Rent expense explained

Rent expense is the cost incurred by an organization for the right to use a specified asset, whether that be property, vehicles, equipment, land, etc. For many companies rent is a significant expense incurred to support their business. Sometimes rent expense can be incurred for buildings, warehouses, or offices occupied by the organization. Other times organizations rent different types of equipment – such as office or maintenance equipment – because they require more flexibility than ownership offers.

Rent expense, for calculation purposes, is a type of fixed expense, as opposed to a variable expense. As an expense, rent is normally a debit balance account, recorded on the income statement. Under ASC 840, accounting for rent was very simple for operating leases. At a high level, the lessee, or tenant, would have recorded a debit to rent expense and a credit to cash to represent the expense for the usage of the asset underlying the lease agreement incurred during the period and payment for that expense in the same period.

However, recent updates have complicated lease accounting. Organizations now have to record both an asset and a liability for their operating leases. Under ASC 842, the new lease accounting standard effective for private companies for fiscal years starting after December 15, 2021, organizations record a lease liability equal to the present value of the remaining lease payments and a right-of-use (ROU) asset equal to the lease liability with any applicable adjustments.

Lease payments decrease the lease liability. A lease expense, equivalent to the straight-line rent expense recognized under ASC 840 for operating leases, is recognized for time value discount of the lease liability and amortization of the ROU asset for operating leases. Called lease expense under ASC 842, this aggregated expense is recorded to the operating section of the income statement.

Straight-line recognition

Straight-line recognition is one of the most commonly used accounting methods whereby the total expense or revenue recorded for a period of time is allocated evenly among all the reporting periods, despite required payments varying over the same term. This method provides a systematic and rational allocation of expense or revenue and is the preferred method of allocation unless a more appropriate method is available.

The straight-line method of recording expenses is commonly applied to fixed asset depreciation and intangible asset amortization. It is also applied to other types of expenses such as prepaid insurance agreements and certain revenue streams like subscription agreements. Specifically, under ASC 840 and ASC 842, the straight-line method is used for the recognition of rent and lease expense and rental and lease revenue from operating leases.

Straight-line rent calculations for leases

Under current US GAAP, the FASB states that when rents are not constant, the lease expense should be recognized on a straight-line basis throughout the life of the lease. This method of rent expense recognition is applicable under both ASC 840 and ASC 842 for leases classified as operating leases.

The new lease accounting standard addresses the recognition of a single lease expense over the term of the lease for operating leases in ASC 842-20-25-6:

“A single lease cost, calculated so that the remaining cost of the lease is allocated over the remaining lease term on a straight-line basis unless another systematic and rational basis is more representative of the pattern in which benefit is expected to be derived from the right to use the underlying asset.”

Under both ASC 840 and ASC 842, the formula to calculate the straight-line expense is as follows: Total net lease payments divided by the total number of periods in the lease.

Straight Line Rent Expense Calculation for ASC 840 and ASC 842For an in-depth discussion of operating lease accounting under ASC 842 and a full example with deferred rent expense and journal entries, read our blog, Operating Lease Accounting under the New Standard, ASC 842: Full Example and Explanation.

Additional items within the lease agreement that need to be factored into the straight-line lease expense calculation may include the following:

  • Lease incentives – An incentive is an instance in which the lessor motivates the lessee to sign the lease by offering beneficial terms. A common example of a lease incentive is a tenant improvement allowance. If the lease incentive has not been paid at the lease commencement date, the anticipated cash inflows from the incentive are netted against the cash outflows for the lease payments and factored into the straight-line rent expense calculation. For a more in-depth explanation of lease incentive accounting please refer to this article, Lease Incentive Accounting under ASC 842.
  • Rent abatements or rent-free periods – These are instances where the lessee is not required to pay rent for a set period or recurring periods of the lease, as stated within the lease agreement. These periods of free rent or rent abatement are factored into the total net lease payments, as well as the straight-line rent expense calculation. Check out our article, Rent Abatement and Rent-Free Period Accounting under US GAAP for a more thorough discussion on rent abatements.
  • Rent escalations – Rent escalations are very common in lease agreements. These are instances where the contract stipulates an increase in base rent payments, typically either a percentage or a dollar amount, over the life of the lease. This will impact the calculation of straight line rent expense as these increases will need to be factored into the calculation. The example below demonstrates how to calculate the straight-line rent expense for a lease agreement with rent escalations.

Example: Straight-line rent expense calculation

Consider the following scenario:

A retailer enters into a 10-year warehouse lease with initial rent payments of $10,000 a month and a 2% annual rent escalation. The lease commences on January 1, 2022 and ends on December 31, 2031. Let’s assume this is an operating lease, and the retailer transitioned to ASC 842 on January 1, 2022.

How do you calculate the straight-line rent expense for the scenario above? In order to arrive at the correct answer under US GAAP, we need to sum the total net lease payments and then divide those payments by the total number of periods in the lease term.

Step 1: Calculate the total payments

The aggregate payments required under the lease total is $1,313,967.

Aggregate Payments for Rent Expense Over the Lease Term

Step 2: Calculate the rent expense by dividing the total payments by the lease term

The annual rent expense is $131,397 ($1,313,967 divided by 10 years), and the monthly rent expense is $10,950 ($1,313,967 divided by a lease term of 120 months).

Annual Rent Expense for 10 YearsIn this example, we calculated a straight-line rent expense of $131,397 per year. We can see from Step 2, the annual payments begin at $120,000 and increase each year to reflect the 2% rent escalation but the expense is consistently recognized on a straight-line basis over the lease term.

Under ASC 840, the difference between the actual cash payment and the expense recognized each period for an operating lease is accounted for in a deferred/prepaid rent account. Under ASC 842, this difference is no longer accounted for in a separate balance sheet account. The new accounting standard captures the difference between the cash payments and the expense recognized for an operating lease as the net change in the lease liability and the right-of-use asset each month.

Summary

Straight-line is an accounting term for the method of recognizing a constant amount over a specific time period which has many applications – rent, depreciation, amortization, revenue recognition. Lease agreements may include rent abatements, and/or escalations. However, the general theory of calculating the straight-line rent expense for a particular contract will remain constant: sum the total net lease payments and divide by the total number of periods in the lease.

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