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. Straight-line recognition is commonly applied to fixed asset depreciation and intangible asset amortization. It is also applied to other types of expenses such as a prepaid insurance agreement and certain revenue streams such as subscription agreements. Specifically, under ASC 840 and ASC 842, the straight-line method is used for the recognition of rent expense and rental revenue from operating leases.
In this article, we will discuss straight-line rent expense calculations for leases. Under current US GAAP, the FASB states that even 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 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.
Please see our article Operating Lease Accounting under the New Standard, ASC 842: Full Example and Explanation for a thorough discussion of operating lease accounting and transitioning to ASC 842.
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.
- Free Rent or Rent Abatements – 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 we walk through below demonstrates how to calculate the straight-line rent expense for a lease agreement with rent escalations.
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 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 $1,313,967. See Schedule 1 below:
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). See Schedule 2 below:
In this example, we calculated a straight-line rent expense of $131,397 per year. We can see from Schedule 2, that the annual payments begin at $120,000 and increase each year to reflect the 2% rent escalation but that 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.
Straight-line is an accounting term which refers to the recognition of a constant amount over a specific time period. This article discussed and provided an example of the calculation of straight-line rent expense, but the straight-line method can have many applications. Lease agreements may include rent abatements, allowances, 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.