Deferred Rent: Understanding the Impact of Changes Brought by ASC 842
The transition from ASC 840 to ASC 842 has significantly changed how organizations report their leases.
What is Deferred Rent?
Deferred rent occurs in lease accounting when the cash rent payments are different than its recognized financial statements and often occurs when a lessee is given free rent in one or more periods.
Consider the following as a practical example. The Vice President of Real Estate in an organization acquires a new location asset for the firm and, in so doing, negotiates a period free of rent payments at the beginning of the lease since the firm will need time to build out the interior of the new location and coordinate the firm's move-in. That free rent period will cause there to be deferred rent recorded on to the lessor's balance sheet.
The Transition to ASC 842
Under ASC 840 and IAS 17, the old lease accounting standard, deferred rent would be calculated by determining the difference between the actual cash rent paid per period and the periodic straight-line rent expense -- i.e., the sum of the periodic rental payments over the entire term of the lease including any free rent periods divided by the overall length of the lease -- resulting in an average rent.
A lease without free rent and rental increases would typically not have deferred rent since the cash payments and straight-line rent expense would be the same every period -- the actual cash flows would not change.
Note: Other items can affect the average or straight-line rent, including initial direct costs and other lease incentives.
Therefore, while certain leases might not have deferred rent, it is more common that a lease has deferred rent. Furthermore, it is the current sum of the deferred payments from each period, known as the cumulative deferred rent balance, that is relevant to the adoption of, and transition to, the new lease accounting rules -- ASC 842 and IFRS 16.
When adopting the new accounting standards, ASC 842 and IFRS 16, the cumulative deferred rent balance under ASC 840 and IAS 17 is treated as a finance adjustment to the Right-of-Use (ROU) Asset balance sheet.
The ASC 842 Solution
Since cumulative deferred rent is such a key component of adoption and transition, any lease accounting software that intends to solve a firm's or lessor's lease management and rent accounting needs must provide a method or mechanism to address the existing ASC 840 / IAS 17 cumulative deferred rent balance.
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