Rent is a common expense for a business. There are various ways rent can be calculated, depending on the setup. In some instances, a business will have an agreement with a landlord for deferred rent, often because the landlord offered one or more free months in the early days of the tenant’s lease. You may see this on the business’ balance sheet as “deferred rent liability,” which is simply how the accountant divided the payments up over the course of a certain period in order to make budgeting easier.
What Is Deferred Rent Liability?
If you sign a lease on an apartment, and the first month is free, you’ll simply enjoy a month of making no rent payment. But it isn’t so easy for a business, especially if that free rent is extended over several months. Businesses need to show monthly operating expenses for a variety of reasons. To make this easier, accountants use something called deferred rent liability, where they take an entire year’s rent and divide it by 12 in order to come up with a monthly rent payment for the balance sheet.
Accountants will sometimes refer to this type of accounting as straight-line accounting, which simply means the rent expense is evened out over the terms of the lease. A similar concept applies to the budget billing that utility companies offer their customers. Instead of having a bill that fluctuates from month to month, you can opt to have your bill estimated and averaged up over the course of a year. This makes it easier to reach your monthly household budget, since you’ll know how much is going to your electric or water bill every month. The same principle applies to business budgeting.
Deferred Rent and Uneven Payments
This form of accounting can also be applied if a business deals with uneven monthly payments. You may, for instance, be given a discount by the landlord during December to account for the many days your office will be closed for the holidays. If your business must vacate the space for a period of time due to construction or building damage, your landlord may waive your rent during this time period, forcing you to recalculate your budget for the year.
Hidden expenses can also make rent payments uneven, as well as unpredictable. Unfortunately, this can make budgeting the right amount for rent complicated, since expenses like building maintenance fees can fluctuate over time. For that reason, a business may round up that figure to ensure that the budget includes any additional charges that arise from one month to the next.
Rent Increases Over Time
You may have a lease agreement where you know in advance that the rent will increase by a certain amount. The first year may be set at one rate, for example a 5 percent increase once you reach the end of that term. If, though, your lease runs from Aug. 1 to July 31, but your fiscal year is Jan. 1 to Dec. 31, you’ll deal with five months of higher rent, creating a disparity. Just as you would if you had received free months at the start of your lease, you’ll need to calculate the monthly rent based on the total of the entire year’s rent payments. This means at the start of each year, you’ll need to closely review your lease agreement to identify any possible increases that might go into effect during that year, then budget your monthly payments accordingly.
Why Businesses Use Deferred Rent Liability
A business’ budget shows its efforts to remain as cash-positive as possible throughout the year. The balance sheet will show assets – everything the business owns from its cash to its equipment and inventory – as well as liabilities, which include the many expenses that a business incurs in the course of doing business. The goal for any business is to show that its assets are strong enough to outweigh the many liabilities it will naturally accrue as it grows.
When rent fluctuates from one month to the next, it can be difficult to accurately determine what a business’ monthly liabilities actually are. Evening it out makes things more predictable. Perhaps even more advantageous is the fact that by straight-lining rent, businesses can take advantage of any deferments they’re getting throughout the year. So if a business is paying $1,000 a month, but gets three free months at the start, that business could deduct $3,000 from the total, then divide it out over that first year. This shows a monthly liability for rent that is significantly lower than it would have been without that discount. A business seeking funding or providing financials to shareholders could come out more positively thanks to this cheaper monthly cost.
What Is the Deferred Rent Calculation?
Calculating deferred rent requires a fairly straightforward formula that can be applied every year. As you’re determining next year’s budget, simply account for every cost that is related to rent for all twelve months. If your leasing agent doesn’t wrap all extra fees into one lump rent payment, add those up, as well. If you have a net-net lease, where you pay rent, property taxes and insurance premiums, add all of those taxes and premiums into your annual payments. So if you pay $1,000 a month for rent and $200 a month for taxes and insurance, multiply $1,200 by 12 to get your annual rent payments of $14,400. If, however, your landlord offered three months of rent free as a move-in incentive, deduct $3,000 from that total to get $11,400, then divide that figure by 12, which brings your monthly rent, insurance and property tax costs to $950, a notable reduction from the original $1,200 a month.
How Deferred Rent Works
When rent is waived for an initial period of time after move-in, your accounting team will treat it as a credit for bookkeeping purposes. So if you move in on Aug. 1 and your rent is free until Dec. 1, your accountants will, in essence, create a liability account and treat the unpaid rent as a credit into that account. When Dec. 1 arrives and you’re responsible for the full amount, part of that unpaid rent will be applied, along with the money you have calculated that you pay after the discount.
If your monthly rent is $1,000 and rent for the first three months is free, your rent is $12,000 for the year, but subtract $3,000, since the first three months are free. Your calculation says you’re paying $12,000 less $3,000, or $9,000, which divided by 12 is only $750 per month. But your landlord is expecting $1,000, not $750, so the extra $250 would come from that liability account your bookkeeper created back on Aug. 1. You’ll take $250 from that account each month for three months, then begin paying the full $1,000 out of your regular budget.
Full-Service Gross Leases
Fluctuations can actually be avoided in the way the lease is being negotiated. The most popular lease type is the full-service gross lease, also called modified gross or modified net. With this type of lease, the landlord and the tenant split operating expenses, which are then bundled into the monthly rent cost. This makes it easier to account for rent over the course of the lease term, since it will not go up or down as expenses change. You’ll still need to account for deferred rent if you’re given a free month or two at the start of your lease, but once you’re locked into a lease, you’ll be able to count on that monthly expense until the end of the term, when the amount may be increased if your landlord chooses.
One downside to a full-service gross lease is that if operating costs are lower than initially calculated, you won’t get a reduction from your rent for that. Unless your leasing agent is especially generous, you likely won’t even see a drop in your rent cost when you reach the end of your lease agreement. On the plus side, though, if costs suddenly increase over the course of the year, the amount you’re paying won’t go up. But it is likely your landlord will take a look at what you’ve been paying and increase the amount once the lease term is up.
Accounting for Short-Term and Long-Term Deferred Rent
Adding yet another level to this is the fact that rent deferments can be classified as either short- or long-term. In some instances, accountants divide rent payments into current and noncurrent expenses, since noncurrent rent amounts won’t be used within the budget period in question. In other words, anything you’ll pay next year is next year’s problem and thereby classified as a long-term expense. Because of this, you won’t include next year’s five-year rent increase when you’re making this year’s budget, even if you know it’s coming. Instead, divide the rent payments across 12 months based solely on what you’ll pay for the term of your budget.
Dealing With Increasing Rates
The best thing about closely monitoring rent payments on your balance sheet is that you're keeping a close watch on expenses. Base year expenses can easily fool you since most leases are set at a certain price for the first year to see if that covers everything. It isn’t unusual for tenants to see rent for commercial space increase in year two based solely on the fact that the first year’s operating expenses were higher than originally planned.
If you notice that your business’ rent increases significantly with your second-year lease, ask your landlord to show you a copy of those operating expenses. Preferably, you’ll get a breakdown of everything you’re paying on a monthly basis within that rent payment. You’re always free to take your office elsewhere, but moving can be costly. For that reason, it will benefit you to discuss with the landlord the possibility of negotiating the increase so you’ll still get a good rate.
Deferred Rent and Acquisitions
At some point in the life of a business, another company may make a purchase offer. If that offer is accepted, the accounting team of the acquiring company will want financials, since the buyer takes on all the assets and liabilities of the company it’s acquiring. When that happens, deferred rent amounts on the balance sheet can complicate things, especially if the terms of the lease mean that the rent will increase in later months. If that increase puts the rent above market rate, the acquiring company has a liability on its hands.
When such a liability appears in the budget, an acquiring company has a decision to make, which is often guided by the advice of the accounting team. In this case, it may be beneficial to move offices to a new location, even though it will cost money to move. The best thing to do is determine fair market rate and run a cost comparison, then present the information to the appropriate parties.