asset. Therefore, you will not start accounting for the lease until you are in possession even if the lease has been signed.

## What amounts do you straight line?

Under ASC 840, the FASB requires that if rent increases because the tenant gets access to additional property, then rent expense should be allocated proportionally to the fair value of the additional property. Sound complicated? Sure. Let’s simplify this with an example:

## Example lease agreement and calculation:

Assume a tenant signs a 10-year lease with a landlord commencing on July 1, 2016 and ending on June 30, 2026. The lease is for a building with a total of 100,000 SF. Significant improvements are required to get the building ready for the tenant’s use, so the landlord allows the tenant to use 10,000 SF starting from January 1, 2016.

Per the lease agreement, occupancy is as follows:

• From January 1, 2016 through June 30, 2016, the tenant will occupy only 10,000 SF of the building (early occupancy period/construction period).
• From July 1, 2016 (the commencement date per the lease document) through June 30, 2026, the tenant will occupy the entire building.

Payment schedule is as follows:

• From January 1 through March 31, 2016, rent is fully abated (no rent payments in those three months).
• From April 1, 2016 through June 30, 2016, rent is \$21/SF (or \$17,500/month) for the 10,000 SF occupied.
• From July 1, 2016 through June 30, 2017, rent is \$24/SF (or \$200,000/month) for the full 100,000 SF occupied.
• Thereafter, rent increases by 3% annually every July 1.

Assume the following:

1. This is an operating lease
2. This is not classified as a sale leaseback transaction
3. Because it is in the same building, each SF in the first 10,000 occupied is deemed to have the same fair value as each SF in the 100,000 building.
4. The tenant does not have access to the other 90,000 SF during the construction period. This is a very important point, and next week’s blog will address why and how this can change the entire accounting treatment.

### Calculating the total lease payments

Per schedule 1 below, our total lease payments for this lease is \$27,565,810.

We now have to allocate the total payment between the first 10,000 SF and the remaining 90,000 SF. Because the fair values are equal (assumption 3), we just use a percentage allocation based on the weighted average SF occupied each period. See schedule 2 below:

The schedule above is calculated as follows: In the first 6 months, the company occupies 10,000 SF, so the average occupancy over a year is 5,000SF. As a result, the expense allocated to the first 10,000 SF in the first 6 months is 137,143 (calculated as 5,000 divided by 1,005,000 multiplied by the total payments of 27,565,810). The expense calculated in the next year (July 2016 through June 2017) is 2,742,867 (calculated as 100,000 divided by 1,005,000 multiplied by 27,565,810).

On the income statement, there will be 6 months of expense of 22,857 (which is 137,143 divided by 6). There will also be 120 months of expense of 228,572 (calculated as 2,742,867 divided by 12).

### Journal entry for the first month of free rent

In January 2016, the journal entry is as follows:

 DR Rent Expense 22,857 CR Deferred Rent 22,857

To record straight-line expense and deferred rent (free rent)

Note that because no cash is paid in January 2016, the only credit is to deferred rent.

### Journal entry for the first month in which rent is paid

In April 2016 (the first time the company actually pays rent), the journal entry is as follows:

 DR Rent Expense 22,857 CR Cash 17,500 CR Deferred Rent 5,357

To record straight-line expense, cash paid and deferred rent for the difference.

### Journal entry on the first month of full occupation

In July 2016 (the first month the company occupies the remaining 90,000SF), the journal entry is as follows:

 DR Rent Expense 228,572 CR Cash 200,000 CR Deferred Rent 28,572

To record straight-line expense, cash paid and deferred rent for the difference.

That concludes our detailed explanation of the accounting treatment for a lease when early access is granted to only a portion of the leased asset.