You may wonder – with the deferred rent classification disappearing under ASC 842, how does that impact the deferred taxes that are recognized associated with my lease account balances?
This article will discuss accounting for deferred rent in a lease agreement and how the changes in the lease guidance may impact the deferred taxes a company is recognizing as they transition to the new lease accounting rules.
What is deferred rent?
Deferred rent was an account specifically defined under ASC 840 lease accounting. Deferred rent is defined as the liability resulting from the difference between actual cash paid and the straight-line expense recorded on the lessee’s financial statements. Under ASC 840, total rent expense is required to be recognized on a straight-line basis over the lease term even if rent payments vary. By crediting or debiting the deferred rent account each month, the lessee can appropriately record rent expense on a straight-line basis and capture any difference between the cash paid and the expense recognized in this account. At the end of the lease, the cumulative balance in the deferred rent account will always equal zero.
What are deferred taxes?
Deferred taxes are recognized for future tax consequences of events recorded in either the financial statements or the tax return, but not yet in both. Deferred tax liabilities are recorded for taxable temporary differences while deferred tax assets are recorded for deductible temporary differences. One of the basic principles of ASC Topic 740, Income Taxes, is that deferred taxes are recognized for temporary differences between the financial statements and tax returns.
Under ASC 740, the difference between the straight-line rent recognized for book purposes and the rent deductible for tax purposes (which is usually the cash paid) is recognized as a deferred tax asset (for the rent they have delayed paying), or the deferred rent liability.
Tax expense recognized under ASC 842
We will show in the examples below that tax expense recognized during the first year of an operating lease will often not change under ASC 842 because federal income tax standards are not changing with the transition to a new lease accounting standard.
However, the calculation of deferred taxes associated with the lease arrangements will change.
Under ASC 842, companies will see a change to the amounts recorded for operating lease assets and liabilities. Temporary differences may now be created as a result of the new ROU assets and lease liabilities recorded on a company’s books.
Companies, and more specifically tax departments, will need to understand the changes happening to the book basis of their lease portfolio in order to reconcile to the current tax basis and possibly create new deferred tax assets and deferred tax liabilities. (This article was written for illustrative purposes to consider the relationship between deferred rent and deferred taxes. This does not represent tax guidance and a company should consult the relevant tax literature and its tax professionals when determining income tax amounts to recognize on its financial statements.)
Initial direct costs
Initial direct costs (IDC) are expenses directly related to the negotiation and execution of a lease agreement, such as legal fees.
Under ASC 840, a lessee capitalized initial direct costs on the balance sheet and amortized these costs over the lease term.
ASC 842 also narrowed the scope of costs that are considered IDC by defining IDC as incremental costs that would not have been incurred if the lease had not been executed. This was a significant change – ASC 840 allowed companies to allocate a portion of internal expenses, such as a percentage of the salaries for internal real estate or legal staff, and recognize over time as an IDC. Under ASC 842, although a lessee doesn’t have a separate account for IDC, they are included in the calculation of the ROU asset so they continue to be recorded on the balance sheet and amortized over the lease term.
They can often be capitalized for tax purposes unless they are de minimis (meaning that they do not exceed $5,000 in the aggregate for US federal tax purposes). In the examples in this article, assume the initial direct costs qualify as IDC under both ASC 840 and ASC 842.
Deferred tax examples and journal entries: Applying to lease accounting
ASC 840: Deferred rent
Let’s assume that a lessee leases a building from a lessor, and the lease is classified as an operating lease. Other facts related to the lease are as follows:
- The lease term is 10 years.
- Rent payments are $100,000 in the first year, escalating 3% per year.
- Payments are made in arrears.
- The lessee incurred $10,000 of IDC related to the lease.
- Lessee has a tax rate of 30%.
- The lease is a true tax lease for income tax purposes and that rent is deductible as paid for tax purposes.
In Year 1, the lessee will make the following journal entries:
Note 1: Total lease payments of $1,146,388 + $10,000 initial direct costs divided by 10 years.
Note 2: $10,000 IDC divided by 10 years.
Note 3: The deferred rent in this example is calculated as the straight-line expense less the cash paid each year. (Deferred rent in year 1 equals rent expense of $115,639 less cash paid of $100,000 for the first year’s rent).
At the end of the first year, the lessee’s deductible expenses for tax purposes are $101,000 (actual cash paid plus Year 1 amortization of the initial direct costs), as a result, the lessee would record a current tax benefit of $30,300 ($101,000 X 30% tax rate). The journal entry to record this is:
Journal entry: Establishing a deferred tax asset under ASC 840
As noted in the second paragraph of this article, deferred taxes are recognized for temporary differences between the financial statements and tax returns. The lessee’s deductible expenses for tax purposes are $101,000 while lease expense for book purposes is $115,639 (see the journal entry above). The deferred rent of $14,639 ($115,639 – $101,000) constitutes a temporary difference that is multiplied by the company’s tax rate of 30% to determine the associated deferred tax asset.
To establish the Year 1 deferred tax asset, the lessee would record a debit of $4,392 ($14,639 x 30% tax rate):
Based on the entries above, note that the total income tax benefit is $34,692 ($30,300 + $4,392), which equals 30% of the recorded book expense of $115,639.
The entries above reflect the journal entries for deferred rent and the related tax effect under ASC 840 lease accounting rules.
For a full example of how to treat deferred rent during transition to ASC 842 check out ASC 842 Operating Lease Accounting Explained with Example.
ASC 842: ROU assets and lease liabilities
ASC 842 requires the recognition of total rent expense on a straight-line basis over the lease term. Generally, accounting for the same lease under ASC 840 (prior to a company’s transition to ASC 842) and then under ASC 842 (after a company’s transition) will have no impact to a company’s net income. As illustrated below the straight-line lease expense recognized under ASC 842 is the same as the straight-line rent expense recognized under ASC 840 for a lease with the exact same terms.
What changes upon transition to ASC 842 is the requirement that lessees record operating leases on the balance sheet. As a result, lease liabilities, which represent the present value of the lessee’s future obligations, and right-of-use (ROU) assets, which represent the lessees rights to use the underlying assets, are recorded at lease commencement.
Although the deferred rent account used under ASC 840 is eliminated under ASC 842, the difference between the straight-line rent expense and the cash paid is still reflected on a company’s books. Under ASC 842, the net activity in the lease liability and ROU asset accounts each month is essentially deferred rent.
Following is a full example of operating lease accounting for a lessee under ASC 842. Let’s assume the same facts we used in the example above, but the lessee has adopted ASC 842. In this example we will also assume that the lease agreement has met the criteria for an operating lease.The entity has determined that the discount rate at lease commencement for this lease is 3%. The lease liability at lease commencement is the present value of the lease payments ($970,874) and the ROU asset is calculated as the lease liability plus the $10,000 of IDC ($980,874).
In Year 1, the lessee will make the following journal entries:
Using the facts presented in this example, the amortization table below is for the entire term of the lease:
The entry the lessee makes at the beginning of the lease agreement under ASC 842 is to record the initial ROU asset and lease liability. Along with recognizing the asset and liability, the lessee also pays $10,000 of IDC which is recorded as an increase to the ROU asset.
Total lease expense of $115,639 is recognized at the end of the first year. Total lease expense is the sum of the liability lease expense of $29,126 and asset lease expense of $86,513. The credit side of the entry at the end of the first year will include the cash paid for the first year of $100,000.
ASC 840 vs. ASC 842: Comparison of deferred rent accounting
If you look back to the amortization table at the beginning of this section, it is apparent that deferred rent is not being separately calculated and identified as it was under ASC 840. The deferred rent account no longer exists under ASC 842, but the accounting for the difference between cash paid and straight line expense continues to be recognized each period in the financial statements.
Looking at the activity in the lease liability and ROU asset columns, you can see we are still accounting for the difference between our recognized expense and cash paid on the balance sheet. The difference between the year one lease liability reduction ($70,874) and the ROU asset reduction ($86,513) is $15,639:
Further, the balance sheet variance ($15,639) less the amortization of IDC costs ($10,000/10) equals the amount we recorded to deferred rent under ASC 840:
Additionally, total lease expense in year one is the same as year one rent expense for an operating lease under ASC 840, as the total cash payments required over the lease plus the cash paid for initial direct costs recognized in expense on a straight-line basis over the term of the lease:
Under both accounting standards, we are recording a cash payment of $100,000 and total lease expense of $115,639. Under ASC 842 periodic lease expense is made up of the periodic interest and asset depreciation shown in columns “liability lease expense” and “asset lease expense,” respectively. The periodic cash payment is now being applied to reduce both the accrued interest and the balance of the lease liability as we amortize the present value of the remaining lease payments over the term of the lease.
Journal entry: Income tax accounting under ASC 842
As a result of the similarities in expense recognition between ASC 840 and ASC 842, the lessee’s deductible expenses for tax purposes under ASC 842 are still $101,000. Year one deductible expenses equal actual cash paid ($100,000) plus amortization of IDC ($10,000/10):
The current tax benefit is calculated to be $30,300 ($101,000 X 30% tax rate). The journal entry to record this is:
It is not as simple to calculate the deferred tax impact after adoption of ASC 842 as it was under ASC 840, when we calculated this based on the deferred rent balance. However, a company will continue to recognize a deferred tax impact for the difference between the book expense recognized and the rent paid.This will be calculated considering the book/tax basis of the Right of Use Asset and the Operating Lease Liability account balances.
Deferred rent is a liability created when the cash payments and straight-line rent expense for an operating lease under ASC 840 do not equal one another. The transition to ASC 842 will result in the elimination of the deferred rent account from the balance sheet, but will generally not impact net income or tax expense. Instead, a company will need to calculate its deferred tax assets and liabilities after consideration of the new ROU assets and liabilities recorded for operating leases. Given these changes to tax accounting that are a result of the new lease accounting standards, it is important that you include your tax department in your implementation planning to ensure the impacts of the adoption of ASC 842 are appropriately considered throughout the financial statements.