A deferred rent concession is a period at the beginning of an operating lease -- typically an operating lease for real estate -- where the lessee is not contractually obligated to make rent payments, or to only make reduced rent payments to the lessor. Under International Financial Reporting Standards and many national Generally Accepted Accounting Principles, the term "deferred rent" indicates additional rent due in future periods to compensate for the rent concession.
Rationale for Deferred Rent Concessions
Deferred rent concessions are typically granted by lessors to allow lessees the opportunity to generate operating cash flows to satisfy rent costs under the lease. Deferred rent concessions are also offered to provide incentive for a lessee to enter into an operating lease. Deferred rent concessions are most common in rental real estate, although they may be used in other operating leases as well. When deferred rent concessions are given to retail and commercial rental real estate tenants, it is often done with the understanding that the tenant will not generate operating income for a period of several months after the lease commencement. When a deferred rent concession calls for no initial payments by a lessee, it is often called "free rent."
Straight-Lining of Rent
Both International Financial Reporting Standards and many national Generally Accepted Accounting Principles, including U.S. GAAP, require that lessees in operating leases account for deferred rent concessions by straight-lining the rent over the non-cancellable period for which the lessee has contracted to lease the asset. This requirement ensures that the lessee does not unduly reflect the reduced cost of deferred rent periods as comparative operating costs during the earliest periods of the lease. Typically, it results in the lessee reporting a liability, referred to as "deferred rent'"on the balance sheet of the lessee. This liability reflects the benefit of the deferred rent concession.
Calculation of Deferred Rent
To calculate the benefit of the deferred rent concession and to record the amount of deferred rent, the lessee must calculate the aggregate cost of the leased property of the remainder of the non-cancellable portion of the lease. To illustrate, consider a lessee who enters into a five-year lease requiring the lessee to pay $10,000 per annum in rent. However, as an incentive to convince the lessee to sign the lease, the lessor offers a deferred rent concession in the form of free-rent for the first five months. Therefore, the first year's payment is only $5,000. Because the aggregate cost of the asset over the five-year non-cancellable life of the lease is $45,000, the lessee must report $9,000 per annum in rent. The difference between the $5,000 in rent actually paid in the first year and the $9,000 recorded is deferred rent.
In the above example, the lessee will make a journal entry to credit cash for $5,000 and debit rent expense for $5,000 when the first year's rent is paid. However, because accounting standards require the rent expense to be $9,000, the lessee must make a second entry to debit rent expense for $4,000 (to reach $9,000) and record a liability on the balance sheet for $4,000. This liability is the deferred rent and represents the value of the deferred rent concession.